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Chapter 05 - Government's Role and Government Failure
CHAPTER FIVE
GOVERNMENT'S ROLE AND
GOVERNMENT FAILURE
CHAPTER OVERVIEW
The chapter begins by reviewing the topic of market failure and the important role that the government
can play in (potentially) improving economic efficiency. The chapter then discusses the difficulties that
democratic governments face when making specific laws and regulations that govern economic activity in
an attempt to correct for this market failure. It is then argued, that as a result of these difficulties, a
government can sometimes pursue policies for which the marginal cost exceeds the marginal benefit.
These inefficient outcomes, defined as government failure, are just as important as market failure in
understanding economic activity. In effect, the lesson from this chapter is that society should be just as
vigilant in looking for instances of government failure as in looking for instances of market failure.
The appendix to this chapter discusses public choice theory. The theoretical discussion includes an
examination of the inefficiency of voting outcomes, interest-group influence, political logrolling, and the
paradox of voting outcomes. The median-voter model is also considered.
WHAT’S NEW
This is new chapter for the 20e. This chapter (with chapter 4) explains the (potential) role of government
in determining economic efficiency.
The government failure section discusses the concepts of regulatory capture, unfunded liabilities, the
tendency for politicians to run deficits to please voters, and the problems associated with politicization of
monetary and fiscal policies.
An important “Consider This ... Does Big Government Equal Bad Government?" discusses the concept of
marginal benefit and marginal cost when assessing the efficiency of government programs.
The appendix to the chapter discusses the median-voter theorem and a potential voting paradox.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Describe how government's power to coerce can be economically beneficial.
2. Explain some of the difficulties associated with managing and directing the government.
3. Explain Government failure and explain why it happens.
4. Explain why representative democracy suffers from the principal-agent problem.
5. Discuss the idea of clear benefits and hidden costs.
6. Define unfunded liabilities and provide some examples.
7. Define and identify the terms and concepts listed at end of the chapter.
8. (Appendix) Explain the difficulties of conveying economic preferences through majority voting.
9. (Appendix) Explain the problems created with majority voting and the median-voter outcome.
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Chapter 05 - Government's Role and Government Failure
COMMENTS AND TEACHING SUGGESTIONS
1. Have students investigate the use of special-interest lobbyists. They may be shocked by their
findings; some may even discover a new career objective since some lobbyists are extremely well
paid. The sheer number of interest groups that hire lobbyists to represent them may also be
surprising to students. The process of lobbying legislatures is itself a big business. Point out that
state legislatures are under the same kind of pressure from interest groups as the Senate and the
House of Representatives.
2. Students could be asked to come up with their own examples of public sector failures after reading
this chapter and, in each case, identify the cause of the “failure.”
3. The following “Concept Illustration” on Rent-seeking may be useful.
Concept Illustration … Rent Seeking
The French economist Frédéric Bastiat (1801-1850) is remembered for his wit and capacity to
point out absurdities in the arguments of his opponents. In the following passage, he satirizes
appeals to government for special benefits at someone else’s expense, or what today we call "rent-
seeking." His message is timeless: When rent-seekers succeed, it is often at the expense of the
general interest.
When, unfortunately, one has regard to the interest of the producer, and not to that of the
consumer, it is impossible to avoid running counter to the general interest, because the
demand of the producer, as such, is only for efforts, wants, and obstacles.
I find a remarkable illustration of this in a Bordeaux newspaper.
M. Simiot proposes this question:
Should the proposed railway from Paris to Madrid offer a solution of
continuity at Bordeaux?
[Mr. Simiot argues that] the railway from Paris to Bayonne should have a
break at Bordeaux, for if goods and passengers are forced to stop at that
town, profits will accrue to bargemen, pedlars, commissionaires, hotel-
keepers, etc.
Here we have clearly the interest of labour put before the interest of
consumers.
But if Bordeaux has a right to profit by a gap in the line of railway, and if such profit is
consistent with the public interest, then Angoulême, Poitiers, Tours, Orleans, nay, more,
all the intermediate places, Ruffec, Châtellerault, etc., should also demand gaps, as being
for the general interest, and, of course, for the interest of national industry; for the more
these breaks in the line are multiplied, the greater will be the increase of consignments,
commissions, transhipments, etc., along the whole extent of the railway. In this way, we
shall succeed in having a line of railway composed of successive gaps, and which may be
denominated a Negative Railway.
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Chapter 05 - Government's Role and Government Failure
The principle of restriction is the very same as the principle of gaps; the sacrifice of the
consumer’s interest to that of the producer, in other words, the sacrifice of the ends to the
means. (1)
1Frédéric Bastiat, Economic Sophisms (Edinburgh: Oliver & Boyd, Ltd., 1873), pp. 80-81,
abridged.
4. Students could be asked to find (or provided with) the actual estimates of the unfunded liabilities of
the federal government. The students should compare the social security unfunded liability, the
Medicare unfunded liability, and the combination of the two with the national debt.
5. Have the students discuss the potential costs and benefits of a government loan guarantee program.
Ask the students if they support this type of program? As a follow-up question ask the students if
they support the guaranteed student loan program.
STUDENT STUMBLING BLOCKS
1. Because government programs are currently viewed with a great deal of suspicion by many
citizens, it may be difficult to focus the students’ attention on the theoretical aspects of this chapter,
as opposed to the emotional reaction that government is inherently wasteful and inefficient.
While there is a focus on public sector failure in this chapter, recall that there are also market
failures that led to the need for government action in the first place. How to balance the public and
private sectors is a question that deserves attention at this point.
2. Students will continue to focus on the size of government and government programs rather than
using marginal analysis to evaluate government and government programs. Sometimes it is helpful
to ask the students to evaluate a large program where the marginal benefit might be larger than
marginal cost (social security, Medicare, etc...) and a small program where the marginal cost might
be larger than the marginal benefit (farm subsidies or the mohair subsidy as discussed in the
Consider This... Mohair and the collective action problem)
3. The student will also struggle with the subjective nature of marginal analysis when applied to
government programs. As in the example above, some students might assign a high marginal
benefit to social security and Medicare while others will assign a low marginal benefit to these
programs. This is a good opportunity to review normative and positive economics. It is also a good
opportunity to discuss why economics is a "methodology" not an "ideology". Economics gives us
the language and tools to evaluate government programs, but the analysis will depend on our
individual views of society.
LECTURE NOTES
I. Learning Objectives – After reading the chapter, students should be able to:
A. Describe how government's power to coerce can be economically beneficial and list some of
the difficulties associated with managing and directing the government.
B. Discuss "government failure" and explain why it happens.
C. (Appendix) Explain the difficulties of conveying economic preferences through majority
voting.
II. Government's Economic Role
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Chapter 05 - Government's Role and Government Failure
A. Although the U.S. economy is primarily a market system where markets and prices
coordinate and direct economic activity, there is still a prominent role for government in
determining how the economy functions.
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Chapter 05 - Government's Role and Government Failure
B. Government's Right to Coerce:
1. One key difference between the economic activities of government and those of private
firms and individuals is that government possesses the legal right to force people to do
things. In many cases this can improve economic efficiency.
2. Force and Economic Efficiency: The government can correct for market failure by
providing public goods and by providing the appropriate incentives to firms (or
households) in the presence of externalities. This will most likely increase economic
efficiency. The government can also reduce private-sector economic risks by enforcing
property rights and enforcing contracts. This will also most likely increase economic
efficiency.
C. The Problem of Directing and Managing Government.
1. The government can substantially improve allocative and productive efficiency if it
directs its coercive powers toward rectifying market failures and providing a low-risk
economic environment for the private sector. However, governments face the daunting
challenge of organizing millions of employees to carry out thousands of tasks. An
understanding of these challenges and complexities will give you a better sense of how
well most governments manage to do despite all of the problems associated with
government failure.
a. No Invisible Hand: Government economic policies are not self-correcting. If a
government program is inefficient there is no pressure forcing this program to
become more efficient or forcing it "out-of-business".
b. Massive size and scope: The size and scope of government makes it difficult to
identify and fix economic inefficiencies.
c. The need for bureaucracy: Given the size of government, elected officials must rely
upon many layers of supervisors to run and manage government programs.
d. The need for paperwork and inflexibility: To make sure that laws are uniformly
enforced, the bureaucracy is regulated by detailed rules and regulations governing
nearly every possible action that any individual bureaucrat might be called upon to
make.
e. The information aggregation problem: Because of their massive size and scope,
bureaucracies have difficulty with effectively aggregating and conveying information
from their bottom layers to their top layers. As a result, top officials will tend to
make inefficient choices.
f. Lack of accountability: Democratic elections do take place, but because the
government undertakes so many activities, it is difficult for the electorate to know
the details of even a small fraction of what the government is up to at any particular
time. As a result, many programs are run poorly without affecting the reelection
chances of the incumbent politicians.
2. Consider This … Does Big Government Equal Bad Government
The actual size of the government is not necessarily "good" or "bad". It is whether or not
the marginal benefit of a government program exceeds the marginal cost of the program.
Thus, the debate over "large" or "small" government is misplaced. It is really a debate
about the marginal benefit and marginal cost of government programs.
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Chapter 05 - Government's Role and Government Failure
III. Government Failure
A. Government can fail despite knowing the preferences of voters (as discussed in the appendix)
because government puts their own interests ahead of the voters’ interests and/or government
chooses policies that create large benefits for a small group while creating small losses for the
majority.
B. Representative Democracy and Principal-Agent Problem
1. The principal-agent problem occurs because conflicts arise when tasks are delegated by 1
group of people (principal) to another group of people (agents).
2. In a democracy, elected officials (agents) have goals like reelection which conflict with
the interests of the voters.
C. Special interests may promote the interests of a small group at the expense of society at large.
1. The special-interest effect refers to the situation where a small number of people will
receive large gains at the expense of a much larger number of people who individually
suffer small losses. The small group will be well informed and highly vocal on the issue
and press politicians for approval. The large numbers who will each suffer small losses
will not have the incentive to be informed or feel strongly. The result is that the politician
will support the special-interest program, whose supporters will notice the vote in their
favor, and ignore the majority who don’t feel strongly.
2. Pork-barrel politics is an example of the special-interest effect. In this case, the benefit
goes to a single political district and to the politician from that political district. The cost
of the project is spread out to many individuals who will never receive the benefits.
Pork-barrel politics is often combined with logrolling.
D. Rent-seeking behavior occurs when a transfer of wealth at someone else’s or society’s
expense occurs through government action. Here the term “rent” means any payment to a
resource supplier, business, or other organization above that which would accrue under
competitive market conditions. Examples include tax loopholes that benefit only certain
groups; public works projects that cost more than the benefits they yield; and occupational
licensing that requires more than is necessary to protect consumers.
E. Clear benefits, hidden costs (or the reverse, immediate costs and future more vague benefits)
are another dilemma for politicians trying to decide on public programs. Where the benefits
are recognizable and popular, the politician may vote for the program even if the costs exceed
these benefits if the costs are diffuse or hidden.
F. Unfunded Liabilities: The political tendency to favor priorities that have immediate payouts
but deferred costs also leads to many government programs having unfunded liabilities. An
unfunded liability occurs when the government commits to future expenditures without
simultaneously committing to collect enough tax revenues to pay for those expenditures
(unfunded liability = present value of projected expenditures on the program - present value
of projected tax revenue for the program).
1. Social Security is one of the largest programs with an unfunded liability.
2. Medicare also has a large unfunded liability component.
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Chapter 05 - Government's Role and Government Failure
G. Chronic Budget Deficits: A budget deficit occurs whenever tax revenues are less than
spending in a particular year.
1. Deficits might result in economic inefficiency by allowing the government to control and
direct a large fraction of the economy's resources.
2. A Debt Crisis might occur because the government has accumulated so much debt that
creditors are no longer willing to lend to the government. This can result is a major
"shock" to the economy as the government raises taxes and cuts spending at
unprecedented levels. It is better to gradually raise taxes and phase out programs
(spending) rather than to implement a drastic adjustment to an economy.
H. Misdirection of Stabilization Policy: Stabilization policy attempts to use fiscal and monetary
policy to "smooth-out" business cycle fluctuations.
1. Fiscal policy attempts to stimulate spending by changing tax rates and spending levels.
2. Monetary policy attempts to stimulate spending by changing interest rates.
3. The problem is that the politicization of fiscal and monetary policy might result in abuse
and inefficiency by government officials. For example, the government might direct
expenditures to specific companies in their district. Or might attempt to change interest
rates before an election (an independent Federal Reserve reduces this possibility).
I. Limited and bundled choice is another problem with public goods. The voter must choose
between a few candidates who will have the power to select the public goods and services to
be financed by the voter’s tax money. The choices are “bundled” in that the limited set of
candidates will govern over a variety of issues, and the voter’s preferences may not perfectly
align with any candidate. In the private sector, the consumer has a multitude of choices
available, and can generally separate out those goods and services not desired.
J. Consider This … Untended Consequences
Sometimes the laws and programs the government puts in place to try to make improvements
in society can have unintended consequences. These unintended consequences can offset
some or all of the intended benefits.
1. Government fuel-efficiency requirements for automobiles forced automakers to produce
smaller vehicles. This increased the number of fatalities in automobile accidents.
2. San Francisco banned plastic grocery bags. The number of foodborne deaths increased
as a result.
K. Bureaucracy and inefficiency can be another problem in the public sector because the profit
motive or competitive pressure to perform efficiently is not present. Ironically, a potential
response of government to a program’s failure is to increase its budget and staff.
1. Government employees, together with the special-interest groups they serve, often have
the political clout to block attempts to pare down or eliminate their agencies.
2. There is a tendency for government bureaucracy to justify continued employment by
looking for and eventually finding new problems to solve.
L. Inefficient Regulation and Intervention: Governments regulate many aspects of the economy
with the hope that these regulations improve economic outcomes. Examples include the
environmental laws and banking supervision.
1. Regulatory Capture occurs when the government agency that is supposed to supervise a
particular industry becomes heavily influenced by the industry that it is supposed to
be regulating.
a. Some argue that regulatory capture has occurred in the FDA with respect to the
pharmaceutical industry.
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Chapter 05 - Government's Role and Government Failure
b. Deregulation as an alternative to regulation will reduce (or eliminate) regulatory
capture, but this might result in other inefficiencies, such as monopolies, false
claims and unsafe drugs, and potential negative externalities from pollution.
2. Government's poor investment track record
a. Loan guarantees reduce downside risk and result potentially inefficient investments.
b. Loan guarantee also socialize losses and privatize gains. If the project fails then the
taxpayer picks up the tab. If project succeeds then the private investors reap the
reward.
M. Corruption often occurs in government when officials abuse their power.
1. A government official is bribed to do what he should already be doing.
2. A government official accepts a bribe to do something he does not have the legal
authority to do.
3. An interesting debate is whether or not campaign contributions constitute a bribe.
N. Imperfect institutions exist in both the public and private sectors, which often makes it
difficult to decide which institutions would perform best in the production of certain goods
and services.
IV. LAST WORD: “Government Failure” in the News
A. A 2004 spending bill set aside $1 million for the Norwegian American Foundation; $443,000
to develop salmon-fortified baby food; and $350,000 for music education programs at the
Rock and Roll Hall of Fame in Cleveland.
B. The $878 billion American Recovery and Reinvestment Act of 2009 had many questionable
spending projects. For example, $10 million was set aside to renovate a train station in
Elizabethtown, PA that hadn't been used in 30 years.
C. In 2009 congress approved $2.5 billion to purchase C-17 aircraft despite the Department of
Defense telling congress they didn't need these aircraft.
D. The government paid out funds on over 900,000 false claims for disaster relief from
Hurricane Katrina.
QUIZ
1. Which of the following are potential problems with directing and managing government?
A. The government's massive size and scope
B. Politicians aren't as intelligent as the rest of society
C. It is difficult for the government to effectively aggregate information from bottom to top
D. Answer A and C are correct
2. What is the correct criterion in evaluating government programs?
A. The size of government: A larger government provides more goods.
B. The size of government: A smaller government has lower taxes.
C. By comparing the marginal benefit to the marginal cost of the government program. If the
marginal benefit exceeds the marginal cost this is an efficient program.
D. By comparing the marginal benefit to the marginal cost of the government program. If the
marginal cost exceeds the marginal benefit this is an efficient program.
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Chapter 05 - Government's Role and Government Failure
3. An unfunded liability for a government program implies that:
A. projected government expenditure exceeds projected government revenue for the program
B. the government program is self-sustaining
C. projected government revenue exceeds projected government expenditure for the program
D. the government has yet to establish the program
4. A special-interest issue is one whose passage yields:
A. large private benefits compared to external benefits.
B. large external benefits compared to private benefits.
C. small economic losses to a small number of people and large economic losses to a large
number of people.
D. large economic gains to a small number of people and small economic losses to a large
number of people.
5. Politicization of fiscal and monetary policy refers to:
A. The use of fiscal and monetary policy to help foreign governments
B. Is the primary reason for public sector efficiency
C. The use of fiscal and monetary policy to help politicians before an election
D. Creates the opportunity for the fallacy of limited decisions
6. Which of the following is the most likely cause of unfunded liabilities?
A. The cost of the program is immediate while the benefit is in the distant future.
B. The benefit of the program is immediate while the cost is in the distant future.
C. Politicians are helping as many people as they can.
D. Voters prefer taxes now rather than in the future.
7. It is often argued that government laws and regulations have unintended consequences. Which of
the following is an unintended consequence of the 2010 healthcare reform law?
A. Everyone will now have insurance.
B. Companies are now willing to employ more full-time workers.
C. Companies are reducing full-time employees to part-time employees.
D. Insurance markets are now more efficient.
8. The concept of limited choices, as used in public choice theory, refers to the fact that:
A. Politicians may not be objective in evaluating economic policy programs
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Chapter 05 - Government's Role and Government Failure
B. Because of the importance of television and other modern communication techniques, the
best and brightest candidates may not be selected by voters
C. Voters must select a candidate who represents a "bundle" of various public policy programs
and who can't register support or opposition for specific programs
D. The most economically efficient public policy programs may not be selected because political
leaders do not know enough about economics
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Chapter 05 - Government's Role and Government Failure
9. Public choice theory focuses on the economics of:
A. fiscal and monetary policy.
B. the behavior of business firms.
C. antitrust and regulatory policy.
D. government decision making, politics, and elections.
10. Regulatory capture is problematic for which of the following reasons?
A. The government collects less tax revenue.
B. The regulations governing an industry are set by the industry itself.
C. Monetary policy is likely to influence the election outcome.
D. There is excess spending on politician salaries.
APPENDIX TO CHAPTER 5: PUBLIC CHOICE THEORY AND VOTING PARADOXES
I. Public Choice Theory
A. Economic analysis of government decision making, politics, and elections.
B. Understanding government failures highlights how changes in government processes can lead
to greater efficiency.
II. Revealing Preferences through Majority Voting
A. Majority voting can lead to inefficient outcomes; that is, the majority can defeat a proposal
that would have provided greater benefits than costs and adopt one that costs more than the
benefits it provides (Figure 1).
1. Illustration of an inefficient “no” vote result: Suppose there are 3 voters who each will
have to pay $300 in tax if a proposal is adopted. It is worth $700 to one, $250 to the
second and $200 to the third. The second and third voters will vote “no” and defeat the
proposal despite the fact that the total benefits ($1150) exceed the $900 cost.
2. Illustration of an inefficient “yes” vote result: Take the same three voters as above and the
same level of taxation. Now the proposal is worth $100 to the first voter and $350 to
each of the others. The vote will be 2 to 1 in favor of the proposal even though the total
benefit of $800 is less than the $900 cost.
3. Conclusion: The problem is that the one-person one-vote rule does not measure intensity
of preferences, so the result may not be economically efficient. Too much or too little of
the good is produced.
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Chapter 05 - Government's Role and Government Failure
B. Interest groups may improve the economic efficiency of results by registering intense feelings
with elected representatives or by organizing major efforts to get the vote to go their way.
C. Logrolling or vote trading may also secure favorable decisions for those who feel strongly
about certain issues, but it may also negate an efficient outcome in favor of a special interest
group where the value of the benefits received does not justify the cost. The efficiency of the
outcome will depend on the circumstances.
D. The paradox of voting is that society may not be able to rank its preferences consistently
through majority voting.
1. Table 1 demonstrates a situation in which three voters have expressed their rankings of
three public projects; each has a different ranking. If voting is done on pairs of projects,
it can be shown that national defense will win over roads, and roads will win over
weather warning systems. But the logical conclusion that the community prefers national
defense to weather warning systems is not the case—they would each get the same
number of points (if points were awarded for a 1st, 2nd, and 3rd choice). In other words,
if one choice must receive a majority of the votes, there will not be a consistent outcome
in this case unless somehow the strengths of the rankings can be measured.
2. Government might find it difficult to provide the “correct” public goods by acting in
accordance with majority voting.
E. Consider This Voting Outcomes
F. The median-voter model suggests that under majority rule the median voter will in a sense
determine the outcomes of elections. The median voter is the person holding the middle
position on an issue.
1. The textbook example has three voters deciding among three types of weather warning
systems. The first is willing to spend $400; the second, $800; the third, $300. The
median-voter model suggests that the $400 proposal will win. In a choice between the
$400 and $800 proposal, the first and third will vote for the $400 type. In a choice
between the $400 and $300, the first and second will vote for the $400 type. In other
words, both extreme voters prefer the median choice rather than the other extreme, so the
median voter will tend to predominate.
2. Real-world examples occur in political positions where candidates seem to aim their
appeal at the median voters within each party to get the nomination and later at the
middle of the population in an effort to win the election.
3. Implications of the median-voter model:
a. Many people will be dissatisfied by the extent of government involvement in the
economy.
b. Some people may “vote with their feet” by moving into political jurisdictions where
the median voter’s preferences are closer to their own.
c. Median preferences can change over time.
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