How should the U.S. government carry out its economic roles?
Government’s involvement in the economy takes many forms, from filling potholes to regulating alcohol to enforcing business contracts to inspecting oceangoing vessels. But most of what government does, it does for two basic reasons. The first is to protect individuals in the economy. The second is to make markets – and thus the economy – work better. This second reason is why government intervenes to correct two forms of market failure: externalities and public goods.
Externalities are spillover effects resulting from production or consumption. They are costs or benefits that affect someone other than the producer or consumer of a good or service.
Externalities can be negative or positive. Air pollution and secondhand smoke, for example, are negative externalities associated with driving and smoking. Without government intervention, such negative externalities can cause great, even if unintended, harm.
Governments can be equally helpful in promoting activities that have positive externalities. Immunizations, for example, prevent individuals from getting harmful diseases. They also prevent individuals from spreading those diseases to others – a positive externality. To encourage immunization, state governments require children to receive vaccinations against common diseases before enrolling in public school.
Goods and services that generate positive externalities tend to be underproduced relative to their benefits. Higher education is a prime example. People who graduate from college gain the benefit of greater earnings. However, education also benefits society by creating a more productive workforce. To support this positive externality, federal and state governments allocate resources to education. They do this through subsidies and public provision, which means providing the education itself.
Subsidies. The government subsidizes both the consumers and the producers of education. It gives subsidies to college students in the form of grants, which do not have to be repaid, and low-interest loans. It also gives grants to schools, colleges, and universities.
Vouchers Vouchers are another form of subsidy. A voucher is a coupon to be used to purchase a specific good or service. Some state and local governments provide school vouchers to low-income families to help them send their children to private schools.
Public provision. If a positive externality is large enough, the government may choose to finance the production of a good or service itself. In the field of higher education, federal and state governments provide most of the revenue needed to support public colleges and universities. Other examples of public provision are the U.S. Postal Service and federal air traffic control systems.
One of the most widespread and troubling side effects of both production and consumption is environmental pollution. Governments can seek to limit this externality in two ways – through command-and control policies and through market-based policies.
Command-and-control policies. The term command and control comes from the military and refers to the use of authority by a commanding officer to accomplish a mission. The commander exercises authority by issuing orders that others are expected to obey. As one writer puts it, “the idea is that people do what you tell them to do, and if they don’t, you yell at them until they do, and if they still don’t, you throw them in the brig for a while.” Regulatory agencies that adopt command-and-control policies follow a similar approach, issuing rules that others are expected to follow.
The Environmental Protection Agency has used command-and-control policies to reduce air pollution. The EPA sets standards for air quality and requires states and cities to meet them. There are problems with this approach, however. As economist Robert W. Crandall observed,
Market-based policies. Economists generally prefer the use of market-based policies to deal with negative externalities. Such policies use incentives. rather than rules and enforcement, to change producers’ behaviors.
One market-based policy is a corrective tax, which the government levies on producers of pollution. Corrective taxes give producers an incentive to reduce their harmful waste products because the tax acts as a penalty. These taxes also have the benefit of raising revenue.
Corrective taxes have been used by local governments in an attempt to reduce the amount of trash that households produce. Under these “pay as you throw” tax schemes, households are charged for each bag of garbage they put out for collection. In response to the trash tax, most households try to find ways to reduce their output of garbage. The effect has been to reduce the amount of waste that ends up in local landfills.
Another market-based policy is known as cap and trade. When using this approach, the government sets a limit. or cap. on the total amount of a pollutant that businesses can emit each year. The government then issues a limited number of pollution permits to every firm that emits that type of pollution. The permit gives the holder the right to pollute a certain amount.
As illustrated in Figure 11.4B. this scheme allows firms to sell their pollution permits to one another. Firms that can easily cut their emissions below their caps have an incentive to do so because they can sell their leftover permits. Firms that are unable to cut emissions enough to reach their caps may buy those extra permits to avoid pollution penalties. At the same time. the added cost of buying permits gives heavy polluters an incentive to decrease their emissions as much as possible.
The EPA used a cap-and-trade policy in the 1990s to reduce the output of sulfur dioxide – a major cause of acid rain – emitted from coal-burning power plants. Coal-fired power plants throughout the United States were directed to reduce their sulfur emissions by 50 percent over a fixed period. They were allowed to meet this target in any way they chose. including by buying permits from plants that came in under target early. The approach resulted in sulfur dioxide emissions being reduced more rapidly than anticipated.
Negative externalities often arise when property rights are not well defined. The air, for example, is what economists call a common resource. Everyone has access to a common resource. For this reason, it can easily be overused and even destroyed. Economists call this problem the tragedy of the commons. Ecologist Garrett Hardin coined this term.
Economists apply the tragedy of the commons to a variety of common resources, including Earth’s atmosphere and oceans. Pollution and other negative externalities, they argue, result from poorly defined property rights. Without such rights, people lack the incentive to care for common resources and to ensure that those resources are preserved for future use.
A number of government policies are aimed at preserving common resources. One policy is to require everyone who uses a common resource to pay a toll, or fee. Highway tolls, for example, provide revenue that can be used to maintain roads. They also function as a corrective tax. To avoid paying tolls, some drivers will seek other routes, join carpools, or take public transportation. By providing an incentive to limit use of certain roads, tolls help reduce congestion.
A second way to preserve a common resource is to establish a quota, or maximum amount of a resource that a person can use or consume in a given period of time. The ocean, for example, is a common resource, as are the fish that live in it. Like the herders in Hardin’s example, people who fish for a living have little incentive to limit their catch. If they do, someone else will come along and take the fish they left behind.
The predictable result has been overfishing. which threatens to destroy several fisheries in U.S. coastal waters. By setting and enforcing fish-catch quotas, however, the government can control the percentage of the fish stock harvested each year. These quotas will help preserve this common resource. A third way to deal with a tragedy of the commons
is to turn the common resource into a private resource -that is, to privatize it. Private ownership restores the incentive to preserve the resource. Consider the problem of overfishing. The government might assign a group of fisheries the property rights to one stock of fish in a particular area. Their “ownership” of these fish gives them an incentive to preserve the resource by limiting the amount they catch each year.
The government plays another widely accepted role in the economy as a provider of public goods. Abraham Lincoln encouraged this form of government engagement when he wrote,
Consider a good that could be produced by a private firm. such as a dam to control the flooding of a river. Some people in the river’s floodplain might be willing to pay for the protection the dam provides. but the firm would not be able to provide that protection only to those people and withhold it from others. Anyone living in the floodplain would be able to enjoy that protection free of charge.
No profit-seeking fi rm can be expected to provide a good that consumers do not have to pay for. A government, by contrast. does not seek to make a profit. Rather. it ca n pay for public goods with tax dollars, thus ensuring that all taxpayers contribute to the cost.
Most people want government to provide public goods, such as national defense and streetlights. But as the scarcity-forces-tradeoffs principle reminds us. no government has the resources to provide everything that people might want. It has to make choices. but how? One way is to analyze the costs and benefits of producing that good.
Consider a proposal before a city council to widen a road in order to relieve congestion. City planners provide the council with detailed estimates of the costs of buying the needed land and hiring a construction company. Estimating the benefits is more challenging. If the road is widened. commuters are likely to spend less time and use less gas stalled in heavy traffic. How much less is uncertain. Nonetheless, estimates of these benefits are made and assigned a dollar value.
At this point, political considerations may also play a part in the council’s decisions. If enough voters want a wider road, the council members might decide to approve the project even if the costs seem likely to out-weigh the benefits. The result would be an inefficient use of the city’s scarce resources. The funds used to widen the road might well have provided more benefits to more people had they been used differently.
Economists describe situations in which government intervention leads to an inefficient use of resources as government failures. Such failures arise for several reasons. Politicians who want to stay in office may support legislation that pleases voters but is not cost effective. Or they may engage in logrolling – agreeing to vote for another lawmaker’s legislation if that lawmaker agrees to vote for their own legislation. Such compromises often lead to wasteful spending and economic inefficiency.
Politicians may also be influenced by interest groups when making decisions. Interest groups are organizations dedicated to getting certain policies enacted into law. Although such policies have high utility for a specific group, they may not benefit the economy as a whole.
People who work for regulatory agencies may also contribute to government failure. Staying employed is an incentive for them to find new problems to solve. Government employees may press for more regulation even if it is not the most efficient solution to a problem.