Government directly provides some goods, and indirectly channels resources into the production and consumption of other goods via taxes and regulations. As we enter the twenty-first century, our society is more regulated and taxed than when economic policies followed a more laissez-faire philosophy: Federal, state, and local governments now directly allocate roughly one fifth of national production; another 15 percent is redistributed through transfer payments, with two-thirds of all transfers being made by the federal government. Transfer payments include welfare outlays, loans to farmers and students, and similar expenditures. Figure 11 illustrates some facets of the size and recent growth of total government activity.
Figure 11 The Growth of Government Outlays
Many people see government action as necessary whenever markets apparently fail to respond to our desires for equity, efficiency, full employment, stable prices, and prosperous growth. Widely accepted economic goals for government in a market economy are:
1. to provide a stable legal environment for business activity;
2. to promote and maintain competitive markets;
3. to allocate resources to meet public wants efficiently;
4. to facilitate equity through redistributions of income; and,
5. to ensure full employment, a stable price level, economic security, and a growing standard of living.
Although macroeconomic and microeconomic policies are unavoidably intertwined, goals 1-4 tend to be microeconomic concerns, while goal 5 is the focus of macroeconomic policymaking.
Providing a Stable Legal Environment
A reasonably certain legal environment helps prevent chaos. Could any system operate efficiently if ownership rights or the rules of business were uncertain? Property rights or contracts, if they existed, would be enforced only through brute force or individual persuasion. Primitive trading could occur, but complex financial transactions–especially those involving time–would be impossible.
In a market economy, government establishes rules about legal relationships between parties, sets standards for money and weights and measures, sometimes insures bank deposits, and engages in other activities intended to promote the public welfare.
Competition allows us to enjoy the benefits of efficient markets. Profits signal that consumers want more of certain goods; losses signal that too much is being offered. New technologies that create better and cheaper products force older firms to adapt or perish. Thus, hand-cranked autos don't clog our highways and motor-driven calculators don't clutter our desks.
Monopoly lies at the opposite end of the spectrum of market structures from competition, and occurs when a single firm dominates a market.
Market power (also known as monopoly power) exists whenever individual firms significantly influence the supply and price of a good, and may be present even if several firms share a market.
In contrast, competitive buyers and sellers are each so small relative to the entire market that, alone, none can noticeably affect total output or prices. Firms with market power boost profits by restricting output and setting higher prices. This is inefficient because equilibrium monopoly prices exceed the opportunity cost to society of additional production.
The basic approach to controlling monopoly power in the United States has been through antitrust laws and regulation. Antitrust laws attempt to curb unfair business practices and prevent huge firms from absorbing all their competitors. Where competition is impractical (e.g., electricity and natural gas companies), regulation is used to limit the abuse of monopoly power.
Providing for Public Wants
No private firm could sell you a cleaner environment without simultaneously providing it for your neighbors. Nor could a neighbor privately buy national defense without protecting you. Because no individual willingly bears the costs of adequately accommodating everyone's desires for goods of these types, price signals emitted by consumers are distorted and firms cannot privately market these goods profitably.
Even if firms operate in a stable and competitive environment, certain market failures may still seem to justify government action. Externalities, of which pollution is one form, can warp price signals so that our demands are not accurately reflected. A difficulty called the public goods problem results when shared consumption is possible but people cannot be denied access to the benefits of a good. National defense is an example.
Externalities occur when some benefits or costs of an activity spill over to parties not directly involved in the activity. For example, when farmers spray their crops, some pesticide may eventually wash into nearby lakes or streams. If the pesticide is absorbed by microorganisms and works its way up the ecological chain, your fishing or health may deteriorate so that you partially bear the cost of the use of chemical sprays. Most human activities generate externalities, some trivial and some of major concern. Internet users tie up phone lines, indoor plumbing fouls the water, cars emit noxious fumes, and loud stereos annoy your neighbors. All forms of pollution–chemical, air, noise, and litter–are negative externalities.
Producers who generate negative externalities tend to ignore costs imposed on others, and the prices they charge reflect only their private costs. Pollution-generating goods consequently tend to be overproduced and underpriced. The government uses regulation to limit various pollutants because a total ban on pollution would probably eliminate all production. There are trade-offs between the cleaner environment most of us would like and the higher consumption levels most of us desire.
Inefficiency may also occur when positive externalities spill over from an activity. Immunization against contagious diseases is an example. You are less likely to suffer from the flu if you are inoculated, and your neighbors are less likely to catch it as well. But you tend to ignore our benefits when you decide whether or not to be immunized, and so are less likely to get a flu shot than is socially optimal. Thus, private decisions result in underproduction and overpricing of goods that generate positive externalities because the value to society exceeds the demand price individuals willingly pay when they are uncompensated for external benefits.
Keeping violent criminals behind bars makes the world more secure for the rest of us, so the safety a prison system provides to society is an example of a public good. Public goods are both nonrival because numerous people can consume the same unit of such a good simultaneously, and nonexclusive, because denying access to such goods is prohibitively expensive. Most goods are private goods. If you eat a corn chip laden with guacamole, no one else can enjoy that particular morsel–such private goods as food, raincoats, or shaving cream are rival and exclusive.
But we need not compete with each other to use public goods once they are produced because their use does not involve rivalry. Most cities would suffer terminal gridlock without traffic lights, which smooth traffic flows and cut accident rates. All drivers benefit simultaneously. Other public goods include research on such things as weather or cancer, democratic government, and national defense. Once the armed forces are maintained and ready, every person in the United States consumes defense services simultaneously, and we all receive this protection whether we pay (through taxes) or not, and whether we want it or not!
Public goods cannot be privately and profitably marketed to efficiently service our collective demands for them. A few people might contribute funds for a nonrival good from which exclusion was impossible, but not enough for efficient provision. There is little incentive to reveal your demands for police protection, space exploration, spraying against mosquitoes, landscaping along a public highway, or maintaining courts and prisons if you will be taxed accordingly. Why not be a "free-rider?" Private firms could not adequately market such services, so government provides a variety of public goods and forces us to pay for them through taxes.
Public provision does not, however, require public production. For example, NASA space probes use equipment built by private firms. Alan Shepard, the first American in space, reported that the last thought that flashed through his mind before his rocket was launched was that it was made of millions of parts, "...all built by the lowest bidder."
Impersonal market mechanisms yield distributions of income and wealth that many view as inequitable. Goods are channeled to those who own valuable resources, whether they "need" them or not. And how valuable a resource is depends on demand. World class ping-pong players usually need a day job in the United States, while equally skilled baseball players are millionaires.
Most people are distressed by the suffering of those who live in abject poverty and, if they are modestly prosperous, will donate to charities to help starving children or the unfortunate poor. But private charity may be inadequate to fulfill society's collective desire for equity because "curing poverty" is a public good–I may not donate if your charitable contribution makes me more comfortable when thinking about the poor. This leads to such government programs as welfare and disaster relief.
Stabilizing Income, Prices, and Employment
Markets systems may lack strong natural mechanisms that consistently yield full employment without inflation. In fact, wide swings in economic activity, called business cycles, may be a natural tendency in market economies. Employment and the price level fluctuate during business cycles, dislocating workers, firms, and consumers, and generally disrupting our institutions.
Shortly after World War II, Congress stated some general goals in the Employment Act of 1946:
The Congress hereby declares that it is the continuing policy and responsibility of the federal government to ... promote maximum employment, production, and purchasing power.
The major tools government uses to try to achieve these macroeconomic goals include variations in taxes, government spending, and the supply of money.
International policies also have macroeconomic ramifications. Throughout the world, governments are reducing trade barriers to hasten economic growth and hold down price levels– international trade fosters growth because of incentives to allocate resources more efficiently allocated, and consumers will not buy imports unless they judge the imports to be lower priced or possessing superior quality. However, in the short run, freer trade may worsen unemployment because labor needs to flow towards domestic industries that are internationally competitive, and away from industries producing at comparative disadvantages relative to foreign producers–another example of how government faces trade-offs in the pursuit of its goals.