In a market-based economy the government makes its appearance when we have to deal with externalities.
“An externality is a situation in which the private costs or benefits to the producers or purchasers of a good or service differs from the total social costs or benefits entailed in its production and consumption. An externality exists whenever one individual's actions affect the well-being of another individual - whether for the better (positive externality) or for the worse (negative externality).”
(In this and next entries, I will keep the definitions in quotation marks because they are copied from The Economics of Seinfeld. Any other text literally copied, either from Wheelan's book or any other source, will be also referenced via quotation marks).
The market, left alone, will not fix the externalities so individuals find an incentive to do things that make them better off at the expense of others. Then, the government role becomes “crucial to deal with externalities": either negative such as mobile phones in public places or in the car, children in planes, dogs poops or barks, litter, obesity, global warming (with firms that do not pay all the cost for the polluted emissions thrown to atmosphere and their harmful effects that extend beyond borders); positive, like beautiful buildings that enhances city skyline, attract tourism and revitalize an area; or both in smoking, harmful for the smokers and close bystanders but beneficial, in the end, for non-smokers since smokers die earlier in average and don´t make use of social security and private pensions funds they have paid in advance.
Government deals with externalities via regulation (banning) or via taxes, called Pigovian taxes after the economist who first introduced the concept of economical externalities. The taxes offer a two-way to offset the difference between private cost and social cost. First, the higher cost discourages the demand and second the additional revenues may be invested either to mitigate negative effects or to reduce other taxes that provide incentives to invest in equivalent less intrusive products R&D. But as anything, nothing is perfect so taxes have an important hiccup, to measure the externality social cost that determines the right amount that compensates for the externality.
Sometimes the externalities situation is privately solved. Let's see how the Coase theorem illustrates the case: one party can pay the other to compensate a negative impact of an activity or vice versa if the utility of one maximizes the other party dis-utility. The property right would determine the payer (the activity practice or to avoid the annoyance). Coase states that “The private parties will always come to the same efficient solution (the one that makes the best use of the resources involved) regardless of which party starts out with the property right”. But to come to a deal “the transactions costs related must be reasonably low for the private parties”. Complex conflicts that involves many parties (I.e. global warming) can only be traded and tackled at a government level.
The government role is not limited to “fix the rough edges of capitalism” but also to establish the frame and the rules that allow the market economy flourish. They develop and sustain the institutions needed to support a market economy against corruption, softening and supporting legal issues and providing the confidence needed for private trading. Trickle-down economies (what a hideous term!) development is not possible without good governments and a “functional market economy” demands that:
- The government sets and protects property rights – this allows safety investments with “the confidence that the investments will belong to investors”. It includes properties, copyright, patents, etc. The pharmaceutical patents are one controvert example of property rights. There are many squabbles about what is more important, the social well-being (being life and death at stake) or to keep the cost charged for drugs that save lives. The cost you pay now for a new drug offsets the research and development costs (usually huge) needed to come up with the drug. If the companies were not able to recover such cost via patents it should be the government who would paid for the cost invested. Otherwise, the companies would not made R&D any longer.
Wheelan gives us many examples of negative effects of lack of property rights guarantees. One odd one is the few brick houses that are built in Indian reserves. Since the land belongs to the Indian nation, the banks do not concede real-state loans, the individual is not an owner. Most of the dwellings are either government financed or trailers that can be retrieved in case of default. Not to talk about negative externalities such as the less work and higher unemployment rate it entails.
- “Governments lower the cost of doing business in the private sector by providing uniform rules and regulations: contract law, rooting out of fraud, circulating a sound currency and infrastructures that increase productivity”. Even e-commerce lean on public infrastructure and regulation! The goods somebody purchases in a part of the world has to be distributed from its origin to destination.
- The government “provides a wide array of “public good”: basic research, law enforcement; parks and open spaces etc...” Public good is characterized by public availability, once it is available for one, it is available for many people at almost no cost. It is very difficult to avoid these other people from using it. Private sector can not afford the costs of free riders so it is the role of the government to cover such basic needs. Wheelan mentions some exceptions to the rule like Wikipedia, but is it such an exception? Lately, the web site is proving unsustainable and Jimmy Wales (Wikipedia founder) keeps asking for users donations to support the site and to avoid the use other private financing sources (advertising) that would change the Wikipedia selfless spirit.
Food for thought: fiber regulation in Spain (NeG blog: El riesgo regulatorio y la falta de desarrollo de fibra optica en España; 20/12/2010). Current regulation dissuades companies from investing in the optic-fiber infrastructure deployment since the last mile has to be shared against those interested in the exploitation. It gives incentives to free-rides to wait and to claim their right to use if it works. Besides, the costs are not regulated, private parties need to come to agreement. So, the network is underdeveloped in a country where a optic-fiber infrastructure is crucial for the country development and productivity growth. Here it could make sense a neutral provider (like Ofcom in UK, or Adif for railroad market) run by the government (but “we are in crisis” with public expenditures limited to a minimum...)
- “Government redistributes wealth”, levies income taxes and uses them to cover basic needs for all. When the government decides to invest on a business, it is “hurting” our pocket and jeopardizing other businesses that do not receive part of our payoff (this is what makes the economist Burton Malkiel to call it “fiscal drag”). On the other hand, incentives at stake, the tax may discourage work being at a “deadweight loss” (ie. Taxing incomes, we can decide stop working so both we and the government stop receiving incomes) or discourage investment in a trade-off between cost (short term benefit) and investment (long term wealth). The analysis of such impact gave birth to the “supply-side economists”. They advocate that “high tax rates discourage so much work and investment that cutting taxes will earn the government more revenue, not less” (In the 70´s, Robert Laffer tried to demonstrate it by what has been called the Laffer curve). In the long term what has been proved is that “lower marginal tax rates and regulation stimulate economic activity” but lower taxes always diminish government incomes, although the decrease may be partly offset by a bigger “pie”. Unlike other lively subjects, the economist don´t give a solution, but a frame, to this problem. Maximizing utility is not directly proportional to a higher global well-being but to relative wealth. The question is what is better? To increase the pie although unevenly distributed or to have a meager pie better distributed? It requests a philosophical or moral answer usually biased by the parties ideology. Liberal or social-democrats argue that government should guarantee the global well-being at the cost, if necessary, of further economical development. Conservatives would back all kind of policies that rush economical growth (tax cuts, government expenditures reduction etc..), a stronger economy make all of us better off. It is up to you to decide which is your best choice.
So many functions involve too much government intervention. Should the government also control individuals to anticipate and avoid their sometimes irrational decisions? Again, economists provide a frame because there is “good evidence that human decision making is prone to certain kind of errors, such as underestimating risk or planning poorly for the future”. Some would advocate for some “middle ground policies” based in the individuals inertia to act in a given way when an output does not involve a “proactive behavior on their part” (I.e.: opt-out versus opt-in organ donation policies in the different countries).
Having a good government makes a difference in market economies growth. The government deals with externalities, smooths the path for market transactions and provides the public goods we are not able to get by ourselves. Last week I was having lunch with some co-workers and we were discussing about why Spanish companies were not actively investing to shift some of their labor costs to developing countries specialized in this kind of global strategies (China, India, Brazil...). We came to the language barrier issue, so another question arose, why don´t we invest in Latin America countries with a cheaper labor cost? I came to one of the main conclusions of this chapter, many countries in that area do not offer the institutions, legal frame and guarantees that the private sector demands to invest.
But the government intervention is not always positive. Let's elaborate a little bit more on this.
As we have seen before, the government is in charge of basic goods developing. Here again, the investment can be done by observing market rules and competition (I.e.: bidding to get the best choice or venture capital firm in CIA to finance others companies investigation) or favoring contacts, pressure groups and monopolistic behavior. “When government controls some element of the economy, scarce resources are allocated by autocrats or bureaucrats or politicians rather than by market (in private sector, it is a market role)” and the economy and performance are underachieved. Wheelan suggests an odd example, Soviet Union did not consider birth control an economic priority so since no contraceptives were available, the abortion was the best alternative to avoid unwanted pregnancy. Abortion rates doubled birth rate because the rulers decided to show their power to the world and dedicated their resources to send the first rocket to space instead.
The way government controls resources can be via direct exploitation (monopolies) or via regulation (firms or enterprise licenses, hiring/firing regulation I.e. language barriers to jeopardize foreigners hiring; environmental control etc...).
Monopolies have proved to restrain market economy growth and “to stifle any need to be innovative or responsive to customers”, and government is a big monopoly. “Government should not be the sole provider of a good or service unless there is a compelling reason to believe that the private sector will fail in that role”. I.e: public health, national defense, etc... More subtle is the case for a public Postal Service. Initially, the government role was necessary to assure coverage in remote areas (as it was for telecommunication service) but now, private companies get that far so the government exploitation ownerships makes no further sense. Why does government still hold it? Because it has not a “huge economical cost” there is not too much pressure to change the status quo. The control of other sectors like “mines, banks, airlines...” and imperfect competition are more crucial for the country economy growth.
Regulation, even positive, have a cost. For example, in 2000, Indian government tried to issue a regulation to limit pollution in New Delhi. Many citizen´s rushed into the streets to protest against it since it implied many factories closure and people to be thrown out of work. Similar examples come to mind: also in India, when government tried to ban rickshaws because they made an attempt on human dignity but they didn´t offer an alternative work for drivers. Or a similar example in Madrid, with the prohibition of sandwich-boards. As we saw in the first entry of Naked economists, these people do not hold sandwich-boards because they are nuts but because they do not have a better alternative.
Other aspects to have into account:
- The way a regulation is implemented makes a difference (I.e.: regulation that limits scarce natural resources captures (I.e.: fish), the result is not the same if aggregated or if divided by "law" among the parties).
- “Firms and professional associations often seek regulation as a way of advancing their own interests if they can´t beat their competitors”.
- “Helping hand vs grabbing hand” or “to facilitate production vs to confiscate it”. Why registering and licensing a new business is tougher in poor countries (Vietnam, Mozambique, Egypt...) while safety and protection against corruption are not granted? Because in many countries, public work payoffs are meager and any fee is a “potential income source for the bureaucrats who enforce it”
- Excessive regulation may lead into the underground economy.
I am not going to finish with the summing up of a summary. Despite longer that expected, I hope to have already gotten the good and evil of government role straight. I will just end with a current issue in Spain: Intellectual Property Rights review in LES (Ley de Economía Sostenible) also called Ley Sinde after its main advocate in Government. It is basically a law to protect intellectual property rights against online piracy. A “Committee” would be given power enough to judge, close websites and punish providers and individuals they consider to have committed an act of piracy. The advocates defend that a judge has to enforce the Committee decision but the law was not so clear and was analyzed and perceived as an attempt not only to confiscate online contents but freedom in the end. Having said this, the law did not passed and the project is being overhauled.I agree that the government must protect the creators property rights, it is a public good, but the way the law is introduced can make a difference either to country progress or to oppress citizens and restrain economy growth in an environment where medium and long term prosperity depends on the web. Online business is a reality and creators must adapt to it. Do you remember “Creative destruction by Schumpeter”?
Time to close this chapter, please, don´t forget to watch The Chicken Roaster with Kramer's externality-benefits trade-off and The Pledge Drive with a curious example of a “public good”.
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