Last week we introduced the topic of government involvement in the economy. We noted Richard Musgrave’s well known model of analysis in which the three economic branches of government include the stability, allocation, and distribution functions.
Today we examine the allocation function which deals with government’s involvement in channeling resources in a manner which differs from that which the free market would choose.
What are some examples of the government rearranging the production of goods and services? When the Bush administration signed into law the Nutrition Labeling and Education Act (NLEA), requiring food producers to list on their packaging certain nutritional data, consumers used their new information to choose a different diet. This changed the food industry in a number of ways.
When local governments hire workers to build roads and water systems, they redirect workers from other types of employment to those projects. The federal government has an extensive system of workers and payroll tax funding which provides unemployment insurance for our labor force. The private sector will not offer unemployment insurance. As such, without the public insurance, those government workers would be employed in a different capacity, and the payroll taxes would be spent on other goods and services.
The government builds and staffs public schools. If education were left to the private sector, far fewer schools would be available. Many current teachers would be doing completely different work. When the Environmental Protection Agency implements air pollution standards, certain manufacturing is altered and reduced.
When the government hires hundreds of thousands of military personnel, they take these men and women away from alternative activities to provide national security for the country.
Finally, when the government lowers interest rates, it tilts the economy toward the production of such goods as houses and automobiles, which are typically financed with borrowed money.
Each of these government intrusions into the economy alters the path of production and consumption. They are examples of the allocation branch of the economic government. They also have another thing in common which we will see in a moment.
First we need a quick lesson in micro theory.
Economic students often receive their earliest training by studying the model of perfect competition. This stylized paradigm, while severely limited in many regards, gives a number of insights into the workings of production, value, consumer preferences, exchange, and, especially, efficiency. Under certain conditions, the competitive market model can be shown, through mathematical proof, to deliver “economic efficiency.”
What is economic efficiency? When economists speak of efficiency or optimality they are usually referring to “Pareto efficiency,” named for the Italian mathematician, Vilfredo Pareto.
Pareto optimality occurs when a particular arrangement of resources, production, and consumption yields the blessed result that no individual can be made better off without making someone else worse off.
While Pareto optimality may not sound very remarkable, it is actually quite a trick to establish such a situation in a complex economy. If a competitive market model delivers such a worthwhile outcome, why would democratic societies ever choose to employ a government to reallocate resources and the means of production? The answer is simple. The competitive model is just a model. Free markets, as they exist in the real world, do not generate a model of perfect competition. Free markets cannot deliver Pareto optimal efficiency.
Free markets are not the same thing as competitive markets. Let me say that again. Free markets are not the same thing as competitive markets.
Why not? The model of perfect competition has certain assumptions or conditions which insure the happy economic efficiency. In the actual world in which we live, many free markets, by their nature, violate the assumptions required for pure competition. When they do, market failures arise which can be, and often are, improved by public intervention.
What are the assumptions of pure competition which give rise to market failures, and what are the types of failures we commonly see? Public sector economists have identified and studied at least six types of market failures which arise from five broad violations of the competitive market paradigm. We will briefly breeze through a broad brush overview of these, with greater examination in future weeks.
First, pure competition requires symmetric information on the part of producers and consumers. When one has more information than the other we find an informational market failure. The NLEA of 1990 was designed to correct just such a situation arising around nutrition.
Second, the competitive model assumes that all buyers and sellers are too small to effect the price of any good or service. In other words, all economic participants are price takers and not price makers. In the real world certain products actually become monopolies. Roads and utilities are among the goods which are not logistically suitable for competition. They are natural monopolies. Such goods represent the market failure of monopolies.
Third, perfect competition assumes that the transaction costs of creating and selling a good or service is negligible. When transaction costs are high, the private sector may not offer a service even though the public would be willing to pay more for it than its actual cost. This type of situation is called a market failure of incomplete markets. Unemployment insurance is one example of this.
Fourth, the stylized competitive paradigm postulates that property rights can be assigned to everything in the economy and these properties can, in turn, be controlled. Yet many things such as the air we breathe, the intelligence we acquire, and the local or national protection cannot be individually owned and controlled.
When property rights break down, we often see two types of market failures. One type arises from “externalities” or byproducts of a good. Pollution is a negative externality. Education carries with it a positive externality. In both cases, free markets will come up with a suboptimal allocation of resources when externalities arise.
Another type of market failure, which is manifested through incomplete property rights concerns “public goods.” These are goods when, once produced, cannot be kept from others. National defense is a good example. Once we hire an army, everyone receives the benefit. As such, free markets will not produce these types of goods.
Finally, pure competition assumes that there is a perfect market clearing mechanism in place so that all resources are utilized effectively. Unfortunately, in real life we experience booms and busts, deflation and inflation, excess and waste. This points to the stability market failure. Government action through interest rate and spending policies can redirect idle resources into productive use when the free markets stumble after a binge of irrational exuberance.
By now you may feel as though you have just taken a drink from a fire hydrant. You have. But with this broad-brush picture, it can now be seen that each of those allocation examples at the beginning of the column also shares one other commonality. Each is a public response to a free market failure which arises from real world violations of the model of pure competition.
Next week we will take a closer look at these market failures one by one with the pros and cons of addressing them publicly.
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
