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Chapter 5
The Economic Role of Government
OUTLINE
I. A Closer Look at Economic Efficiency
A. Economists often use the concept of efficiency to judge actions because the efficient
use of resources implies the maximum value of output from the resource base.
B. Two conditions are necessary for ideal economic efficiency:
2. No activities that provide benefits less than costs should be undertaken.
II.
A. Although perfection is a noble goal, it is rarely worth achieving because additional
time and resources devoted to an activity generally yield smaller and smaller benefits
and cost more and more.
B. Inefficiency can result when either too little or too much effort is put into an activity.
III. Thinking About the Economic Role of Government
A. Protective Function of Government: The most fundamental function of government is
the protection of individuals and their property against acts of aggression.
1. Involves the maintenance of a legal structure (rules) within which people interact
peacefully and have a process for the settlement of disputes.
B. Productive function of Government
1. Involves the provision of a limited set of goods that are difficult to supply through
the market.
IV. Potential Shortcomings of The Market
A. There are four major reasons why the invisible hand may fail to allocate resources
efficiently: (1) Lack of competition, (2) Externalities, (3) Public goods, and (4) Poor
information.
1. Lack of Competition: Sellers may gain by restricting output and raising price. Too
few units will be produced.
2. Externalities the failure to fully register costs and benefits.
a. External cost: Present when the actions of an individual or group harm the
property of others without their consent. Note: problem arises because property
rights are imperfectly defined and/or enforced.
(2) Units may be produced that are valued less than their cost.
(4) Pollution problems are often a side effect.
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b. External benefits: Present when the actions of an individual or group generate
benefits for nonparticipating parties.
(1) Demand curve understates total value of output.
(3) From the viewpoint of efficiency, too few units may be produced.
3. Public Goods
a. Goods that are (a) jointly consumed by individuals who simultaneously enjoy
consumption of the same product or service and (b) non-excludable
consumption of the good cannot be restricted to the customers who pay for it.
(1) If a public good is made available to one person, it is simultaneously made
available to others.
b. Because those who do not pay cannot be excluded, no one has much incentive
to help pay for such goods. Each has an incentive to become a free rider, a
4. Problems Arising From Poor Information
a.
regularly.
b. Major problems of conflicting interests and unhappy customers can arise when
goods are either (a) difficult to evaluate on inspection and seldom repeatedly
purchased from the same producer or (b) potentially capable of serious and
V. Market Failure and Government Failure
A. Market Failure
2. When markets allocate goods inefficiently, the problem can generally be traced
back to the absence of competition, externalities, public goods, or poor information
B. Government Failure
1. Government failure is the term used to describe the situation when there is reason to
2. Government action directed by political decision-making is merely an alternative
3. Merely because market failure is present, it does not follow that political action will
necessarily lead to a more efficient allocation of resources.
OBJECTIVES
This chapter explains why public sector actions might improve efficiency when certain conditions
are present. Monopoly power, externalities, public goods, and economic instability are economic
forces that are likely to result in market inefficiency. When the market fails to meet our conditions
of ideal efficiency, public-sector action can potentially generate net economic gain for a community
(or an economy). Public-sector action need not be merely a zero-sum game in which the gain of one
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IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. The concept of economic efficiency must be explained carefully. First, explain that efficiency
simply means getting the most out of the available resources. When applied to the entire
2. After pointing out that competitive markets are consistent with efficiency, indicate that lack of
competition (monopoly, collusion, etc.), spillover effects, and public goods create
3. When explaining what economic theory says about public sector economic organization, point
4. Exerting an influence on government is costly. Yet moving a government toward more efficient
6. Since this chapter emphasizes the discussion of efficiency, it is helpful to show students that
analytical questions pertain to what it depends on and how importantly it depends on each of
the determinants. For example, you can show students that the most efficient car for a given
7. Roommate problems provide a rich source of analogies that illustrate the analysis of public
goods and externalities, particularly the free-rider problem. Whether one considers the
8. Games one to five will help reinforce the material in chapter 5.
Chapter 5/The Economic Role of Government 67
GAMES
1. Externalities on a River
Type: In-Class Demonstration
Topics: negative externalities
Textbook: Chapter 5: The Economic Role of Government
Materials Needed: none
Time: 10 minutes
Class limitations: works in any size class
Purpose
This helps students understand who bears external costs and why externalities are a type of market
failure.
Instructions
Draw a simple picture of a river. (Two curving lines are sufficient.) Add a rectangle labeled
68 Chapter 5/The Economic Role of Government
Explain that a by-product of sweater production is toxic sludge. Draw thick lines representing this
s discharge pipe. This sludge is dumped in the river. Draw more thick
lines of sludge over the stick figure and into the brewery.
Points for discussion
Avoiding external costs, such as the pollution damages, increases the supply curve just like
avoiding any other cost of production. In this case the costs are not truly avoided, but imposed on
decision based on its private costs.
Comparing the two intersections on the graph shows: consumers pay too low a price for sweaters
and too large a quantity is produced. If the external costs were considered, prices would be higher
and quantity lower.
There are several possible ways to improve the outcome. All involve making decision makers
consider the external costs. This example can be used to introduce the concepts of discharge fees,
regulation, liability rules.
An interesting extension is to explore how changes in ownership might affect the outcome. If the
sweater factory, the beach, and the brewery were all owned by one individual then the external
costs would be considered.
Type: In-Class demonstration
Topics: negative externalities
Purpose
This helps students understand external costs and why externalities cause non-optimal outcomes.
It also illustrates externalities in consumption.
Instructions
Light the cigar and smoke it. Blow as much smoke as possible at the students. Tell the class how
enjoyable the cigar is.
Chapter 5/The Economic Role of Government 69
As the room fills with smoke, explain that you intend to bring a cigar to class everyday, since it
gives so much pleasure. Ask if anyone has objections.
Common answers and points for discussion
Most of the class will object to daily exposure to cigar smoke. Second-hand smoke is a negative
ignores these external costs. The private decision will not be optimal.
3. Private Goods/ Public Goods: A Demonstration
Type: In-Class Demonstration
Topics: public and private goods
Textbook: Chapter 5: The Economic Role of Government
Materials Needed: a candy bar
Time: 10 minutes
Class limitations: works in any size class
Purpose
This example vividly illustrates the difference between public and private goods.
Instructions
Ask for a volunteer. Give the volunteer a candy bar and ask him or her to eat it.
to be marred by taking notes. Offer to draw some beautiful artwork on the board to increase the
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Points for discussion
The candy is a private good. It is depletable and excludable. Only the volunteer got to enjoy the
4. Alphabet Soup: The Role of Government
Type: In-Class assignment
Topics: The role of government
Textbook: Chapter 5: The Economic Role of Government
Materials Needed: none
Time: 15 minutes
Class limitations: works in any size class
Purpose
This assignment shows many government activities exist in a market economy.
Instructions
Ask the students to list as many government-provided goods and services as possible. They should
include activities at the Federal, State and Local levels.
dominantly market economy, does
the government play so many roles?
Common answers and points for discussion
Students will be able to list dozens of government activities and nearly as many agencies.
The rationale for government action can include:
5. Article on the Role of Government
Type: Take-home assignment
Topics: the role of government, market failure
Textbook: Chapter 5: The Role of Government
Materials Needed: none
Class limitations: works in any size class
Purpose
This assignment gives students an opportunity to identify real-world market failures and how
government can address these issues. Categorizing a real problem helps students clearly
distinguish the various types of market failure.
Instructions
This assignment is difficult for many students, particularly if they are unclear on the concept of
market failure. Not every example of government action will be appropriate for this assignment.
Students may find it easier to make a list of possible areas of market failures before looking for an
article.
Points for discussion
A market system depends on accurate price signals to allocate goods and services. Market failure
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Name____________________ Course ______________________
Role of Government
Find an article in a recent newspaper or magazine that shows the government addressing market
failure.
Identify the type of market failure. Is it a problem of negative externalities, positive externalities,
public good, or open access?
Chapter 5/The Economic Role of Government 73
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
4. The antimissile system is a public good for the residents of Washington, D.C. Strictly
6. Without protection of person and property, there is no assurance that one can benefit from
either (1) current productive effort or (2) saving (and investing) for the future. Under such
14. A government intervention would be efficient if the benefits from the intervention exceeded