Seat of government, the Michigan State Capitol

# Unit 12 Governments and markets in a democratic society

## Introduction

• Governments and markets, along with firms and families, are the major economic institutions today; how they are organized and how they interact affect the extent to which economic outcomes are efficient and fair.
• Some economic activities are better organized primarily by markets, others by firms, families, and governments.
• Market competition allows large numbers of people to interact in mutually beneficial ways because prices convey important economic information that would be difficult, if not impossible, for a government to obtain and use in their absence.
• A government is distinct from other actors in society not because public officials are less self-interested than private economic actors, but because it has the capacity to act on behalf of all the people and require citizens to abide by its decisions, using force if necessary (for example, police powers).
• Governments also use tax funds to provide goods and services (such as the courts or schooling and, in some countries, health care), that are usually free of charge.
• Ideally, democracy empowers citizens by extending voting rights in competitive elections to everyone, and limits what governments and other powerful bodies can do by ensuring individual rights of speech and association.
• Even in cases in which public policies to address unfairness or market failures are economically feasible, they may still not be carried out because powerful groups, including the wealthy or government elites, pursue other objectives, or because governments do not have the capacity to implement them.

The Social Science 125 course at Harvard University was oversubscribed; more students had signed up for it than could be enrolled, given the 95-student limit placed on class size. Students who crowded into the lecture hall on the first day of the semester were surprised when the professor announced that admission to the course would go to the 95 highest bidders. The sums collected, he explained, would help to pay for the cost of extra materials to be circulated to students. He then asked students to write down their student ID numbers and the amount of US dollars they were willing to pay for admission to the course.

‘Why should I pay to get into a class?’ one of the students asked politely. The professor replied that limiting the class size was regrettable but necessary. In the circumstances, he said, the best way to allocate the scarce places was to identify the students most willing to pay for a place.

What other methods could he have considered?

• Randomly selecting students to be admitted by lot: This would mean that some students who really wanted to take the class would be excluded, while others who were barely interested would be enrolled.
• Asking students how interested they were: This would not work, he explained to his students, because there would be no reason to tell the truth if it meant you might not win a place. Each student would have an incentive to exaggerate.

As an economist, the professor proposed to allocate places in the class in a similar manner to the way in which access to most goods and services is allocated in a capitalist economy, that is, by means of a market. Students could bid for their places. Imagine that you had been there, hoping to enrol in the class that day. Would you have accepted his logic? Most of the students did not. And when he tried the same thing in another class, some students shouted insults at him and walked out!

The professor wasn’t really going to auction places in his class to the highest bidders; his experiment was simply a first lesson in economics for the students. Nevertheless, every day school administrators, healthcare providers, managers of food banks, and many others face the problem of allocating scarce resources among individuals with differing needs. Their decisions are real.

Here is one of those real-life dilemmas. You must decide who will receive an organ transplant, say, a kidney:

• Buying and selling kidneys is illegal in most places: An illegal (black) market exists, in which the huge differences between the price received by organ donors (many of them very poor) and price paid by organ recipients (mostly rich) deliver profits to the criminals who organize the transactions.
• Some generous people choose to donate a kidney: This is legal, and they are allocated according to medical professionals’ determination of medical need; possible beneficiaries are under the care of well-connected physicians.

Kidneys can be allocated using a combination of medical need and generosity. We know that many people waiting for kidney transplants die every day, because there are too few donors to save everyone who needs a transplant. So, might it be feasible to let people buy a kidney instead? If so, we can add a third option:

• Create a legal market for kidneys: Some people would prefer to be able to buy and sell kidneys, if there were strict regulations to ensure the safety of donor and recipient.

But letting kidneys be allocated by markets like any other good that is sold—like clothes or cars—has been criticized on the grounds that, under this arrangement, only rich people would get transplants. You might object to this system, reasoning: ‘The difference between the people who get replacement kidneys and the people who don’t, is not that one group values life more than the other; it is that only one group can afford it.’ In this case, ‘willingness to pay’ is simply ‘ability to pay’.

There is yet another way to improve the way in which kidney transplants can be organized:

• Create a matching platform for kidneys: This would use a digital technology like Airbnb or Uber. The platform would connect potential donors and recipients, but with a twist. Suppose your brother needed a replacement kidney, and you were willing to donate one of yours. But you are very unlikely to be able to donate your kidney to your brother because matching between donors and recipients is complicated (blood and tissue type must match). So, under this proposal, you would contribute your kidney to the overall supply of available kidneys, and in return be entitled to a properly matched kidney for your brother.

A network of exactly this kind is providing replacement kidneys in the US under the New England Program for Kidney Exchange (NEPKE), which you can hear more about in our ‘Economist in action’ video featuring Alvin Roth, a Nobel Laureate in economics and former president of the American Economic Association. NEPKE is like a market in that it allows exchanges to take place among total strangers who are matched by what they need or can provide. But unlike a market, who gets what is not based on the willingness to pay. The key to getting a replacement kidney is not being wealthy enough to afford one, but instead having some friend or family member (or even a stranger) who is willing to contribute a kidney to the pool so that the person needing the replacement gets a kidney matching his type.

Markets sometimes seem to be everywhere in the economy, but this is not so.

• Firms are not markets: Recall Herbert Simon’s image from Unit 6 of a Martian viewing the economy. The Martian mainly sees green fields, which are firms. They are connected by red lines representing buying and selling in markets, but many resource allocation decisions are made within the firms.
• Families are not markets: They do not allocate resources between parents and children by buying and selling.
• Governments are not markets: They use the political process rather than market competition to determine where, and by whom, schools are built and roads maintained.

Why are some goods and services allocated in markets, while firms, families, and governments allocate others? This is an old question, and one that is hotly debated. But the main reason is that some kinds of activities are better organized if they are regulated by the rules of the game that characterize families, or governments, or firms, instead of by markets. It is hard to see, for example, how conceiving and raising children could be effectively carried out by firms or markets. A combination of families and governments (schooling) does the job in most societies.

People disagree about the appropriate extent of the market. Some think that things that are now to some extent for sale—like sex, or influence over political decisions—should be allocated by other means. Others think that markets should take a larger role in the economy. These disagreements are about matters of fact (for example, do public schools or home schooling do a better job?) and matters of value (is the sale of sexual services or bodily organs immoral, even if these transactions are well regulated?).

In this unit, we consider why some economic activities are organized primarily by markets and some are organized in other ways, by firms, families and governments. Family is the main institution that organizes how we give birth to infants and raise them in their first few years of life. In the rules of the game characteristic of families, parents teach and set limits for children, and these rules differ from the way markets determine outcomes. Similarly, as you learned in Unit 6, firms organize the process of production through a top–down structure of command, from owners to managers at various levels, down to production workers. Here, we explore how governments work, and how they interact with firms, families, markets and other institutions.

We have seen in the previous units that markets often fail to implement efficient and fair outcomes, and we have shown how governments can address market failures and unfairness. In this unit, we will also explain why governments often fail to address the problems of market failures and unfairness, and how these government failures can themselves be addressed.

## 12.1 The market and other institutions

Markets are one way of organizing the production and distribution of goods and services. For example, you may hire a person on the labour market to take care of your child while you are at work. But your child’s caregiver could also be a relative who is not paid a wage. Or the infant could be cared for in a government daycare centre that is free as a matter of right to any citizen, or by the firm you work for, as part of your compensation package. Each of these are examples of different economic institutions—markets, families, governments, and firms—organizing some particular activity.

In Unit 2 you learned that our interactions with others can be represented as games; for this reason, the institutions that organize these interactions can be described as the rules of the game. In Unit 5 you saw that the way pirates interacted at sea was determined by the rules of the game laid out in the constitution of The Royal Rover.

In the introduction, we contrasted markets with firms, families, and governments. As economists, we can think of each situation as a different game with its own particular rules. In this sense, markets are just one of the ways that we organize our societies—you pay for what you get. But what about the others?

• In firms: Your interaction with other members of the firm you work for is organized, in part using a contract that you (or your trade union) negotiated with the owners, and in part according to your position in the firm’s organizational structure.
• In families: you get what you get as a matter of love, reciprocity and obligation among family members.
• In governments: What you give to and get from the government depends on your rights and responsibilities. A country’s constitution is typically a written document that lays out the formal structure of a government, that is, the rules of the game for our interactions with the government.

Just like a country’s constitution, we can take all the rules of the game that apply to us in our roles as parents, voters, employees, shoppers, and so on, and consider them to also have constitutions. The rules of the game of markets can be seen as a ‘constitution’, with firms, families, and governments making up the institutions that jointly organize how we interact with each other in producing and distributing our livelihoods.

In the previous unit, we explained that market failures—large and small—are the rule, not the exception, and result in Pareto-inefficient outcomes. So why do we use markets at all?

### Firms, governments, and the extent of the market

In many cases, we do not use markets. The structure of our economy, taken as a whole, shows that markets are not the chosen way to organize many aspects of the production and distribution of goods and services.

If you think of the economy as a territory, as Herbert Simon’s imaginary Martians did in Unit 6, then even setting aside families, vast areas are not organized by markets.

• Firms are centrally planned economies: Firms are organized this way because it costs more for privately owned firms to buy some of the components of the product they sell than to make the components in-house. As a result, in-house production is more profitable than acquiring the same thing by purchase.

Coase explained that, as a result, the boundaries of this divide between the firm and the market are set by the relative costs of the ‘make it’ and ‘buy it’ options. Thus, the extent of the market is determined by the firm’s decision about which components of a product to produce and which ones to buy.

His explanation underlines an important fact that is often lost in heated debates about the merits of decentralized systems of organization-like markets, as opposed to more centralized ones like governments. There are some things that centralized systems (like the firm) are better at, and others that are better handled by the market.

The beauty of this demonstration is that it is not a judgement by some, possibly biased, observer; it is the verdict of the market itself. Competition among firms ultimately punishes firms that overdo the ‘make it’ option by overextending the boundaries of the centralized system through internal expansion. And market competition equally punishes the firms that fail to take advantage of centralized decision making by overly opting for the ‘buy it’ option.

• Governments are top–down organizations: We will see that they organize very substantial portions of the economic life in most societies today. Given the prevalence of market failures, why is the whole of the economy not organized by some combination of firms and governments?

The answer is that, just as there are market failures, there are also failures of centralized and top–down organization. And there are limits too, to what families can do. Markets are important parts of all modern economies and have been important in most economies in human history.

Markets are essential economic institutions, not because they work perfectly (the previous unit shows they do not), but because there are a great many aspects of production and distribution for which markets do better than the alternative institutions—governments, families, and firms.

## 12.2 Markets, specialization, and the division of labour

When you hear the word ‘market’ what word do you think of? ‘Competition’ probably comes to mind, and you would be right to associate the two words.

But ‘cooperation’ applies too. Why?

Because markets allow each of us, pursuing our private objectives, to work together, producing and distributing goods and services in a way that, while far from perfect, is in many cases better than the alternatives. Markets allow us to interact with people (for the most part complete strangers to us) in ways that we can mutually benefit from, specializing in the things we are relatively good at doing.

This is a more amazing accomplishment than it might at first seem.

Look around at the objects in your workspace. Do you know the people who made them? What about your clothing? Or anything else in sight from where you are sitting?

Now imagine that it is 1776, the year that Adam Smith wrote The Wealth of Nations. The same questions, asked anywhere in the world at that date, would have had different answers.

At that time, many families produced a wide array of goods for their own use, including crops, meat, clothing, even tools. Many of the things that you might have spotted in Adam Smith’s day would have been made by a member of the family or someone in the village. You would have made some objects yourself; others would have been made locally and purchased from the village market.

One of the changes that was underway during Adam Smith’s life, but has greatly accelerated since, is specialization in the production of goods and services. As Smith explained, we become better at producing things when we each focus on a limited range of activities. This is true for three reasons:

economies of scale
These occur when doubling all of the inputs to a production process more than doubles the output. The shape of a firm’s long-run average cost curve depends both on returns to scale in production and the effect of scale on the prices it pays for its inputs. Also known as: increasing returns to scale. See also: diseconomies of scale.
• Learning by doing: We acquire skills as we produce things.
• Some people are better at producing some things than others: This might be because they have more skill, or because of natural surroundings, such as the quality of the soil.
• Economies of scale: Producing a large number of units of some good is often more cost effective than producing a smaller number. (We studied economies of scale in Unit 7.)

These are the advantages of working on a limited number of tasks or products. People do not typically produce the full range of goods and services that they use or consume in their daily lives. Instead, we specialize, some producing one good, others producing other goods, some working as welders, others as teachers or farmers. This is called the division of labour.

Adam Smith begins The Wealth of Nations with the following sentence:

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.1

But people do not specialize unless they have a way to acquire the other goods they need. For this reason, specialization and the resulting division of labour pose a problem for society: how are the goods and services to be distributed from the producer to the final user?

This result—the coordination of the division of labour—is accomplished in different ways, depending on a society’s institutions. In the course of history, the division of labour has been coordinated by means of direct government requisitioning and distribution, as was done in the US and many economies during the Second World War, or by gifts and voluntary sharing as we do in families today; it was even practised among unrelated members of a community by our hunter-gatherer ancestors. Today, in most countries, markets play an essential role in coordinating the division of labour.

Chapter 3 in Smith’s Wealth of Nations is titled ‘That the Division of Labour is Limited by the Extent of the Market’, in which he explains:

When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.

Markets accomplish an extraordinary result: they create unintended cooperation on a global scale. The people who produced the phone in your pocket did not know or care about you. They produced it because they are better at producing phones than you are, or were willing to work for lower wages than you are. You ended up with the phone because you paid the producers, allowing them to buy goods, also produced by total strangers to them.

## 12.3 Prices are messages plus motivation: The magic of the market

The key to how this process works can be expressed in a single sentence. When markets work well, prices send messages about the real scarcity of goods and services. The messages provide information that motivates people to take account of what is scarce and what is abundant, and as a result to produce, consume, invest, and innovate in ways that make the best use of an economy’s productive potential.

### Prices coordinate specialization among complete strangers

If drought in the American Great Plains means that there is less wheat on the world market, the resulting increase in the price of bread sends a message to the shopper: ‘Consider putting potatoes or rice on the table tonight instead of bread.’ The shopper may know nothing about weather conditions in America and need not be the slightest bit concerned about consuming less of a good that has become scarcer. To respond to the message of the higher price in a way that makes the best use of a society’s available resources, the shopper needs to be concerned about just one thing: saving money. The shopper not only gets the message, but has a good reason to act on it.

It is this—the fact that prices combine information and a reason to act on the information—that allows the market system (many markets interlinked) to coordinate the division of labour through the exchange of goods among entire strangers, without centralized direction. Friedrich Hayek, who was part economist and part philosopher, suggested we think of the market as a giant information-processing machine that produces prices; the prices provide information that guides the economy, usually in desirable directions. The remarkable thing about this massive computational device is that it’s not really a machine at all. Nobody designed it, and nobody is at the controls. When it works well, we use phrases like ‘the magic’ of the market.

### Are the prices sending the right messages?

But for this to be the case, the messages that prices send must convey the right information—how scarce a good really is. Think about what this means—the scarcity of a good is measured by its social marginal cost, that is, the total cost of having one more unit of it, including not only the cost of those producing and distributing it, but also the external effects imposed on others (for example, environmental damages).

You have seen many cases in the previous units in which the price of a good is not equal to its social marginal cost. The price of bananas in Martinique, for example, did not include the loss of life and livelihood inflicted on the downstream fishing community by the pesticides used on the plantations.

The price may fail to reflect the social marginal cost due to either:

• A lack of competition: Price is greater than the private marginal cost to the producer.
• External effects that are costs: For example, the negative environmental effects just mentioned.
• External effects that are benefits: For example, the positive external effect for others if your scientific research created a valuable piece of knowledge that was a public good.

When prices send the wrong messages, as you saw in the previous unit, we ask whether some modification of how markets work could be introduced by public policies to improve economic outcomes, for example, taxing production processes that emit greenhouse gases or subsidizing basic research.

We now illustrate how prices can send the right message, and sometimes not, by two real world cases.

### Great economists Friedrich Hayek

The Great Depression of the 1930s ravaged the capitalist economies of Europe and North America, throwing a quarter of the workforce out of work in the US. During the same period, the centrally planned economy of the Soviet Union continued to grow rapidly under a succession of five-year plans. Even the arch-opponent of socialism, Joseph Schumpeter, had conceded: ‘Can socialism work? Of course it can. … There is nothing wrong with the pure logic of socialism.’2

Friedrich Hayek (1899–1992) disagreed. Born in Vienna, he was an Austrian (later British) economist and philosopher who believed that the government should play a minimal role in the running of society. He was against any efforts to redistribute income in the name of social justice. He was also an opponent of the policies advocated by John Maynard Keynes, designed to moderate the instability of the economy and the insecurity of employment.

Hayek’s book, The Road to Serfdom, was written against the backdrop of the Second World War, when economic planning was being used both by German and Japanese fascist governments, by the Soviet communist authorities, and by the British and American governments. He argued that well-intentioned planning would inevitably lead to a totalitarian outcome.3

His key idea about economics—that prices are messages—revolutionized how economists think about markets. Messages convey valuable information about how scarce a good is, information that is available only if prices are free to be determined by supply and demand, rather than by the decisions of planners. Hayek even wrote a comic book, which was distributed by General Motors, to explain how this mechanism was superior to planning.

But Hayek did not think much of the theory of competitive equilibrium, in which all buyers and sellers are price-takers. ‘The modern theory of competitive equilibrium,’ he wrote, ‘assumes the situation to exist which a true explanation ought to account for as the effect of the competitive process.’4

In Hayek’s view, assuming a state of equilibrium (as Walras had done in developing general equilibrium theory) prevents us from analysing competition seriously. He defined competition as ‘the action of endeavouring to gain what another endeavours to gain at the same time.’ Hayek explained:

Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called ‘perfect competition’ prevails? I believe that the answer is exactly none. Advertising, undercutting, and improving (‘differentiating’) the goods or services produced are all excluded by definition—’perfect’ competition means indeed the absence of all competitive activities.5

The advantage of capitalism, to Hayek, is that it provides the right information to the right people. In 1945, he wrote:

Which of these systems [central planning or competition] is likely to be more efficient depends mainly on the question under which of them we can expect [to make fuller use] of the existing knowledge. This, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to dovetail their plans with those of others.6

## 12.4 Prices as messages

Prices worked as messages on a global scale even before the transatlantic telegraph was introduced. Students of American history learn that the defeat of the southern Confederate states in the American Civil War ended the use of slaves in the production of cotton and other crops in that region. There is also an economics lesson in this story.

At the war’s outbreak on 12 April 1861, President Abraham Lincoln ordered the US Navy to blockade the ports of the Confederate states. To preserve the institution of slavery, these states had declared themselves independent of the US.

### Lincoln’s blockade halts the export of cotton

As a result of the naval blockade, the export of US-grown raw cotton to the textile mills of Lancashire in England came to a virtual halt, eliminating three-quarters of the supply of this critical raw material. Sailing at night, a few blockade-running ships evaded Lincoln’s patrols, but 1,500 ships were destroyed or captured.

excess demand
A situation in which the quantity of a good demanded is greater than the quantity supplied at the current price. See also: excess supply.

We have seen in Unit 7 that the market price of a good, such as cotton, is determined by the interaction of supply and demand. In the case of raw cotton, the tiny quantities reaching England through the blockade were a dramatic reduction in supply. There was large excess demand—at the prevailing price, the quantity of raw cotton demanded exceeded the available supply. As a result, some sellers realized they could profit by raising the price. Eventually, cotton was sold at prices six times higher than before the war, keeping the lucky blockade runners in business. Consumption of cotton fell to half the pre-war level, throwing hundreds of thousands of people who worked in cotton mills out of work.

### British textile mill owners increase demand

Mill owners responded. For them, the price rise was an increase in their costs. Some firms failed and left the industry due to the reduction in their profits. Mill owners looked to India to find an alternative to US cotton, greatly increasing the demand for cotton there. The excess demand in the markets for Indian cotton gave some sellers an opportunity to profit by raising prices, resulting in increases in the prices of Indian cotton, which quickly rose to almost match the price of US cotton.

### Farmers in India and Egypt switch to cotton

Responding to the higher income now obtainable from growing cotton, Indian farmers abandoned other crops and grew cotton instead. The same occurred wherever cotton could be grown, including Brazil. In Egypt, farmers who rushed to expand the production of cotton in response to the higher prices began employing slaves, captured (like the American slaves that Lincoln was fighting to free) in sub-Saharan Africa.

There was a problem. The only source of cotton that could come close to making up the shortfall from the US was in India. But Indian cotton differed from American cotton and required an entirely different kind of processing. Within months of the shift to Indian cotton, new machinery was developed to process it.

### Mill owners introduce new machinery

As the demand for this new equipment soared, firms that made textile machinery, like Dobson and Barlow, saw profits take off. We know about this firm, because detailed sales records have survived. Dobson and Barlow responded by increasing production of these new machines and other equipment. No mill could afford to be left behind in the rush to retool, because if it didn’t, it could not use the new raw materials. The result was, in the words of Douglas Farnie, a historian who specialized in the history of cotton production: ‘such an extensive investment of capital that it amounted almost to the creation of a new industry.’7

### A change in price was the message and the motivation

The lesson for economists—Lincoln ordered the blockade, but in what followed, the farmers and sellers who increased the price of cotton were not responding to orders. Neither were the mill owners, who cut back the output of textiles and laid off the mill workers, nor were the mill owners desperately searching for new sources of raw material. By ordering new machinery, the mill owners set off a boom in investment and new jobs.

All these decisions took place over a matter of months, made by millions of people, most of whom were total strangers to one another, each seeking to make the best of a totally new economic situation. American cotton was now scarcer, and people responded, from the cotton fields of Maharashtra in India, to the Nile delta, to Brazil, to the Lancashire mills.

To understand how the change in the price of cotton transformed the world cotton and textile production system, think about the prices determined by markets as messages. The increase in the price of US cotton shouted: ‘Find other sources, and find new technologies appropriate for their use.’ Similarly, when the price of petrol rises, the message to the car driver is: ‘Take the train’, which is passed on to the railway operator: ‘There are profits to be made by running more train services.’ When the price of electricity goes up, the firm or the family is being told: ‘Think about installing photovoltaic cells on the roof.’

In many cases (like the chain of events that began at Lincoln’s desk on 12 April 1861) the messages make sense, not only for individual firms and families, but also for society; if something has become more expensive, then it is likely that more people are demanding it, or the cost of producing it has risen, or both. By finding an alternative, the individual is saving money and conserving society’s resources. This is because, in some conditions, prices provide an accurate measure of the scarcity of a good or service.

See Who’s in Charge?, Chapter 1 of Paul Seabright’s book, for more detail on how market economies manage to organize complex trades among strangers.

Paul Seabright. 2010. The Company of Strangers: A Natural History of Economic Life (Revised Edition). Princeton, NJ: Princeton University Press.

### Centrally planned economies (or firms)

In planned economies, which operated in the Soviet Union and other central and eastern European countries before the 1990s (discussed in Unit 1), messages are sent deliberately by government experts about how things are produced. They decide what is produced and at what price it is sold. The same is true, as we saw in Unit 6, in large firms like General Motors, where managers (and not prices) determine who does what.

The amazing thing about prices determined by markets is that individuals do not send the messages, but rather the anonymous interaction of sometimes millions of people. And when conditions change—a cheaper way of producing bread, for example—nobody has to change the message (‘put bread instead of potatoes on the table tonight’). A price change results from a change in firms’ costs. The reduced price of bread says it all.

## 12.5 Putting motivation behind the message

Fish and fishing are a major part of the life of the people of Kerala in India. Most of them eat fish at least once a day, and more than a million people are involved in the fishing industry. But before 1997, prices were high and fishing profits were limited due to a combination of waste and the bargaining power of fish merchants, who purchased the fishermen’s catch and sold it to consumers.

### The importance of timing

When returning to port to sell their daily catch of sardines to the fish merchants, many fishermen found that the merchants already had as much fish as they needed that day. They refused to buy any more fish at any price. The price was effectively zero! Fishermen at these markets just dumped their worthless catch back into the sea.

A lucky few returned to the right port at the right time when demand exceeded supply, and they were rewarded by extraordinarily high prices.

On 14 January 1997, for example, 11 boatloads of fish were brought to the market at Badagara, which was found to be oversupplied; the catch was jettisoned. There was excess supply of 11 boatloads. But at fish markets within 15 km of Badagara, there was excess demand—15 buyers left the Chombala market unable to purchase fish at any price. The luck, or lack of it, of fishermen returning to the ports along the Kerala coast is illustrated in Figure 12.1.

Only seven of the 15 markets did not suffer either from over- or under-supply. In these seven villages (on the vertical line), prices ranged from Rs4 per kg in the market at Aarikkadi to more than Rs7 per kg in Kanhangad.

When the fishermen had bargaining power because there was excess demand, they got much higher prices. In markets with neither excess demand nor excess supply, the average price was Rs5.9 per kg, shown by the horizontal dashed line. In markets with excess demand, the average was Rs9.3 per kg. The fishermen fortunate enough to put in at these markets obtained extraordinary profits, if we assume that the price in markets with neither excess demand nor supply was high enough to yield economic profits. Of course, on the following day they may have been the unlucky ones who found no buyers at all and would have to dump their catch into the sea.

Prices contained important messages: ‘Fish are scarce in Chombala, but not in Badagara’, but the fisherman did not receive them in time to motivate them to change what they did so as to adjust to surpluses in one market and excess demand in others.

### Cell phones deliver the message on time

This all changed when the fishermen got cell phones. While still at sea, the returning fishermen phoned the beach fish markets and pick the one where the prices were highest that day. If they returned to a high-priced market, they would earn an economic rent (that is, income in excess of their next best alternative—returning to a market with no excess demand or, even worse, one with excess supply).

By gaining access to real-time market information on relative prices for fish, the fishermen could adjust their pattern of production (fishing) and distribution (the market they visit) to secure the highest returns.

A study of 15 beach markets along 225 km of the northern Kerala coast found that, once the fishermen had cell phones, differences in daily prices among the beach markets were cut to a quarter of their previous levels. No boats jettisoned their catches. Reduced waste and the elimination of the dealers’ bargaining power raised the profits of fishermen by 8%, at the same time as consumer prices fell by 4%.

Cell phones allowed the fishermen to become very effective rent seekers. Their rent-seeking activities changed how Kerala’s fish markets worked—virtually eliminating the periodic excess demand and supply—to the benefit of fishermen and consumers, but not of the fish dealers who had acted as middlemen.

This happened because the Kerala sardine fishermen could respond to price messages. The information given by the prices at different beach markets came at the right time, so they were motivated to land at the markets where fish was needed most.

### Question 12.1 Choose the correct answer(s)

Figure 12.1 shows how bargaining power affected prices in Kerala beach markets on 14 January 1997. Based on this information, what can we conclude?

• The higher the excess supply, the lower the price of fish.
• The price of fish in all markets with excess demand is Rs9.3 per kg.
• In cases of demand being equal to supply, the price that fishermen faced was the same in all markets.
• The data demonstrates that buyers have bargaining power when there is excess supply.
• The price of fish is zero in all markets with excess supply.
• The average price in the markets with excess demand is Rs9.3, per kg but the higher the excess demand, the higher the price.
• Even when demand equalled supply, fish were sold at different prices in different places.
• When there is excess supply, the price is zero. The buyers have all the bargaining power, while sellers have none.

## 12.6 The limits of markets: Repugnant markets and merit goods

Seeing prices as both message and motivation teaches us the following: markets work well when prices are informative about the real scarcity of goods and services, and when people can change their behaviour to take account of change in this information. When this is the case, we have ‘the magic of the market’; when it is not the case, we have market failures.

But even when markets work well in this sense, many (probably most) people think that there are reasons to organize the production and distribution of some particular goods and services by other means.

repugnant market
The exchange of some thing (such as infants, organs or sex) that many people find morally offensive.
merit goods
Goods and services that should be available to everyone, independently of their ability to pay.
• Repugnant markets: Marketing some goods and services—vital organs, votes, prizes, or human beings—may violate an ethical norm, or undermines human dignity.
• Merit goods: It is widely held that some goods and services (called merit goods) should be available to all, independently of a person’s ability or willingness to pay. Access to personal security, basic and emergency health care, and fair judicial proceedings are examples.

### Repugnant markets

In most countries, there are well-established institutions that allow parents to voluntarily give up a baby for adoption, but laws typically prevent parents from selling their infants.

The research done by Alvin Roth, the economist whose video you watched when we discussed kidney transplants, has identified many of these repugnant markets.8

Why do most countries ban the buying and selling of babies? Is it not true that a market for infants would provide opportunities for mutual gains from exchange between parents wishing to sell and would-be parents wishing to buy?

A common response is that some goods and services are different from the shirts, haircuts, and other goods that we routinely buy and sell on markets. Virtually all countries ban the sale of human organs for transplant. Commercial surrogacy—a woman becoming pregnant and giving birth to a baby for another couple for pay—is not legal in most countries (although it is legal in some states in the US, Thailand, and Russia).

Some economists might reason that it is wrong to prevent these transactions if both parties engage in them voluntarily—preventing those exchanges would be Pareto inefficient. But economic reasoning of this kind does not apply to just any transaction, and most economists now recognize that not everything should be put up for sale.

• The sale may not be truly voluntary: For example, poverty might force people to enter into a transaction that they might later regret, and the baby put up for sale is surely not doing this voluntarily.
• Can you put a value on dignity? Putting a price on a baby, or a body part, or sex may violate the principle of human dignity.
• It undermines institutions: Putting votes or human beings up for sale undermines the workings of valued social institutions or principles, such as democracy and freedom of movement.
• It might not be fair: Allocating goods according to the willingness to pay (which depends on an individual’s income), as is done in markets may, seem less fair than other ways of determining who gets what, such as ‘first come first served’ or universal access to the good.
• It encourages self-interest: Markets, and the monetary incentives on which they are based, may lead people to act in a more self-interested and a less public-spirited way than they would under other institutions.

Regarding the final bullet point, recall (from Unit 3.7) that this seems to have occurred when parents were fined for coming late to pick up their children at daycare centres in Israel (more parents picked their kids up later after the fine was imposed).

Michael Walzer and Michael Sandel, two philosophers, have discussed the moral limits of markets. Some market transactions conflict with the way we value humanity, such as buying and selling people as slaves; others conflict with principles of democracy, such as allowing people to sell their votes.

Michael Sandel. 2009. Justice. London: Penguin.

Michael Walzer. 1983. Spheres of Justice: A Defense of Pluralism and Equality. New York, NY: Basic Books.

Sandel investigates the moral limits of his audience (students around the world) in a talk called ‘Why we shouldn’t trust markets with our civic life’ and in a series of videos called ‘What money can’t buy’.

### Merit goods

Economists recognize that there are some goods and services that are considered special in that they should be made available to all people, even those who lack the ability or willingness to pay for them. These are called merit goods; they are provided by governments rather than allocated by a market governed by the willingness to pay.

In most countries, primary education is provided free to all children and financed by taxation. Basic health care—at least emergency care—is also often available to all, irrespective of the ability to pay. The same holds for legal representation at trial in many countries—a person unable to pay for a lawyer should be assigned legal representation without charge. Personal security—protection from criminal assault or home fires, for example—is typically ensured in part by publicly provided police protection and fire-fighting services.

Why should merit goods be provided to people free of charge? People of limited income do not have access to a great many things. They typically live in substandard and often unhealthy housing and have very limited opportunities for recreational travel. Why are basic health care and schooling, legal representation, and police and fire protection different? The answer is that in many countries, these goods and services are considered the right of every citizen.

### Exercise 12.1 Capitalism among consenting adults

Should all voluntary contractual exchanges be allowed among consenting adults?

State what you think about the following (hypothetical) exchanges. You may assume in each case that the people involved are sane, rational adults who have thought about the alternatives and consequences of what they are doing. In each case, decide whether you approve, and if you do not approve, whether you think the transaction should be prohibited. In each case explain why the transaction described produces mutual benefits (that is, it is a Pareto improvement over not allowing the exchange).

1. A complicated medical procedure has been discovered that cures a rare form of cancer in patients who will otherwise certainly die. Staff shortages make it impossible to treat all those who could benefit, and the hospital has established a policy of first come, first served. Ben, a wealthy patient who is at the bottom of the list, offers to pay Aisha, a poor person on the top of the list, $1 million to exchange places. If Aisha dies (which is very likely), then her children will inherit the money. Aisha agrees. 2. Melissa is 18. She has been admitted to a good university but does not have any financial aid, and cannot get any. She signs a four-year contract to be a stripper on the Internet and will begin work when she is 19. The company will pay her tuition fees. 3. You are waiting in line to buy tickets for a movie that is almost sold out. Someone from the back of the line approaches the woman in front of you and offers her$25 to exchange positions in the line (he takes her position in front of you and she takes his at the back of the line).
4. A politically apathetic person, who never votes, agrees to vote in an election for the candidate who pays him the highest amount.
5. William and Elizabeth are a wealthy couple who give birth to a baby with a minor birth defect. They sell this baby to their (equally wealthy) neighbours and buy a child without any birth defects from a family that needs the money.
6. An individual with an adequate income decides that he would like to sell himself to become the slave of another person. He finds a buyer willing to pay his asking price. The aspiring slave will use the money to further his children’s education.

## 12.7 The government as an economic actor

The reasons why institutions other than markets play an important part in production and distribution include market failures, the status of some goods or services as merit goods, and the morally repugnant nature of some exchanges. This helps to explain why governments are major economic actors. Government spending, taxation, laws, wars, and other activities are as much a part of economic life as the working, investment, saving, buying, and selling activities of families and firms.

When we say that governments are economic actors (as we did in calling firms economic actors), we refer to those making the key decisions—policymakers, military leaders, and top judicial authorities in a government.

In earlier units, especially the previous one, we identified many cases in which government policies could be introduced to address problems of either inefficiency or unfairness. But in Unit 3, we also showed how governments (like firms and individuals) are limited in what they can do, not only because they have limited resources to accomplish their objectives, but also because, in most economic matters, even a powerful government cannot dictate what citizens do.

The government can require that a minimum wage be paid to all workers, but it cannot require workers to work hard instead of loafing on the job. The government can require the owners of a business to pay taxes, but it cannot require them to invest in building new productive capacity instead of purchasing a second home. In many cases, the most it can do is to alter the circumstances under which people decide what to do. Here we return to the question of government policies, stressing not what governments might do to address market failures, unfairness, and other problems, but instead what they actually do and why that sometimes falls short of what we would like.

A government allows people to do things together that they could not do individually. An example is going to war. Governments also engage in activities that vastly improve living standards and the quality of life of their citizens. Examples include:

• Reduced poverty: Fifty years ago, even in rich countries, many retired or elderly people were trapped in poverty. For example, in 1966, 28.5% of US citizens aged 65 and over were classed as ‘poor’. Government transfers in many countries have virtually eliminated serious economic deprivation among the elderly. In 2012, just 9.1% of elderly people in the US were poor.
• Increased life expectancy and the dramatic reduction in child mortality in many countries: When these improvements occurred in the late nineteenth and early twentieth century, they were not primarily the result of advances in medicine, most of which came later. They followed government policies that improved sanitation and water supply.
• Economic security: The increased size of government spending has reduced economic insecurity by dampening the extent of booms and busts. This is referred to as reducing the volatility of the business cycle.

More about the economics of poverty reduction: Angus Deaton. 2013. The Great Escape: health, wealth, and the origins of inequality. Princeton: Princeton University Press.

### Coercion and providing public services

Governments are actors on a scale unparalleled by families and most firms. The US government—federal, state and local—employs almost 10 times as many people as the country’s largest firm, Walmart. However, governments were not always economic actors on this large a scale. In Figure 12.2 we show the total tax revenues collected by the government of the UK as a fraction of gross domestic product—a measure of the size of the government relative to the size of the economy—over more than 500 years. The figure rises from about 3% in the period prior to 1650 to 10 times that amount after the Second World War.910

Even when tax revenues were only 3% of gross domestic product, the government of the UK was an immensely important actor. It is not the size of governments that make them unique, or uniquely important as actors.

Within a given territory, only a government has the authority to use force and restraints on an individual’s freedom to achieve its objectives. Because citizens generally see the use of the government’s coercive powers to maintain order, regulate the economy and deliver services as legitimate—meaning that they accept the government’s authority—most citizens comply with government-made laws. One application of government’s coercive power is the collection of taxes, which can be used to fund its operations.

government
Within a given territory, the only body that can dictate what people must do or not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. Also known as: state.

To distinguish governments from private economic actors like firms, families, individuals, trade unions, and professional organizations, we define the government as the only body in a geographical territory (the nation) that can legitimately use force and the threat of force to pursue its ends. Governments routinely do things—locking people up, for example—which, if done by a private individual, are considered wrong and illegal.

Beyond its legitimate use of coercive powers, a second feature of the government is that it has obligations to its citizens based on civil and human rights; this feature also distinguishes the government from firms and other private economic entities. To advance and protect these rights, governments use tax funds to provide services such as national defence, police protection, and schooling. These services are often available to citizens without restrictions to those who use them, and without charging a price.

People differ greatly in their income and wealth and, therefore, in the taxes they pay; however, as citizens, they are equally entitled to many government provided services. This simple fact is at the root of many debates about the appropriate ‘size’ of the government; people with less income and wealth benefit from many government services, but people with more wealth and income pay more (in absolute terms) of the taxes that finance these services. The tax, transfer, and expenditure systems of democratic governments typically redistribute income from those with higher incomes to those with lower incomes (See Figures 5.20 and 5.21 in Unit 5).

### Part of the solution

Jean Tirole, an economist who specializes in the role of intervention and regulation, describes the way that governments can intervene in his Nobel prize lecture.

Governments may adopt the twin objectives that we have used in this course:

• Maximizing the surplus: They may try to ensure that the mutual gains possible through our economic interactions are as large as possible and are fully realized.
• Ensuring fairness: They can influence how that these gains are shared.

Examples of policies commonly adopted by governments to address market failures and unfairness include:

• Competition policies: To reduce the price-setting powers of monopolies.
• Environmental policies: To reduce emissions of pollutants.
• Subsidies: For Research and Development (R&D).
• Policies that establish the expectation that the economy is relatively stable: So that firms invest.
• Public provision of health care or compulsory insurance.
• Providing information: To allow people to make better decisions, such as the risks associated with financial products, children’s toys, and foods.
• Central bank policies: That require commercial banks to minimize their risk exposure by restricting the leverage of their balance sheets.
• Minimum wage laws: That prohibit contracts that pay below a stated minimum.

Governments pursue these objectives by some combination of four means:

• Incentives: Taxes, subsidies, and other expenditures alter the costs and benefits of activities that have external effects that would lead to market failures or unfair outcomes if left unaccounted for.
• Regulation: Direct regulation of economic activities, such as the degree of competition, including mandatory universal participation in social and medical insurance, and regulation of aggregate demand.
• Persuasion or information: Altering available information and people’s expectations about what others will do (for example, their belief that their property is secure or that other firms will invest) so as to allow people to coordinate their actions in a desirable way.
• Public provision: In-kind provision or through monetary transfers, including merit goods such as basic education, legal representation in court proceedings, and income transfers to alter the distribution of living standards.

### Part of the problem

To accomplish these valuable objectives, governments must have extraordinary powers to acquire information and to compel compliance. This creates a dilemma. For the government to be a successful problem solver, it must also be powerful enough to potentially be a problem itself. Examples from history, and today’s news, show governments using their monopoly on the use of force to silence opposition and to acquire huge personal wealth for their officials and leaders.

• Ivory Coast: As president from 1960 to 1993, Felix Houphouet Boigny accumulated a fortune estimated to be between $7 billion and$11 billion, much of it held in Swiss bank accounts. He once asked, ‘Is there any serious man on earth not stocking parts of his fortune in Switzerland?’
• Romania: Nicolae Ceausescu, the head of state under Communist Party rule for over two decades, amassed extraordinary wealth, the most visible parts of which were more than a dozen palaces that had bathrooms with gold-tiled baths and solid-gold toilet paper holders.
• Russia: Personal connections with President Vladimir Putin have allowed a class of business people called oligarchs to obtain hundreds of millions of roubles’ worth of assets.

Before the French Revolution, Louis XIV of France constructed a luxurious palace and grounds for himself at the Palace of Versailles, which is now one of the top tourist attractions in the world. He was called the Sun King by his subjects and claimed, ‘L’etat, c’est moi’ (‘I am the state’). The word ‘state’ is sometimes used—as the Sun King did here—to mean ‘government in general’, distinguishing it from any particular body, such as the government of France. In neighbouring Britain, at almost the same time, William Pitt had a different view of his King, declaring that ‘The poorest man may in his cottage bid defiance to all the forces of the Crown,’ as we saw in Unit 1 (Exercise 1.5).

Well-governed societies have devised ways to limit the damage that the use of government powers can inflict, without undermining the government’s capacity to solve society’s problems. These have generally included a combination of:

• Democratic elections: To allow citizens to dismiss a government that is using its powers for its own benefit or for the interests of some other small group.
• Institutional checks and balances and constitutional restrictions on what the government can do: These entirely prohibit some actions by a government, such as imposing a particular religion on a population.

The second point is why Pitt could observe that, while the farmer may have difficulty keeping rain out of his cottage, he could confidently exclude the King of England.

In a capitalist economy, aside from the obligation to pay taxes and in exceptional circumstances, the government cannot seize what you own; this limits the government’s capacity to enrich itself at your expense. This is an essential limit on arbitrary government powers.

An example of an exceptional case would be if you owned a piece of land that was the only possible site for a bridge needed to solve a traffic problem. Most governments have the right to acquire the land at what is independently judged to be a fair price, even if you are unwilling to sell. This power to take private property for public use has many names. For example, it is known as the ‘right of eminent domain’ in the US or a ‘compulsory purchase order’ in the UK. Even with well-designed limits on government powers and provision for exceptions allowing governments to better serve the public, we will see that governments, like markets, sometimes fail.

### Question 12.2 Choose the correct answer(s)

Which of the following statements are correct?

• A government should not be able to seize private property.
• A government should not be the monopoly supplier of a service.
• A government should not be allowed to use force against its citizens.
• A government should not collect information about its citizens.
• Generally speaking, this is correct. Some individuals might regard taxation as the seizure of a certain category of private property, but it is done with the consent of the society as a whole, according to rules that society has approved; taxation is accepted as payment for services provided by the state.
• There are some services that must be provided by a monopoly in order to ensure standardization and economies of scale. An electricity grid is one example. If a monopoly is required, it may be better that the monopolist is the state and subject to democratic control, rather than a private firm.
• A degree of force may be legitimate, provided it is reasonable, exercised against individuals committing serious misdemeanours (terrorism, insurrection), and is exercised within a framework of rules (law) that has the prior approval of its citizens.
• We accept that the state has to hold some information about its citizens in order to function properly. It needs to know the size of the population, gender, age, and other demographic information. For security reasons, it needs to know who is entering and leaving the country. However, the extent of this collection (and holding) of information is subject to rules approved by its citizens. When the UK tax authorities announced plans to collect financial information previously considered private, this was controversial and led to some criticism.

### Government failure

natural monopoly
A production process in which the long-run average cost curve is sufficiently downward-sloping to make it impossible to sustain competition among firms in this market.

To understand why neither markets nor governments may provide ideal solutions to economic problems, think about the case of a natural monopoly. An example would be the provision of tap water in a city, or electricity transmission over a national network. In these cases, as a result of economies of scale, the most efficient solution is to have a single entity provide the service. This could be a private firm, an economic monopoly, or the government, which is a political monopoly.

If the firm were privately owned as a monopoly, we know from Unit 7 that it would face a downward-sloping demand curve, which would limit the price at which it could sell its goods. In order to maximize the profits of the firm, and hence the value of the owners’ assets, the monopoly firm would both seek to reduce costs and restrict output so that it could charge a higher price. The result would be a price above the marginal cost of production, which would mean that some consumers who value the service at more than its marginal cost would not consume it. Private ownership of the monopoly would result in a market failure.

Would the government do a better job?

government failure
A failure of political accountability. (This term is widely used in a variety of ways, none of them strictly analogous to market failure, for which the criterion is simply Pareto inefficiency).

Ideally, a government-owned natural monopoly would set the price equal to the marginal cost and finance the fixed costs through taxation. But the government may have little incentive to reduce costs. The publicly owned water- or electricity-supply company may be under pressure to overstaff the company with well-paying jobs for politically connected individuals. As a result, the costs may be higher. Wealthy individuals or firms may lobby the government-owned monopoly to provide its services on favourable terms to special-interest groups. These outcomes of public ownership would be a government failure.

economic accountability
Accountability achieved by economic processes, notably competition among firms or other entities in which failure to take account of those affected will result in losses in profits or in business failure. See also: accountability, political accountability.
political accountability
Accountability achieved by political processes such as elections, oversight by an elected government, or consultation with affected citizens. See also: accountability, economic accountability.

This case illustrates both the similarities and differences between the economic accountability provided by the market and the political accountability provided by a democratic form of government. Both the owners of the monopoly firm and the government decision makers may act to further their own interests at the expense of the consumer or citizen, but they would both operate within constraints. The monopoly firm would not be free to charge whatever price it wished; its profits are limited by the demand curve. The government would not be entirely free to inflate the costs of provision by hiring or catering only to ‘friends of the government’, because it may suffer an election defeat.

market failure
When markets allocate resources in a Pareto-inefficient way.

These two cases—private or government ownership of a natural monopoly—illustrate the problem of market failure (the monopoly charging more than the marginal cost) and what is sometimes called government failure (the failure to minimize the cost of providing the service), and the problem of adopting policies in a real world in which neither issue can be avoided entirely.

Andrei Shleifer. 1998. ‘State versus private ownership’. Journal of Economic Perspectives 12 (4): pp. 133–150.

Which works better? There is no general answer to this question. And there are many choices besides private ownership or government ownership, including private ownership under public regulation, or public ownership with competition among private firms for the time-limited right to produce and price the service.

Viewing the government as an economic actor that pursues its objectives but is constrained by what is feasible, helps us clarify which factors can influence a government to be more of a problem solver, and less of a problem.

### Exercise 12.2 Building self-control into government

James Madison, a leading figure in the debates about the US Constitution after the formerly British colonies in the United States of America won its war of independence, wrote in 1788:

‘In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.’11

How does democracy (including the rule of law) address Madison’s concerns to oblige the government to ‘control itself’?

### Exercise 12.3 The relationship between economic development and size of government

1. Why was Pax Britannica a period of smaller government?
2. Compare Figure 12.2 with Figure 1.4. Why do you think the growth of the size of government coincides with both the emergence of capitalism as an economic system in the seventeenth and eighteenth centuries, and the increase in output per capita?
3. Compare two ‘peacetime’ periods—Pax Britannica and the period since the end of the Second World War. Why do you think the size of government was so much larger in the second period?

### Question 12.3 Choose the correct answer(s)

In order to be able to deal effectively with cases of market failure, unfairness, and to discharge its other obligations, the state needs to be sufficiently large and powerful. This means that the problem solver is also big enough to be a potential problem. How is this paradox usually resolved?

• the rule of law
• constitutional restrictions
• international pressure
• democratic elections that give citizens the power to dismiss the government
• Most countries have a framework of laws that apply to all, without exception. These laws must be interpreted and enforced by a judicial system. The effectiveness of the rule of law when it comes to constraining government behaviour usually comes down to the question of how independently (of government) the judiciary can function.
• Some countries have written constitutions. A constitution is a set of rules that is more permanent than the laws that individual governments can make and unmake. To give a constitution a special status, it is difficult to change. For example, an amendment to a constitution may require a vote of 66% rather than a simple majority, and this vote may have to be widely replicated amongst different groups.
• Most governments are probably sensitive to international pressure, but that does not mean that they feel bound to accept it. There are plenty of examples of governments behaving for years with complete disregard for international opinion, even in face of sanctions. South Africa during the apartheid regime was one example; more recently Zimbabwe and North Korea have shown how an authoritarian government can ignore international pressure.
• This is perhaps the ultimate constraint. Provided the elections are ‘free and fair’ (requiring secret ballots and other conditions), a democratically elected government must ultimately accept the will of the people.

## 12.8 Political rents and democratic political competition

Monica Martinez-Bravo, Gerard P. I. Miquel, Nancy Qian, and Yang Yao. 2014. ‘Political reform in China: The effect of local elections’. NBER working paper, 18101.

Just as competition disciplines firms in the economy by limiting the profits they can get by producing less and setting a price greater than marginal cost, competition to win elections is the way that a democracy disciplines its politicians to provide the services desired by the public at a reasonable cost (in terms of taxes it raises to pay form them). In the ‘How economists learn from data’ box below, we use evidence from the US to answer the question: ‘Does electoral competition affect policy?’. There is also evidence from other countries that the prospect of being removed from office affects what politicians do. The introduction of village-level elections in China led to increased provision of local public services such as health services and schooling, and arguably a reduction in corruption.

### Political rents

Our analogy between firms and governments suggests a similarity between a dictator and a monopolist—neither faces much competition. But there are other similarities. Think about what a dictator can do. The examples above from Russia, Ivory Coast, France and Romania show that the lack of competition allows the ruler to gain substantial income that would not be possible were it not for his political position.

political rent
A payment or other benefit in excess of the individual’s next best alternative (reservation position) that exists as a result of the individual’s political position. The reservation position in this case refers to the individual’s situation were he or she to lack a privileged political position. See also: economic rent.

This income is called a political rent. It is political because it is associated with a political position or connections. It is a rent in the sense already used many times in this course—a payment above and beyond what the actor can get from his or her next best alternative. This is similar, for example, to the employment rents received by an employed worker. In the case of the worker, the next best alternative is considered to be unemployment; for a member of the political elite, the next best alternative is what the person would receive without a political position or connections. In the case of the Russian oligarchs mentioned above, their political rents are the income they have received above and beyond what they would have had in the absence of any privileged connection to the Russian government. In Figure 12.3 we illustrate political rents by contrasting the effects of competition and the lack of competition in the economy and in government.

Varieties of political and economic competition Source of rents or reasons for their absence Controls on political elites and firm owners Power of the non-elite (citizens and consumers) Profits/rents
The extreme case of limited political competition (a dictator) The dictator uses tax and other government revenues as a source of personal income above what he would receive as an ordinary citizen. Limited threat of removal from office, e.g. revolutionary overthrow Little Political rents > 0
The extreme case of limited economic competition (a monopolist) The monopolist restricts sales, charges prices above the average cost of production and receives a profit greater than the opportunity cost of capital. Limited threat of market entry by competing firms Little Economic profits > 0
‘Ideal democracy’ Rents are eliminated by competition among political parties and other freedoms such as a free press Electoral loss is certain if significant political rents are extracted. Exercised mainly through ‘Voice’–vote for someone else Political rents = 0
‘Perfect competition’ among firms Rents are eliminated by competition among firms Zero sales (and firm failure) if sets a price higher than average cost. Exercised mainly through ‘Exit’—buy from someone else Economic profits = 0

Political and economic rents under competition and monopoly.

Figure 12.3 Political and economic rents under competition and monopoly.

### Question 12.4 Choose the correct answer(s)

Why is the term ‘political rent’ used to describe the increases in personal wealth often enjoyed by dictators?

• The income is derived from hiring out public property to private individuals.
• These are ‘excessive’ earnings resulting from the dictator’s political position.
• Political rent is income that dictators earn from confiscating private property and letting it to friends at preferable rates.
• ‘Rent’ is a term used to describe any excessive level of income.
• This seems to be confusing the economist’s use of the term ‘rent’ with the everyday use of the term to describe income from hiring out property, usually (but not always) buildings.
• Economists use the term ‘rent’ to describe any earnings over and above what the resources could earn in their next best use (in other words, abnormal profit). Rents here are ‘political’ because they are the result of political institutions.
• While this kind of behaviour is characteristic of some dictatorships, it does not capture the economic meaning of the term ‘rent’.
• It is true that ‘rent’ implies a strict definition of ‘excess’; it is the return in excess of that which could be earned in the next best use. However, the answer needs to describe why these rents are considered ‘political’.

### Question 12.5 Choose the correct answer(s)

The magnificent chateaux in France’s Loire Valley, built between 1550 and 1780, are a major tourist attraction. Many of them were commissioned and built by finance ministers serving French kings of the period. How might this be explained in the context of this unit?

• There was a lack of accountability.
• The king’s ministers were drawn from aristocratic French families who were generally very wealthy.
• Building a magnificent chateau was a way of confirming one’s status.
• The Loire valley was well provided with the essential materials for building.
• French kings of this period (Francois I to Louis XIV) and earlier were autocratic, effectively dictators, and answerable to no one, although as the unit explains they always had to ensure the loyalty of their armed forces. This meant they could dispense favours to anyone they liked and were accountable to no one. Favours inevitably went to those on whom they relied. Ministers of finance were key individuals in this respect, since the lavish lifestyles of autocratic monarchs depended on their success.
• Inevitably, the king’s court was dominated by aristocratic families, but ministers of finance often came from bourgeois backgrounds, perhaps because the ministerial role required some knowledge of trade and commerce. What is striking is how quickly these people amassed personal fortunes once they had been introduced to the court.
• This may well have been part of the motivation, but the means to do it came from the ability to amass a private fortune out of public funds.
• As it happens, it wasn’t. Much of the stone was transported over long distances. Caen in Normandy was one major source. But even if it had been, this would not explain the strange coincidence between the chateaux being built by people who had influential positions at the French court.

### Question 12.6 Choose the correct answer(s)

The role of the dictator can perhaps be compared to that of the monopolist, in that both earn rents that they try to protect, either by spending on police and security services (dictator) or by creating barriers to entry (monopolist). In what important respects do these rent seekers differ?

• The dictator is looking to maximize benefits for himself, and possibly for his family and various interest groups.
• The monopolist is a private firm and subject to government regulation, whereas the dictator is the government. The state is always more powerful than an individual firm.
• Unlike the monopolist, the dictator seeks to maximize long-run rents by staying in office for as long as possible.
• Some of the barriers to entry used to protect monopoly rents (for example, economies of scale, innovation) yield some economic benefits. This not true for the dictatorship.
• The monopolist is assumed to be maximising profit for the shareholders, while the dictator is maximising rents for himself (and some others, perhaps), but this is not a major difference.
• The monopolist faces the constraint that the government possesses numerous powers, which it can legitimately use to terminate the monopoly if it acts too far outside the public interest. The dictator, however, is the government and is only constrained by the possible use of force.
• This behaviour is similar to that of a monopolist, who tries to protect supernormal profits for as long as possible.
• In a dictatorship, rents are often protected by high levels of spending on police, armed forces, and security services. It is difficult to see much social benefit in this.

### How economists learn from data Does electoral competition affect policy?

Think of a politician as wanting to stay in office and knowing that she must satisfy a majority of voters when seeking re-election. But she also has her own objectives: to advance a particular project that she favours, or to maintain good relations with wealthy individuals who will support her political campaigns or employ her when her political career is over. Does the threat of ‘give the voters what they want or get thrown out’ lead her to emphasize the public’s interests, instead of her own?

Just comparing the policies adopted by politicians in districts that are non-competitive (for example, there is no other candidate for the seat) with those who face electoral competition does not answer the question. The reason is that competitive and non-competitive political districts, and the politicians who represent them, are different in so many ways that the comparison would mix the effects of political competition with the effects of these other differences.

Tim Besley and Anne Case, two economists, devised an ingenious way to answer the question. Some state governors in the US are limited to two four-year terms of office. This means that, at the end of their first term, they face electoral competition when they ask voters to re-elect them. During their second term, the prospect of political competition does not affect them, because they are not allowed to stand for re-election.12

Considered as an experiment, the ‘treatment’ is the prospect of electoral competition, the governors in their first terms are the ‘treatment group’ and the same governors in their second terms are the ‘control group’. As in any good experiment, other important influences are held constant. We are measuring the same individuals, in the same districts, under a treatment and a control condition.

Besley and Case found that, during the governors’ first terms (the treatment period), Republican and Democratic governors implemented virtually identical levels of total taxation per capita. But during their second terms (the control period), Democratic Party governors, who tend to favour more public expenditure and taxation, implemented much higher levels of taxation than did the Republicans. Republican governors, when not facing political competition, implemented much lower levels of the state minimum wage.

Whether Democrat or Republican, governors faced with electoral competition in their first term implemented very similar policies to those favoured by the ‘swing’ voters ,who tend to change who they vote for, and so tend to decide many elections—lower taxes and higher minimum wages. But the governors diverged according to their own political preferences or economic interests when electoral competition was removed.

### Democratic political competition

political institution
The rules of the game that determine who has power and how it is exercised in a society.

In Unit 6 we explained that the firm is not only an actor, it is also a stage on which the various groups making up the firm also act, sometimes in conflict, sometimes in cooperation. The same can be said of governments. On the stage of government, politicians, political parties, soldiers, citizens, and bureaucrats interact according to the informal and formal rules that constitute political institutions.

The political institutions of a country are the rules of the game that determine who has power and how it is exercised in a society. Democracy is a political institution, which means it is a set of rules that determine

• who makes up the government
• the powers they can use when governing.

Political institutions differ from country to country and over time. Major categories of political institutions include democracy and dictatorship.

The key value motivating democracy is political equality. Citizens should have substantially equal opportunities to be able to express their views in ways that can shape the policies and other activities of the government. Recall that in Unit 1 we explained that we use the term ‘democracy’ to refer to a form of government characterized by the rule of law, civil liberties, and inclusive, fair, and decisive election. Inclusive means that no major group—for example, women, ethnic minorities, those without property—can be excluded from the right to vote.

Democracy is sometimes advocated as a means to ‘let the people rule’, or in Abraham Lincoln’s words, a ‘government of the people, by the people and for the people.’ But who ‘the people’ are and what ‘the people’ want is difficult to determine. Kenneth Arrow is the economist who contributed most to our understanding of the problems that elections sometimes encounter in selecting between different courses of action.

### Great economists Kenneth Arrow

Kenneth Arrow (1921–2017) was born in New York City to Romanian American parents. His essay, ‘A cautious case for socialism’, explains how the Great Depression and the Second World War influenced his ideas, especially those of ‘freedom and avoidance of war’.13

Steven Durlauf’s essay, ‘Kenneth Arrow and the golden age of economic theory’, provides a good summary of Kenneth Arrow’s explanation of the problems of using voting to determine which action is preferred, and his broader contributions to economics and social science.14

In addition to his work on voting systems, Arrow was among the first to demonstrate that there were conditions under which something like Adam Smith’s ‘invisible hand’ would work. Characteristically scholarly and detached from ideological rhetoric, he later wrote:

There is by now a long and … imposing line of economists from Adam Smith to the present who have sought to show that a decentralized economy motivated by self-interest and guided by price signals would be compatible with a coherent disposition of economic resources that could be regarded … as superior to a large class of possible alternative dispositions. … It is important to know not only whether it is true but whether it could be true. (original emphasis) (General Competitive Analysis, 1971)

Arrow was a pioneer in the study of many of the themes in Economy, Society, and Public Policy, including asymmetric information and the economics of knowledge. He helped broaden the scope of economics to include insights from other disciplines.

No existing government fulfils the democratic ideal of political equality, with each citizen having equal influence over an outcome. Similarly, no government today can be said to perfectly match the three political institutions that define democracy.

Think about inclusive elections. Some population groups—for example, those convicted of major crimes—are excluded from voting in many countries, but we still consider the country’s political system as democratic. However, exclusion of a major population group—women, for example, as was common in recent history—is a sufficiently serious violation of the ‘inclusive elections’ criterion to disqualify a country from the club of democratic nations.

Some examples include:

• The US: The Voting Rights Act of 1965 secured the vote for large numbers of effectively disenfranchised African American citizens. The result was a substantial shift in educational spending in districts with large numbers of previously excluded black voters.
• Brazil: In Brazil, before the mid-1990s, casting a valid ballot required that voters could read and write reasonably well (which perhaps a quarter of the population could not). Around 11% of ballots cast were declared invalid due to communication barriers, most of them cast by poor voters. New electronic voting introduced in 1996 used pictures of candidates, an interface similar to phone keypads or ATM screens, and prompted the voter through the process step by step. The effect was to increase the number of valid votes made by the poor. The resulting change in the nature of the electorate led elected political leaders to prioritize the kinds of spending predominantly benefiting the less well off. Expenditure on public health, for example, increased by more than a third.15

Albert O. Hirschman, an unconventional economist, helped define how the performance of entities such as firms and governments could be improved by his concepts of ‘exit’ and ‘voice’, which we mentioned briefly in Figure 12.3.

### Great economists Albert O. Hirschman

Albert Hirschman (1915–2012) lived an extraordinary life. Born in Berlin in 1915, he fled to Paris in 1933 after Adolf Hitler won power in Germany and joined the French Resistance in 1939, helping many artists and intellectuals to escape from the Nazis. He emigrated to the US in 1941.

Given this history, it’s hardly surprising that Hirschman’s career as an economist did not follow a conventional path. He crossed disciplinary boundaries with ease, grappled with questions that lay well outside the professional mainstream, and developed ideas that were imaginative, profound, and enduring.

Among Hirschman’s many influential contributions, he is best known for the thesis laid out in his 1970 book, Exit, Voice and Loyalty. He was concerned with how the performance of entities such as firms and governments could be improved.16

He identified two forces—exit and voice—that could serve to alert an organization that it was facing decline and provide incentives for recovery. ‘Exit’ refers to the departure of a firm’s customers to a competitor. And ‘voice’ refers to protest, the tendency of disappointed customers to ‘kick up a fuss’. When a company performs poorly or unethically, shareholders can sell their shares (exit) or campaign for a change of management (voice).

Hirschman observed that economists had traditionally extolled the virtues of exit (competition), while neglecting the operation of voice. They favoured exit-based policies, for example, those that made it easier for parents to choose which school their children attended so that schools would have to compete to enrol students.

He considered this an omission, because voice could allow a lapse to be reversed at little cost (in this example, parents who exercise their voice in meetings could usefully seek changes in school policies), while exit might waste physical capital and human capabilities. Also, exit is not an option in some case—for example, tax administration—so the free exercise of voice is critical to good performance.

For further reading on Albert Hirschman, see this blog: Rajiv Sethi. 2010. ‘The Astonishing Voice of Albert Hirschman’. Updated April 7 2010.

The interplay between exit and voice works through a third factor, which Hirschman called loyalty. Attachment to an organization is a psychological barrier to desertion. By slowing exit, loyalty can create the space needed for voice to do its work. But loyalty can hinder performance if it becomes blind allegiance, because that stifles both exit and voice. Organizations may promote loyalty for precisely this reason. But if they were too effective at repressing exit and voice, they would ‘deprive themselves of both recuperation mechanisms’.

## 12.9 Government spending priorities of a nation

Joseph Schumpeter once wrote that the public budget is the ‘skeleton of the state stripped of all misleading ideologies’. He argued that the way in which a government spends its money reveals its true priorities, much in the way that an individual’s spending pattern is a lens through which to study his or her preferences.17

As we have seen, before the twentieth century a major activity of governments was defence (in some cases, predation on other nations), and raising the taxation to support it. But well before that time, some ruling institutions came to understand that they would benefit from providing conditions for the growth of the economy—building canals, roads and schools in the nineteenth century, for example. Economic development could be an asset by creating a larger tax base, educating a more scientifically oriented cadre of citizens, or by building financial institutions that could loan money to the government.

During the twentieth century, large-scale production in firms was easy for the government to see and it happened in one place. This made taxation and regulation of firms easier, and governments could also use the accounting books and payroll records of firms to find out who was paid what. This meant that taxing individuals became easier, too. Governments in many countries deducted tax directly from the pay of their citizens, and many workers were taxed explicitly for ‘social security’, that is, to fund pensions and sometimes health care.

Many governments are currently investigating whether their systems of taxation are efficient and fair. An example is the 2010 Mirrlees Review, which offered proposals for a comprehensive reform of the UK’s tax and transfer system, establishing the scope for better addressing market failures and unfairness.

Changes in the structure of the economy also made it easier for governments to levy taxes, not on a specific good—such as salt or imports—but also on consumption in general and ultimately on value added in production. These broad-based taxes play an important role in the public finances of advanced economies. With the extension of voting rights to virtually all adults, governments became accountable to their citizens for delivering services.

The historical processes of transition from political monopoly to political competition have produced most of the modern governments in the world, with their distinctive patterns of spending.

Figure 12.4 shows how the democratic governments of the US, South Korea, and Finland spend their money.

Patterns of public expenditure in Finland, the US, and South Korea (2013) measured as a percentage of total spending by government.

Figure 12.4 Patterns of public expenditure in Finland, the US, and South Korea (2013) measured as a percentage of total spending by government.

The size of the government spending in Finland is 57.5% of its GDP, which is the largest of the three countries. For the US, it is 38.8%. Note: this does not mean that the US spends less than Finland in absolute terms, just that government expenditure is a smaller fraction of the country’s GDP. Expenditure by South Korea’s government is 31.8% of its GDP.

This is what the categories mean:

social insurance
Expenditure by the government, financed by taxation, which provides protection against various economic risks (for example, loss of income due to sickness, or unemployment) and enables people to smooth incomes throughout their lifetime. See also: co-insurance.
• Public services: These include funds for running parliament, congress, local councils, also foreign aid and public debt transactions.
• Military: As previously stated, one of the motivations for government has been for protection or to wage war.
• Economic affairs: This includes expenditures on infrastructure such as roads, bridges, and the Internet.
• Public order and safety: This includes police, fire, prison services, and law courts.
• Social protection: Social insurance spending that a government might make, such as unemployment benefits and pensions is labelled ‘Social protection’ in the figure.
• Schooling: All governments are responsible for at least some education provision.
• Health: This includes medical equipment, hospital and outpatient services, and public health.

There are many reasons why governments differ in their spending patterns. One reason is that political institutions differ, even among democracies.

### Exercise 12.4 Past influences on current government spending patterns

1. How would you characterize the two biggest differences in the spending patterns among the three pairs of countries (the US vs South Korea, the US vs Finland, and Finland vs South Korea)?
2. Can you think of factors in the countries and their histories that might account for these differences? You need to do some research to support your claims.

### Exercise 12.5 Using Excel: Comparing government expenditures

Go to the source of Figure 12.4, OECD statistics, and see if you can find different countries for each of the criteria below (for the year 2015, or the most recent year available). For each of your chosen countries, plot a stacked column chart similar to Figure 12.4.

• General government expenditure (as a percentage of GDP) is greater than South Korea’s, but less than Finland’s.
• Government expenditure on health (as a percentage of GDP) is greater than the US’s.
• Government expenditure on social protection (as a percentage of GDP) is greater than Finland’s.
• Government expenditure on defence (as a percentage of GDP) is greater than South Korea’s.

### A puzzle: Persistence of unfairness and market failures

It is clear that even governments considered to be ‘small’ in spending relative to their economy—South Korea and the US in the above figure—control vast economic resources that could be used in pursuit of both efficiency and fairness. But previous units have revealed many cases in which economic outcomes are Pareto inefficient, so potential mutual gains remain unrealized. These seem like potentially ‘win–win’ situations that those engaged in political competition—aspiring electoral candidates or political parties, for example—would energetically exploit. Yet the problems persist.

We know that citizens in many countries think the distribution of wealth or income is unfair. In 2005 in the US, for example, both Republicans and Democrats, both rich and poor, when asked said that the poorest 80% of the wealth distribution should receive at least three times the wealth that they then had received. More recently, changes in US tax policy have favoured the wealthy, not the bottom 80%.

This is a puzzle.

## 12.10 Economic feasibility

economically feasible
Policies for which the desired outcomes are a Nash equilibrium, so that once implemented private economic actors will not undo the desired effects.
Policies for which the government has sufficient information and staff for implementation.
politically feasible
Capable of being implemented given the existing political institutions.

To make sense of this puzzle, we must think about the feasibility of the policies that a government might adopt. Fixing some problem of Pareto inefficiency or perceived unfairness will happen only if:

• It is economically feasible: The policy to fix the problem, if implemented, must work.
• It is administratively feasible: The government must have the capacity to implement the policy.
• It is politically feasible: Those who determine which policies are implemented—both officials and private interests—must want to see the policy implemented and, if they do implement the policies, they or others supporting the policy must remain in office.

We take up these three problems in turn, starting with economic feasibility.

Given people’s preferences and the information available to private economic actors, there may not be a feasible set of policies that would sustain an efficient and fair outcome. For a policy to have economic feasibility, it must be a Nash equilibrium, which means no actor can improve its position by changing its behaviour.

In Section 3.8 we showed that a government’s policy to raise the tax rate for the rich to be able better to provide needed services to low-income families might be less effective than expected if the high tax rates make it cost effective for the wealthy to engage in tax evasion.

To take another example, a government that tries to enforce perfect competition in every industry will fail. Since firms are free to advertise, and to differentiate their products, it is impossible for the policymaker to legislate that demand curves be horizontal.

We have also seen that no macroeconomic policy can entirely eliminate unemployment, given that the threat of unemployment motivates people to work hard and well.

### Economic feasibility: An example from Chile

The model of tax evasion in Unit 3 is a simplification, but it helps us understand real economic forces operating in the world. The experience of Chile provides such an example.

In 1970, the socialist Salvador Allende was elected president of Chile in a surprise victory, on a platform promising greater public services and nationalization of many of the privately held firms in the country.

To interpret the data in Figure 12.5, notice the vertical line that marks the day before the election. The series for share prices dropped dramatically the next day. The fall in share prices indicates a major sell-off of shares in Chilean companies as soon as the news arrived. This tells us that the victory of Allende was a surprise. Had his victory been anticipated, the stock market would have fallen before the election.

A stock (or share) is a share in the ownership of a company; its price measures how much it is worth to own part of that company and as a result receive a share of its profits, and benefit in the future from selling it to another person.

Share prices rise when, taking everything into account, owners or potential buyers of shares think that the company will be more profitable in the future. When a socialist president was elected in Chile, wealthy people were worried about:

• higher taxes
• policies favouring employees that would mean paying them higher wages
• and the possibility that the government or even workers might expropriate (take over the ownership of) the assets of private firms.

In turn, these worries created a limit to the policies that would prove economically feasible for the Allende government. If the wealthy thought that the firms they owned would be less profitable in the future, they would have no incentive to invest in increasing the assets of the firm. Rather than invest in these firms, these people might instead invest in another country (known as capital flight), in housing, or in other Chilean assets more likely to be valuable in the future.

The result was poor economic performance of the Chilean economy. We will return to the Chile story a bit later, when we will see that political interests, as well as economic infeasibility, can limit what a democratically elected government can do.

### Question 12.7 Choose the correct answer(s)

What is meant by economic feasibility?

• Policies that solve the problem must be possible to implement in practice.
• For a policy to have economic feasibility, it must produce a Nash equilibrium and sustain a fair and efficient outcome.
• Policies that would solve the problem and are politically acceptable.
• Must be able to make someone better off without making anyone else worse off.
• This description refers to administrative feasibility (see the next section), which some policies can lack. Economic infeasibility refers to policies that can be implemented but do not have the desired outcomes.
• This may be impossible given the information available to the policymaker and/or people’s preferences, or there may be unintended consequences.
• Some policies may be able to solve the problem and could be introduced in practice, but political pressures may prevent their adoption. For example, between 1815 and 1846, the UK parliament maintained a series of ‘Corn Laws’ that kept food prices high. As a means of lowering food prices, their abolition would have been economically and administratively feasible. But the Corn Laws benefited landowners who dominated parliament at the time and resisted giving up the benefit for many years.
• This is the definition of a Pareto improvement.

## 12.11 Administrative feasibility: Information and capacities

Even if there exists an economically feasible set of policies that would address market failures, in order to design and implement these policies, the government needs:

fiscal capacity
The ability of a government to impose and collect substantial taxes from a population at low administrative and other costs. One measure of this is the amount collected divided by the cost of administering the tax system.
• information about the nature of the uncompensated external effects that account for the market failure
• the administrative and fiscal capacity to design and implement effective policies.

As we have seen, the magic of the market means that, as long as prices reflect social marginal costs, the information required to direct resources to more highly valued rather than less highly valued uses arises as a by-product of people’s everyday transactions.

Contrast this with the case of a citizen attempting to get a remedy through the courts for an environmental market failure. If the citizen suffering from a respiratory illness could bring a lawsuit against the polluting firm that caused it, and secure compensation for the costs of his illness, then this might ‘internalize’ the external costs of the polluter’s actions, leading to more effective abatement efforts. But in most cases, this cannot be done because the citizen does not have the necessary information about who is polluting, or cannot afford the legal and other costs of pursuing the case.

### Governments have limited information

Market failures arise because essential information is not available to buyers, sellers, and other private economic actors. But this information is not likely to be available to the government either, limiting its ability to design policies that address environmental market failures. Governments often do not know how much citizens value environmental quality, or how effective environmental policies will be in ensuring a sustainable environment. If prices are sending the wrong messages, and if the government is to correct them through the implementation of taxes, subsidies, or regulation, it must find ways of collecting the necessary information to design those interventions.

Limited information is not the only factor limiting the administrative feasibility of policies to remedy market failures.

### Limited fiscal capacities

To levy taxes effectively and collect the revenue, governments need revenue officers who are competent, not corrupt, with sufficient resources to find and punish tax evaders, and with enough legitimacy to ensure that most people pay their taxes.

Administrative capacity is required for many different kinds of taxes, from trade tariffs enforced at the border, to payroll taxes levied on wages, and to corporate income taxes charged on legally incorporated economic entities. The use of accounting books in large firms makes it easier to audit firms and accurately assess their tax bill. But this also depends on the technology and institutions available. International flows of difficult-to-track financial obligations make illegal tax evasion, and legal tax avoidance (for example, by moving profits to international tax havens), a problem for governments who want to collect tax. This lowers their fiscal capacity.18

Lack of administrative capacity affects all aspects of government, not just taxes. An educational reform, for example, requiring teachers to abandon rote-learning methods and engage in more active student-centred learning may simply be impossible to implement, given the skills of the current teaching force.

### How economists learn from data Administrative infeasibility: An application from Nigeria

A lack of information about the progress of infrastructure projects funded by the government, and a poorly functioning and corrupt administration, resulted in poor outcomes in Nigeria.

In 2006–2007, the public sector was given funding and made responsible for implementing 4,700 small-scale infrastructure projects like installing water wells, constructing dams, and building health centres. Just 31% of the projects were completed and 38% were not even started. For example, the funding was paid for 1,348 water wells, but 846 were never completed, leaving hundreds of thousands of people without improved access to water.

Economists Imran Rasul and Daniel Rogger wanted to find out why some organizations succeeded in completing projects on schedule and budget, while others did not. They could do their research because the Nigerian government had collected information from independent teams of engineers about the quantity and quality of completed projects. Accurate information of this kind from independent observers on the quantity and quality of public services is very rare for a low-income country.19

Rasul and Rogger found that ‘getting things done’ by public sector organizations is affected by how the organizations are managed. They were surprised to discover that using performance incentives, with which managers were rewarded for good performance as measured by the organization (not by independent assessors), was correlated with lower completion rates. In organizations where officials had greater autonomy in making decisions—not in response to performance incentives—outcomes were better.

While financial incentives can play a positive role in motivating government officials, the Nigerian case shows that, if it is difficult to collect and verify information, trying to attach simple performance incentives to complex tasks may backfire. If there is poor information, then it may be better to give organizations greater autonomy. In this case, officials given autonomy observed social norms of responsibility, and completion rates were higher.

## 12.12 Political feasibility

In a democracy, it is often said that ideally the government is the servant of the people. In economic terms, government officials are the agents and the citizens are the principals. But this immediately raises two questions:

principal–agent relationship
This is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.
• Why would the agent (the elected official) do what the principals (the citizens) desire? As in any principal–agent relationship, the agent has his or her own objectives, and they differ from the principal’s objectives. We saw that, although political competition can help, the problem does not disappear in a democracy.
• Who are ‘the people’? In economic terms, who is (or are) the principal(s)? Until now the principal has been the lender or the employer, which we could simplify by representing as a single individual. But there are many citizen-principals and they have differing priorities for what the government should do, for example, abatement of pollution, school improvement, policies to boost innovation, tax-funded transfers to the poor, and so on.

Think about the first problem—motivating the elected official to do what the citizens prefer—as a principal–agent problem, like the employer trying to motivate a worker to contribute to the profits of the firm. What are the possible solutions when the manager tries to motivate workers? The manager could:

• Pay the agent an economic rent: She will fear losing it if she does an unsatisfactory job.
• Monitor the work activity of the employee: To detect signs of inadequate work.
• Replace the worker with another worker: If the work is found to be unsatisfactory.

In a democracy, elected officials are held accountable to the electorate by a similar set of strategies:

• Give the official a sufficient salary, prestige, and other amenities of office: The official would then like to keep the job.
• Monitor the activities of the government: Determine the quality of the government’s performance using legal principles of transparency and judicial review, along with a free press and free speech.
• Hold periodic elections: A government that has not performed well in the citizens’ eyes is replaced by a different set of political leaders.

But these methods—while essential components of a democratic society—sometimes work imperfectly, if at all. There are many reasons. But one is that citizens or groups that can amass substantial wealth for the purposes of influencing the government have extraordinary political influence even in a democracy.

Elites and organized groups seem to have much more influence on policy than average citizens: Martin Gilens and Benjamin I. Page. 2014. ‘Testing theories of American politics: Elites, interest groups, and average citizens’Perspectives on politics 12 (03): pp. 564–581.

### How economists (and political scientists) learn from data Does money talk?

In the US, people often say ‘money talks’. Many are concerned that it talks particularly loudly when it comes to politics.

To some, it is obvious that, when a candidate for political office receives a large contribution for his electoral campaign from a business or a trade union, the candidate is more likely to use political power to influence policy in favour of the contributor.

Research by Joshua Kalla and David Broockman, two political scientists, shows that election campaigns for the US congress in 2012 spent on average \$8.5 million per congressional seat. But did the winners provide favours for the donors that would not have occurred without the donors’ contributions? We might ask if the members of congress who received contributions from those with investments in the oil industry tended to favour the interests of those firms afterwards. Or did those receiving funds from trade union members support an agenda that favoured the union’s interests? The answer in both cases would be that they did.20

But this does not demonstrate that donor contributions purchased influence over the legislator. Remember, causation can work both ways; those with oil wealth are likely to donate to candidates who already favour that industry’s interests; trade union members will donate money to those who already support the interests of trade unions. Simply showing a correlation between the source of the funding and the policies supported by the legislator does not show that the contributions caused the legislator to act differently.

Kalla and Brockman designed a clever experiment to see if the donation caused the congress member to behave in the donor’s interest. They reasoned that citizens could influence legislators by meeting with them and expressing their views. Members of congress are busy people, so gaining access to them for a meeting is something that groups compete for.

It seems that democracy alone cannot reverse rising inequality: Adam Bonica, Nolan McCarty, Keith T. Poole, and Howard Rosenthal. 2013. ‘Why hasn’t democracy slowed rising inequality?’ The Journal of Economic Perspectives 27 (3): pp. 103–123.

Kalla and Brockman wanted to find out if those who gave money to a congress member were more likely to be granted a meeting. With the cooperation of a (real) interest group Credo Action, they contacted 191 members of congress to ask for a meeting. All the constituents making this request had contributed some funds to the member’s campaign. The control group, randomly chosen, and half of the total sample, said only that they were residents of the member’s district. The treatment group also identified themselves as donors. All callers in both groups read from a script, so the requests for a meeting were otherwise identical.

Among those not identified as donors, 2.4% gained a meeting with either the congress member or the chief of staff. For those identified as donors, 12.5% got a meeting.

The authors concluded “The vast majority of Americans who cannot afford to contribute to campaigns in meaningful amounts are at a disadvantage when attempting to express their concerns to policy makers.”

### Political feasibility: The story of Chile continued

What happened after the election of Allende in Chile in 1970 tells a story not only of economic limits to feasible policies, but also of political limits.

Amid faltering economic performance, due in part to potential investors holding back on investment in Chile, opposition to President Allende’s government mounted, some of it supported in secret by the US government. In 1973, the Chilean armed forces attacked the presidential palace, defeating troops loyal to Allende. They took over the government, ending democracy and replacing Allende with General Augusto Pinochet, who ruled as a dictator—without the democratic constraints of elections and individual political rights—for the next 17 years.

Stock market prices in Chile: The military overthrow of the socialist government, 1973. (Note: Time zero is the first trading day on the Santiago stock market following the military takeover.)

Figure 12.6 Stock market prices in Chile: The military overthrow of the socialist government, 1973. (Note: Time zero is the first trading day on the Santiago stock market following the military takeover.)

The wealthy anticipated that Pinochet would introduce pro-business policies, so stock prices rose again (Figure 12.6). The Pinochet dictatorship would remain until a constitutional referendum in 1988 demanded a return to democracy, which the armed forces respected.

Allende’s economic program was infeasible for two reasons:

• It was economically infeasible: He could not force private firms to invest in Chile, and without their investment the economy would stagnate or even shrink.
• It was politically infeasible: Though democratically elected, he did not control the Chilean armed forces that, with the support of businesses and the US Central Intelligence Agency, turned against him.

## 12.13 Policy matters and economics works

In this unit, you have learned that Adam Smith’s reasoning about the men on the chessboard can now be expressed in economic terms by saying that, for a policy to improve an outcome, it must change the current Nash equilibrium to a different and preferable one (economic feasibility). And it also must be favoured by a governing elite with the authority and capacity to implement it (political and administrative feasibility).

The limits posed by special interests, as well as economic and administrative feasibility, explain why governments often do not successfully address the problems of market failure and unfairness that we have encountered throughout this course. Looking at the different economies of the world, however, you see substantial differences in the extent to which these problems are effectively addressed. As a result, the limits posed by economic, political, and administrative feasibility differ substantially among countries.

### Policies differ across countries

To see this, we return to the problem of climate change introduced in Section 2.10. In Figure 12.7 we can see that Sweden, Australia and the US have roughly the same per capita income. If they all faced similar constraints of economic, administrative, and political feasibility in adopting policies to limit greenhouse gas impacts on climate, then we might expect to see their similarity in income matched by similarity in CO₂ emissions per capita.

But this is not at all what we see in the figure. The US and Australia emit about three times as much per capita as Sweden. It seems likely that what is economically feasible may not differ very much in these three countries, as all share the same knowledge about technologies, and their citizens are likely to respond in similar ways to incentives to adopt cleaner energy sources. The government information and capacities in the three countries are also similar—all have well-informed and capable governments.

Although carbon dioxide emissions are affected by industrial structure and trade specialization, they are also affected by what is desired by the elites, who have political influence. Policies to address climate change are more likely to have political support in Sweden than in Australia and the US. One reason for this difference is the importance in US and Australian politics of lobbies representing the natural resource industries, including the gas, oil, and coal producers.

A similar contrast appears when we look at inequality, shown in Figure 12.8. Germany and the US have both experienced about the same rate of growth in GDP per capita over the past four decades, but they differ markedly in inequality of living standards, as can be seen by the much higher Gini coefficient for disposable income in the US. The comparison for the measure of intergenerational inequality is similar. Denmark, Sweden, and Finland are more equal by this measure than even Germany.

Many things could account for these differences. They are, at least in part, due to the greater political influence in Germany than in the US, of those who value sustaining a higher living standard for the least well off.

What can we learn from the comparisons in Figure 12.8 showing that high income countries with a similar growth in GDP per capita do not necessarily have similar levels of inequality.

### Lessons from the experiences of different countries

One lesson, if we wish to address problems like climate change and unfair inequalities in living standards, is that for most countries it is possible to do a lot more than is currently being done. The fundamental forces contributing to inequality in the high-income countries—new technologies and growing imports (from China, for example) that make the skills of low-paid workers redundant—do not differ much among the high-income countries in Figure 12.8. The differences appear to be a matter of choices among the similar set of policies that are economically and administratively feasible, some countries opting for policies that sustain high levels of inequality, and others pursuing the goal of greater equality.

We also have a lot to learn from the top performers in these and similar figures, by studying the policies and institutions that appear to account for their success in addressing market failures and unfairness.

Not all policies and institutions that are effective in one country can be transferred to another. For example, a comparison between the innovation systems in Silicon Valley and in Germany in Section 21.2 of The Economy shows how different combinations of innovating firms, government policies, financial institutions, and social norms in these two regions produce effective solutions to the market failures associated with knowledge production. Neither would be easily adopted in the other country.

### Schooling and inequality

Some countries have school systems that teach much more effectively than others. Because educational policies differ greatly among countries, we can get some idea of the importance of good policy by looking at differences among nations in performance on a mathematics test administered to 15-year-old students around the world.

You can access the data from a test at the OECD’s Programme for International Student Assessment.

Using the OECD data, let’s compare two countries that are ethnically diverse and have about the same per capita income: the US and Singapore. The average maths score in Singapore was 20% higher than in the US. Even more striking, the student whose score placed him or her in the middle of the US students (the student with the median score) would have been in the bottom quarter of Singapore’s students. A similar comparison would place the median American student in the bottom quarter of Japanese students, and just above the bottom quarter of Finland’s students.

Economic research has explored the question of how schooling and preschool experience affects inequality. In our ‘Economist in action’ video, James Heckman shows how economists can learn from experiments and other data about how to level the playing field for children growing up poor. You may also want to read his book Giving kids a fair chance.21

His book begins by noting that: ‘The accident of birth is a principal source of inequality in America today. American society is dividing into skilled and unskilled … birth is becoming fate.’

Heckman’s ‘strategy that works’ to address this problem is based on the following logic. ‘Both cognitive and socio-emotional skills develop in early childhood and their development depends on family environment.’ Growing up poor deprives children of opportunities to develop these skills, and ‘family environments in the US have deteriorated’.

In response, Heckman advocates ‘early interventions’, such as enriched preschool environments and home visits by professionals to assist parents, which his research shows can ‘produce positive and lasting effects on children in disadvantaged families.’

Policies of the kind advocated by Heckman are being implemented in several countries, including Colombia, Jamaica, Chile, and in the state of Orissa in India. Teams of economists and experts in child development are rigorously evaluating them for their longer-term effects and to assess the feasibility of scaling them up from small pilot interventions.

We know that the kids of poor parents often grow up to be poor. We now also know that this has little to do with genetics, and more to do with the socio-emotional behaviour associated with growing up poor. We now know of, and governments can implement, effective policy remedies to break this cycle of poverty.

### Question 12.8 Choose the correct answer(s)

Watch the ‘Economist in action’ video of James Heckman. According to Heckman, which of the following individual attributes are NOT among the reasons for persistent poverty in a family from generation to generation?

• inherited IQ
• limited schooling
• race
• social behaviour
• Inherited IQ could contribute to persistent poverty, but it is not mentioned in the video.
• Heckman argues that this is among the reasons for persistent poverty.
• Heckman argues that this is among the reasons for persistent poverty.
• Heckman argues that this is among the reasons for persistent poverty.

### Politics matters and economics works

Harold Lasswell, a prominent mid-twentieth-century American political scientist, is best known for his book, Politics: Who gets what, when and how. The title captures a basic point of this unit. Politics is all about:

• Who gets what.
• Who gets to be what.
• Who gets to do what.

The reason is that political processes determine the rules of the game—the basic institutions that govern how we interact in the economy and other arenas of our society.22

‘Sound economic policy should be based on a careful analysis of political economy’: Daron Acemoglu and James A. Robinson. 2013. ‘Economics versus politics: Pitfalls of policy advice’The Journal of Economic Perspectives 27 (2): pp. 173–192.

But politics is not simply about dividing up a pie, with the powerful getting the larger slice and the struggle for power sometimes resulting in a smaller pie. Well-designed government policies are also able to increase the size of the pie, improving living standards for the vast majority of people. Examples that you have already seen include the economic policies of the government of China, which since the 1980s resulted in the most rapid eradication of large-scale poverty ever witnessed in human history. Another example was the clean water and sanitation policies that were behind the global reduction in child mortality.

## 12.14 Conclusion

Governments and markets are two major economic institutions today, and they exist because they can better organize some economic activities compared to other major institutions (firms and families).

Markets can allow large numbers of people to interact in mutually beneficial trades, relying on prices to convey information rather than centralized planning or coordination. However, markets are not ideal in the cases of repugnant markets or merit goods, and even for goods where markets are acceptable, market failures are common. Therefore, we need governments to produce and distribute some types of goods and to help address unfairness or inefficiencies resulting from market failure.

A government is distinct from other economic actors because it has the authority to act on behalf of all people within a given territory and to require citizens to abide by its decisions. These powers allow the government to be a successful problem solver, but also to become a problem itself. There are many examples in which governments were more concerned with earning political rents than serving the interests of their citizens.

In well-governed societies, democracy is a political institution that gives citizens the power to dismiss the government. This political accountability constrains what governments can do to further their private interests. Still, the principal–agent relationship between government officials and the citizens that exists because of differences in objectives means that some policies are not politically feasible.

Besides political feasibility, governments may fail to adopt policies that solve society’s problems for two reasons. First, the policy may not be economically feasible, meaning that an efficient and fair outcome is not a Nash equilibrium. Second, the policy may not be administratively feasible, meaning that it is impossible for the government to implement it in practice, given the information available and its fiscal capacity. The extent to which governments can address problems of unfairness and inefficiency depends on the limits posed by economic, political, and administrative feasibility.

repugnant market
The exchange of some thing (such as infants, organs or sex) that many people find morally offensive.
merit goods
Goods and services that should be available to everyone, independently of their ability to pay.
market failure
When markets allocate resources in a Pareto-inefficient way.
government
Within a given territory, the only body that can dictate what people must do or not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. Also known as: state.
political rent
A payment or other benefit in excess of the individual’s next best alternative (reservation position) that exists as a result of the individual’s political position. The reservation position in this case refers to the individual’s situation were he or she to lack a privileged political position. See also: economic rent.
political institution
The rules of the game that determine who has power and how it is exercised in a society.
political accountability
Accountability achieved by political processes such as elections, oversight by an elected government, or consultation with affected citizens. See also: accountability, economic accountability.
principal–agent relationship
This is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.
politically feasible
Capable of being implemented given the existing political institutions.
economically feasible
Policies for which the desired outcomes are a Nash equilibrium, so that once implemented private economic actors will not undo the desired effects.
Policies for which the government has sufficient information and staff for implementation.
fiscal capacity
The ability of a government to impose and collect substantial taxes from a population at low administrative and other costs. One measure of this is the amount collected divided by the cost of administering the tax system.

## 12.15 Doing Economics: Government policies and popularity: Hong Kong cash handout

In Sections 12.9–12.13, we looked at government spending priorities in different countries, and discussed how economic, administrative, and political feasibility influence government policy decisions.

An important role of the government is to use tax funds to provide goods and services for its citizens. When governments have a budget surplus (taxes exceed government spending), they may choose to increase spending on public programs or improve the goods and services provided to their citizens.

In Doing Economics Empirical Project 12, we will look at an unconventional policy adopted by the Hong Kong Government in 2011, which was to simply give a lump sum to every citizen aged 18 or above. We will assess the effects that this policy could have on inequality, and discuss some reasons why governments may choose this policy over other redistributive policies.

Go to Doing Economics Empirical Project 12 to work on this project.

### Learning objectives

In this project you will:

• draw Lorenz curves
• assess the effect of a policy on income inequality
• convert cells from text to number format
• convert nominal values to real values (extension).

## 12.16 References

1. Adam Smith. (1776) 2003. An Inquiry into the Nature and Causes of the Wealth of Nations. New York, NY: Random House Publishing Group.

2. Joseph A. Schumpeter. (1943) 2003. Capitalism, Socialism and Democracy. pp. 167—172. Routledge.

3. Friedrich A. Hayek. 1944. The Road to Serfdom. Chicago, Il: University of Chicago Press.

4. Hayek, Friedrich A. 1948. ‘The Meaning of Competition’, in Individualism and Economic Order. Chicago, Il: University of Chicago Press.

5. Hayek, Friedrich A. 1948. ‘The Meaning of Competition’, in Individualism and Economic Order. Chicago, Il: University of Chicago Press.

6. Hayek, Friedrich A. 1945. ‘The Use of Knowledge in Society’, reprinted in Friedrich A. Hayek. 1948. Individualism and Economic Order. Chicago, Il: University of Chicago Press.

7. Douglas A. Farnie. 1979. The English Cotton Industry and the World Market: 1815-1896. Oxford: Oxford University Press.

8. Alvin E. Roth. 2007. ‘Repugnance as a Constraint on Markets’Journal of Economic Perspectives 21 (3): pp. 37–58.

9. Peter Lindert. 2004. Growing Public: Social Spending and Economic Growth since the Eighteenth Century. Cambridge: Cambridge University Press.

10. Jon Bakija, Lane Kenworthy, Peter Lindert, and Jeff Madrick. 2016. How Big Should Our Government Be? Berkeley: University of California Press.

11. Alexander Hamilton, James Madison, and John Jay (1961). The Federalist. Middletown, Ct., Wesleyan University Press.

12. Timothy Besley and Anne Case. 2014. Does Electoral Accountability Affect Economic Policy Choices? Evidence from Gubernatorial Term Limits. Quarterly Journal of Economics 110: pp. 769–798.

13. Kenneth J. Arrow. 1978. ‘A cautious case for socialism’Dissent 25 (4): pp. 472–480.

14. Steven Durlauf. 2017. ‘Kenneth Arrow and the golden age of economic theory’VoxEU.org. Updated 8 April 2017.

15. Thomas Fujiwara. 2015. ‘Voting technology, political responsiveness and infant health: Evidence from Brazil’. Econometrica 83 (2): pp. 423–464.

16. Albert O. Hirschman. 1970. Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States. Cambridge, MA: Harvard University Press.

17. Joseph Schumpeter. 1918. ‘The crisis of the tax state.’ Reproduced in Swedberg R. (ed.) 1991. Joseph A. Schumpeter, The Economics and Sociology of Capitalism. Princeton University Press.

18. Timothy Besley and Torsten Persson. 2014.‘Why do developing countries tax so little?’The Journal of Economic Perspectives 28 (4): pp. 99–120.

19. Imran Rasul and Daniel Rogger. 2016. ‘Management of bureaucrats and public service delivery: Evidence from the Nigerian civil service.’ The Economic Journal.

20. Joshua L. Kalla and David E. Broockman. (2015). ‘Campaign contributions facilitate access to congressional officials: A randomized field experiment’American Journal of Political Science 60 (3): pp. 1–14.

21. James J. Heckman. 2013. Giving Kids a Fair Chance. Cambridge, MA: MIT Press.

22. Harold D. Lasswell. 1936. Politics; who gets what, when and how. New York: Whittlesey House.