Unit 12: Markets and Public Good

Jim’s Guide for Unit 12: Markets, the Public Good, and Society

Are Free Markets Enough?

So far in this course we have focused on private markets.  That is, we’ve looked at situations where private individuals, households and firms, buy and sell from each other in markets.  In the units on consumer choice and how firms maximize profits we discussed and analyzed how both consumers and firms are motivated by maximizing utility and profits.  Of course, they are interested in maximizing their own profits or utility. Yet, we also saw that if markets are competitive, then all this private, self-interested maximizing behavior actually results socially desirable results.  Competitive free markets will result in efficient production and efficient distribution. Given that society has scarce resources, this efficiency is a very good thing for society.  Also, we saw from the production possibilities curve analysis that when people specialize and trade in markets, we are all able to have a higher standard of living than is otherwise possible.

The story sounds very good: markets produce great results. Indeed, many people, both politicians and some economists, maintain that the ideal society would handle everything through private free markets.  These people suggest that government can only  make things worse.  At first glance the study of markets might lead us to similar conclusion.  After all, in an earlier unit on markets, we did discuss what happens when government attempts to interfere with markets by creating price floors, price ceilings, or quotas.  We concluded at that point that government involvement in markets through price/quota controls results in  unattractive outcomes: surpluses, or shortages, or undeserved profits and high prices, or a host of other problems.  However, a view that says there is no role useful role for government is very one-sided and incomplete. We now set out in this unit to remedy this.

In this unit, we start to look closer at the government and markets. In this unit have two main objectives: First, to understand why it is necessary for government to sometimes interfere with the market and establish certain “rules”. In other words, we want to look at situations where an unregulated free market may not achieve outcomes that are optimal or consistent with the public good and why government action is an alternative. Our second objective is to understand why, despite the need, democratically elected representative governments (such as the US and most Western nations have) may not always work for the public good.

Why Involve Government in Markets

There are at least five reasons why government action may be needed to help markets achieve optimal outcomes.  The first two reasons have to do making sure that markets actually function well.  We won’t spend much time in the textbook on studying these two reasons here but I’ll list them anyway.

    1. Enforce contracts and the “rules of the game”.  At the very beginning of the course we suggested that there was a role for government to “establish the rules of the game”.  This is the first reason for government involvement with markets.  Essentially this involves government providing the mechanism to enforce and adjudicate contracts and disputes, and also to provide a useful legal tender or money.  Markets only work when buyers and sellers trust each other to deliver on their promises.   A court system, backed up by the authority of the state, is necessary to make sure that contracts are indeed enforced.
    2. Ensure markets are competitive. As we say when we studied monopoly, the outcomes of a monopoly are not in society’s interest. The monopolist gets rich at the expense of consumers.  The monopolist produces inefficiently and charges too high of a price.  Unfortunately, some industries are prone to monopoly due to the economies of scale that go with current technology.  It takes government to establish rule that either prevent monopolies, break-up existing harmful monopolies, or regulate the behavior of  a monopolist.  Much of this area involves the subjects of “anti-trust” and “monopoly regulation”.  These are interesting topics and your textbook has a chapter on them.  Unfortunately we do not have time here to discuss it.

This leaves us with three reasons for government involvement that we will study closely in this unit.  These units are a little less obvious than the two just listed.  These are externalities, public goods, and income/wealth inequality.

Externalities, Positive and Negative

If you sell me something, you and I are the people who negotiate the price.  The way free markets work, I will agree to the deal if I think it’s in my own self-interest (profit or utility) to do so.  Likewise, you will only agree to the deal if you think you’ll be better off after doing so.  For a market to reach the socially optimal decisions, all of the benefits and costs of the transaction need to be experienced by the seller and buyer, you and I.  But suppose for a moment that there’s a third-party (let’s call him Fred) that will be strongly affected by whether you and I strike a deal.  But Fred has no say in the deal or the price.  In this situation we say that Fred experiences an externality. There are benefits or costs to our proposed transaction that are external to you and I — they occur to Fred.

Positive Externalities

Externalities can be either negative (harmful) or positive (beneficial). Let’s look first at a simple beneficial externality.  Suppose I own a just bone-ugly house that has peeling paint and damaged siding (I don’t, by the way, but just suppose I did).  Let’s further suppose that you are siding-replacement contractor.  We negotiate a proposed deal.  You look at your costs, competitive pricing, the profit potential, and offer me a price to replace my siding.  I consider your proposed price and what the new siding would do for me.  New siding would look nice (increase my utility when I come home) and it would increase the value of my home (profit for me).  Suppose I decide that while it would have benefits, the benefits just aren’t quite enough to justify spending my hard-earned money on it.  I decide not to buy your siding.  Now consider poor Fred, my next-door neighbor.  He would have benefitted greatly if I had gotten the new siding – he, too, would have increased utility (he actually sees my house exterior more than me!) and his house value would most likely also have increased, as would all the other houses in the neighborhood.  Yet, Fred’s potential benefit never got considered in the decision of whether or not purchase and install the siding.  As a result,  a less-than-socially optimal outcome resulted: no siding.  Had Fred’s benefits been considered in addition to my benefits and then weighed against the costs (purchase price), a different decision may have occurred.  Granted this is a simple small example of a beneficial externality.  But there are widespread beneficial externalities throughout the economy:  R&D, new inventions, neighborhood improvements, community services, etc.  To the degree positive externalities exist, a free market will result in a less-than-optimal smaller quantity.

Negative Externalities

Negative externalities may also exist.  A negative externality is when the third-party, the one who has no say in the transaction, will be harmed by the transaction happening.  Pollution and environmental damage is the classical example of a negative externality, although it is by no means the only situation where negative externalities exist.  You buy products in the market.  Like all consumers, you compare the marginal benefits of consuming the product to the marginal cost of acquiring the product.  You assume that the price offered by the seller must reflect all of the costs of producing that product – after all, what producer would deliberately price below their cost of production and lose money?  But suppose that the manufacturer of the product was able to obtain some critical, scarce, costly resources (inputs to manufacturing) for free?  These scarce resources would not be part of the manufacturer’s costs.  The manufacturer wouldn’t consider them when calculating costs, prices, and profits.  As a result, the manufacturer would offer you a lower price than what the real true cost of all the inputs would suggest. You look at the lower price and end up buying a larger quantity than you would if the price reflected the cost of all inputs.  So what might these “free” scarce resources be?  Inputs like clean air, clean water, and a healthy environment.  Suppose the manufacturer is able to use clean air as part of manufacturing process (to run furnaces, burn fuel, etc) and then simply returns dirty air to the environment without cleaning it up or paying for it.  In this case a critical input, clean air, would not be reflected in the cost and pricing of the product.  You and other consumers would buy more of the product than you would if the cost of environmental degradation were accounted for.  You and the product purchasers benefit. The firm benefits. But everybody else has to breathe the dirty air and they had no say in whether or how much of this dirty product should be produced.  Everybody else would experience a negative externality.  Negative externalities result in less-than-optimal larger quantity of some product.

When externalities exist, a role for government exists to attempt to remedy the situation.  There are many approaches a government can take to remedy an externality.  They can regulate either quantities (quotas) or prices to attempt to alter the market equilibrium outcome to more accurately reflect the externalities.  They may attempt to tax products or behavior in an attempt to make prices reflect the negative externality.  Another approach is to try to establish a property right in the resource that isn’t priced properly.  For example, former Vice-President Al Gore and others have proposed to establish rights to emit carbon dioxide and then sell these rights to businesses as a way to combat climate change.  The idea is that by having to purchase a “right to emit” CO2, firms will now consider their carbon footprint and emissions in their product costing and pricing, resulting in market product prices that better reflect the resources used (our environment). Yet another approach for government is to simply prohibit or to limit particular behaviors or to require other specific behaviors. For example, many communities have laws that require homeowners to mow the lawn and maintain the appearance of their property.  This is an attempt to force behaviors that might not otherwise happen because there are positive externalities.

In this course, I am not concerned with getting into detail about the pros and cons of all the different approaches government may take to address externalities.  I am concerned that you understand what externalities are and why they might require government involvement.

Public Goods – Markets Don’t Provide Enough of Them

Public goods are somewhat similar to goods that have positive externalities but are slightly different.  First, you need to know that not all goods provided by government are public goods. Nor, are all public goods necessarily provided by government.

Nonexcludable Goods

Suppose you want to produce some good and sell it.  You are profit-maximizing firm.  I am an interested buyer.  I like your product, enjoy consuming it, and want it.  I agree to buy it.  Fine, we’re both happy.  But suppose you have some fixed costs involved in producing the good – you need more than just me to buy it. You need lots of customers.  Indeed, your business plan counts on being able to sell to me, my neighbor, and lots of other people.  So far this sounds like most normal situations for most normal, private goods.  But suppose, the nature of the product or good was such that if I buy it, then everybody else necessarily gets the benefit, even though they don’t pay for it. You have no way to keep them from enjoying the benefits of the good even though they didn’t pay for it. Such a good is called nonexcludable.  You, the seller or producer, have no way to exclude people who didn’t pay for it from enjoying the benefit of it.  Nonexcludable goods often include broad service such as police protection, national defense, or even parks. Consider the situation of a small park owned and maintained by a city. In effect, the taxpayers of the city pay for the park.  Yet, it is impractical to limit the use or enjoyment of the park to only taxpayers only.  Any member of the public can stop and sit on the park bench, enjoy the trees, or otherwise play.

Nonexcludable goods lead to what we call the free-rider problem.  The people who didn’t pay get the benefit anyway. They “free-ride” on the goods produced and purchased by others.  If you have ever had class that involved a group project for a group grade, you may have probably experienced the free-rider problem.  You may even have been the free-rider yourself (but we won’t talk about that, will we).  As you know, in a group project for a group grade, there is a tendency for some group members to do more of the work (incur the costs) than the others. Yet all the members get the same grade.  At the extreme, it is possible for 1 or 2 members to do all the work, earn a good grade, and a 3rd member to do nothing (incur no cost), and yet all three members benefits from the group’s good grade.  The 3rd member was “free-riding” on the efforts of the first two.  Free-riding situations generally strike most people as unfair, although the free-rider generally thinks of it as “great deal” or “just being clever”.  Either way, free-riding and nonexcludable goods lead to less-than-optimal market outcomes.  Why?  Because the seller/producer isn’t given the right signals in prices and quantities about how much to produce.  The free-riders benefit, but don’t contribute.  As a consequence, the seller/producer tends to produce too little.

Nonrivalrous Goods

Another aspect of public goods is that they are also nonrivalrous.  “Nonrivalrous” sounds complicated, but it’s really not.  If you  consume a product and that keeps me from consuming that same exact unit of that good, then the good is rivalrous.  For example, if you eat that lovely chocolate-covered doughnut, then I cannot eat that same doughnut.  The doughnut is rivalrous in consumption.  But consider what happens when we move from the world of tangible physical objects (like doughnuts) to intangible goods.  Consider ideas.  Suppose I have a recipe for the world’s most delicious chocolate doughnut. The recipe is an idea, a chunk of knowledge. It’s also a secret. Only I know the recipe.  Clearly I can benefit from having this good, the recipe. Now suppose I share this idea with you (makes no difference whether you pay me or not).  After I share the idea (recipe) with you I can still fully enjoy the benefits of the idea. I can make the world’s most delicious doughnut. But now you can also benefit from the idea.  You can now make the most delicious doughnut in the world.  But the fact that you can now benefit from having the good does not in any way diminish my ability to continue to enjoy the same good.  The idea or recipe for the doughnut is a nonrivalrous good.  The doughnut itself may be rivalrous – only one of us can eat it.  But the knowledge of how to make the doughnut is nonrivalrous – there’s no reason we both can’t benefit from it at the same time.

Music: Copyright, file-sharing, and so-called “piracy”.

The major music studios, represented by the RIAA, have made a big deal about what they call “music piracy”.  But, actually it’s more properly called file-sharing.  It’s when I have some digital music files (MP3’s) that are copyrighted, but then I provide a copy to you.  I still retain the old file and can continue to enjoy the music, but now you can also enjoy the music. The studios have called this behavior “theft” and “piracy”. They’ve actually sued hundreds of people for this alleged “piracy”. But it’s not really “theft” or “piracy”.  Piracy and theft require that the good be rivalrous.  In other words, if I have something that is exclusively mine and you steal it, then I cannot have it.  If I still have the good after you obtain it, then you haven’t stolen anything from me.  Because the resource cost of an additional copy of a digital MP3 file is so infinitesimally small, file-sharing has effectively made recorded music into a nonrivalrous good.  If you steal my Compact Disc of The Who’s Quadrophenia album, you have definitely stolen something because you have it, I wouldn’t, and I wouldn’t be able to play it. (you would also, BTW, incur enormous wrath from your instructor).  But, if you obtain a digital MP3 copy of my Quadrophenia album MP3 file, then I still have my copy and can still play it.

WARNING:  Just because file-sharing isn’t really “piracy” or “theft”, it’s still illegal unless the usage falls under a certain number of “fair use” applications..  The catch is that it violates copyright laws which are government-granted monopolies.  That’s actually what the music studios sue over.  But they publicly claim it’s “piracy” and “theft” in order to try to make the public sympathetic.  When the studios claim that somebody has “stolen” or “pirated” their music it sounds more offensive and makes the studio sound like the victim.  It certainly sounds different when it’s properly described as “suing to obtain my government-granted monopoly profits”.

The Challenge of Public Goods

When goods are both nonexcludable and nonrivalrous, they are definitely public goods.  A private free market will not provide enough or the right incentives for such goods and will not provide enough of these goods.  The entire society suffers. In response, government usually has to find a way to pay for these goods or to ensure the provision of these goods.  Sometimes, government taxes people and provides the goods itself.  Examples of government-provided public goods include parks, police and fire services, national defense, product safety regulation, and basic research.  Research, experimentation, and knowledge-creation are important and often-overlooked public goods that pay out with great positive externalities in the form of future economic development. Most major technologies have their original roots in some kind of government funded or subsidized research at some point in the past.

Also, many goods are not necessarily public goods, but from a practical standpoint must be.  For example road, highways, and other transportation/communication infrastructure.  Theoretically, we could make all roads toll-roads and pay for them by charging only those people who use them.  It wouldn’t be practical.  Imagine having to pay a nickel toll just to turn onto the street where you live.  With roads and highways, we let government provide the goods.  taxes pay for the roads. We do attempt to structure the tax so that people who use roads more pay more, and those who use them less pay less. That’s one reason we tax gasoline to pay for roads.  The assumption is that anyone using more gasoline is likely using the roads more.

This role of government in the provision of public goods is often overlooked or ignored by those that are opposed to government period.  Often such people are not aware of either history or how all of us can benefit from such public goods spending.  For example, many people realize that the US would not have been settled or grown as rich or prosperous as it is without the help of railroads in the 19th and 20th centuries.  Yet few people realize that virtually every railroad in the US was started with at least a subsidy from either the national, state, or local government.  Left to a purely private free market, railroads certainly wouldn’t have developed when they did, might not have happened at all, and the US certainly would have been poorer.

Income and Wealth Inequality

When we studied the unit on factor markets, we observed that if firms are profit-maximizers, they will hire until marginal revenue product equals marginal resource cost (MRP=MRC).  If labor markets are competitive (a huge “if”, really), then it means that markets will direct workers to where they are needed most. Further, this model suggests that workers will get paid the value of their marginal contribution to productivity.  In simpler words, the market will make sure workers get paid for what they contribute at the margin.  Again, this initially sounds like a big endorsement and reason for having free markets direct resources and labor.  To an extent it is.  It implies that workers will get paid what they contribute and therefore if people want to live better/have more stuff, they should work harder and contribute more.  [note this is an argument often made by those who already get paid high incomes or who hope to soon be one of those].  It’s only a short leap from this statement to concluding that if some people are richer they deserve it and vice versa.

But there are problems with this view.  First, labor markets are not competitive.  Labor markets and incomes also depend on education and educational opportunities are not equitably distributed.  Some people work hard but because of lack of opportunity simply cannot achieve higher incomes.  On the other hand, other people are born into fortunate circumstances and get high incomes even without having to really work hard or contribute a lot.  Government can play a big role in ensuring at least equal opportunity.

A second problem is that free private markets may achieve an efficient equilibrium, but there are multiple possible “efficient” equilibria.  In technical terms, the outcomes in terms of how much money you make, or how much wealth you get, depend upon what you (or your parents, assuming they liked you) started with.  Effort alone is not enough.  The proof of this is a little beyond the scope of this course, but it was part of the work that earned Ken Arrow and Gerard Debreu the Nobel prize in economics.  In simpler terms, it means  that just because somebody is richer than you doesn’t mean that they contributed more to our economy or our social well-being.  It may simply mean they had a head-start: more wealth to start with, more educational opportunities, more family support, etc.

Governments have a role in correcting these outcomes, but they have to do balancing job.  Governments can re-distribute income, meaning take income away from high-earners (via taxes) and distribute income, benefits, or opportunities to lower-income people.  If government doesn’t do any redistribution of income, the experience of market economies is that income  inequality gets worse and worse –  the rich keep getting richer and the poor poorer.  Eventually societies that have too much concentration of income/wealth among a narrow elite will grow slowly or possibly end in revolution.  On the other hand, if government over-does redistribution of income, they weaken the market incentives to invest and provide labor.

The experience of the US has been varied.  During the period 1890-1930’s, income distribution in the US became more unequal.  Then programs established in the Great Depression saw a reversal.  From the 1930’s until approximately 1980 income in the US  became more equal (not equal – just more towards equal).  In other words, the middle class and poorer classes saw rising real incomes during this period.  Rich people’s incomes also grew, just not as fast.  Since 1980, however, things have reversed again.  There has been a pronounced trend towards more inequality.  The rich are definitely getting richer, both in absolute terms and in relative terms.  In contrast, the middle-income groups in the US have seen stagnant real incomes for the last 35 years.  Poorer people, the lowest 20%ile of all households,have seen declining real incomes.  The gap between rich and poor has become bigger.

How Government Really Works: Public Choice Theory

Now that we have established some of the reasons why government involvement is needed to correct failures or inadequacies of free markets, let’s look take a brief look at how government itself makes decisions.  Warning, this is not your high-school civics class lesson on government.  This is more of “the real inside story” explanation of why government often gets it wrong. In particular we focus on trying to explain two aspects of most elected representative governments, the so-called democratic republics:

    1. Why do so many eligible voters choose NOT to vote?
    2. Why do elected governments often respond more to special interests than to the broad interests of all voters?

The Rationally Ignorant Voter

Both of these observed behaviors can be explained as rational using micro-economic optimization models.  In other words, voters choose not to vote because it is rational not to do so. If we assume that voters are people who are maximizing their utility throughout life, we can examine the marginal benefits and marginal costs of voting.  Oftentimes, looked at this way, it’s hard to justify making the effort and spending the time to vote.  To explain why voting turnout is so weak, it is not necessary to accuse non-voters of being apathetic or lazy.  They may be making an optimal use of their time by not voting.  Indeed, after looking at voting as an economic activity, you may wonder why so many people actually do vote.

The Special Interest Effect

Elected officials often enact policies that benefit some narrow group of people at the expense of the general public good.  For example, in the case of agricultural products, the food you and I buy could be a lot cheaper if governments didn’t enforce farm price supports, quotas, price floors and other programs.  With over 300 million of us all eating in this country the savings would be dramatic.  Clearly, the overall social or public benefit would be to end the programs.  Not only would food be cheaper, but the government wouldn’t have to tax us as much.  But a relatively small number of people would suffer: some farmers and food processing corporations.  So why don’t elected representatives opt for the greater good?  The answer is special interest politics.  It is not necessary to appeal to incompetence or corruption as explanations.  It is in the nature of the issue.  Elected officials respond to the “squeaky wheel” – those groups who are politically active and noisy.  Officials don’t respond to pleas or demands that are never expressed to them.  Those people who stand to benefit from special interest legislation, the food processing corporations for example, stand to greatly benefit.  It is profitable and worth their time/effort to lobby the legislators.  On the other hand, you might stand to lose from the proposed special interest legislation.  Yet you stand to only lose a little from any particular law.  The harm/benefit is not worth the cost of time and effort to let the lawmakers know how you feel.  Result:  the elected officials respond to the noisy lobbyists, not the broader public interest.

What’s Next

In the next unit we will examine an area where special interests are very powerful: international trade.  We will look at why free trade makes sense in theory, but seems so hard to achieve in practice.

To finish this unit, be sure to:

  1. Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
  2. Take a look at any tutorials, videos, or articles in Closer Look
  3. Try the practice quiz
  4. Complete the Graded assignments in your school’s Learning Management System