THE ROLE OF

GOVERNMENT IN THE

ECONOMY

Under Ideal Market Conditions

• The gov’t has almost no role as long as

society only cares about efficiency

• If the market system works very well,

the outcome will be efficiency in the

use of scarce resources

– That state of the world in which all

opportunities to make someone better off

without making anyone worse off are

exhausted

• Efficiency means not wasting

resources

– all resources allocated so that no more of

one type of good can be produced

without having to produce less of another

type of good.

– This concept of production efficiency can

be illustrated with a Production

Possibilities Curve

Consumption Goods

Cap

ital

Go

od

s

0

Efficient

Inefficient

Production Possibilities Curve

In the Real World

• Conditions are not ideal (The market

causes too few or too many resources to

be allocated to an economic activity.

• Society cares about more than efficiency

– cares about economic stability and fairness

– wants to ensure that the environment is safe and

clean

– wants to impose certain paternalistic

requirements on consumption• merit/demerit goods

Market Failure

• Market failure describes a situation in

which the unrestrained market system

is inefficient, wasteful and leads to over

production or under production of

goods and services.

• That is, it allocates too few or too much

resources to a specific economic

activity.

Major Instances of Market Failure

– Businesses tend to experience severe business

fluctuations – recessions, economic booms

– Inability of market forces to deal with spill-

over (third party) effect - externalities

– Market forces cannot provide public goods and

does a poor job of providing merit goods

– Market forces lead to unequal distribution of

income and wealth

– Market forces fail to deal with growth of

monopolies

The Roles of Government

1. Stabilization by smoothing out the ups and

downs in overall business activity through fiscal

and monetary policy. The aim is to:

2. Allocation by dealing with externalities,

providing merit, and reducing or eliminating

demerit goods

3. Redistribution using a redistributive tax

structure to redistribute income and provide

welfare

Stabilization of the Economic

Environment

• The aim is to:– Maintain full employment

– Keep prices steady

– Achieve an equilibrium on the balance of payment

– Sustain economic growth

– Prevent environmental damage

– Redistribute income and provide welfare

Allocation

• The aim is to:

– Deal with or correct externalities

– Provide public and merit goods in

quantities required

– Prevent the growth of monopolies

Externalities

• An externality is a spill-over (third party) effect of

an economic transaction not accounted for by the

economic decision makers (i.e. the parties engaged

in the transaction).

• An externality could be negative or positive.

• Total (social) cost = Private cost + External Cost

• When only private (internal cost) is accounted for

and social cost is not accounted for, Negative

externality exist

• Total (social) Benefit = Private benefit +Social

benefit.

Externalities Cont’d

• Negative externality

– costs not accounted for by economic decision makers

• Social Cost is greater than private cost

• Leads to over production – i.e. firms produce more than

they can produce if they were taking care of (internalizing)

external cost.

• Positive externality

– benefits not accounted for by economic decision makers

• Social benefits is greater than private benefit

• Leads to under production – i.e. firms produce less than

they should produce if the total benefit was taking into

account

• Externalitycauses divergence

between what should be produced

and what is actually produced.

• Thus, market equilibrium is not

efficient

– that is, the market fails to achieve an

efficient state

– society stands to gain from government

correction of the externality

Pollution – Negative Externality

• Happens because of failure to define a

property right

• Air pollution

– lack of private property right to the

atmosphere

– factory uses the atmosphere as an input for

which it does not pay

– society incurs a cost not accounted for by the

factory

– too much of good produced

D

S

S1$

Q0

External cost

QmarketQeff

A

B

CABC = welfare loss triangle

= net social gain from

reducing output to Qeff

overproduction

Negative Externality From Pollution

• Education (Social Benefit)

– students receive private benefits from

education

– others receive benefit of associating with

educated person

– student cannot capture this public benefit• i.e. lacks property right needed to charge for this

service to others

– causes too little education to be

consumed

Q0

$

D

D1

S

Qmarket Qeff

A

B

C

= welfare loss triangle

= net social gain from

increasing output to Qeff

ABC

Positive Externality From Education

Externality Policies

• These are policies the government can employ to

deal with externalities.

• Pollution

– Employ the Pigouvian taxes• tax factory

– shifts S up to MSC

– how to measure value of pollution/amount of tax

– not common

» gas tax

– tax the product

» works in short run but no incentive to find less polluting technology

– tax the pollutant

» better long run incentives

• command and control

– require pollution reducing capital, clean

fuels, etc.• e.g., stack scrubbers

• lacks long run incentive to find better technology

• same rules for all firms regardless of costs

• easier to administer and politically more acceptable

– past reluctance to adopt market-based solutions like taxes

Cost-Benefit Analysis• CBA is an investment appraisal technique that analyses

the external cost and benefits alongside the internal

(private) cost and benefits of carrying out an economic

activity.

• It involves identifying monetary values for all the internal

and external costs and benefits of a project allowing a total

(social) price to be arrived at.

• To decide whether or not to locate a cement factory near a

community, a CBA has to be conducted before a final

decision is taken.

• The limitation of the CBA technique lies in “what is

actually measured” and “how the related monetary

value is identified”

Public Goods

• an apple is a PRIVATE good

• national defense is a PUBLIC good

• What distinguishes private goods from

public goods?

– private goods are EXCLUDABLE

– public goods are NONEXCLUDABLE• an apple is a private good because a consumer who does not

pay the price can be excluded from consuming it

• no one can be excluded from consuming public goods -- can

anyone not be protected by national defense?

– private goods are RIVAL in consumption

– public goods are NONRIVAL in

consumption• if I eat an apple, you cannot

• when I consume national defense, it’s still there for

you to consume

– therefore, it costs nothing to provide to additional

consumers

» therefore, the efficient price is zero

– since no one can be excluded from

consuming a public good, and since the

efficient price is zero, the private sector

would ordinarily not be able to provide it

• WARNING! A good is public or

private because of these

characteristics, not because the

government provides it or doesn’t

– governments provide all sorts of things,

including private goods• e.g., electricity, steel

– private sector sometimes finds ways to

provide public goods• e.g., TV broadcasting

• Government provides public goods

at zero price

• Funding out of general budget

– we pay taxes based on income,

consumption, etc., not on the amount of

public goods we consume• for example, a household earning $100,000 pays

more tax than a household earning $10,000 but both

consume the same national defense

• Quantity determined through

political process

Additional Characteristics of Public Goods1. Public goods are usually indivisible – i.e. they cannot be

produced and sold in small units very easily. E.g. You

cannot buy GH¢50 worth of street light.

2. They can be used by increasing numbers of people at no

additional cost. E.g. Once a light house is built,

additional ships can use it without any additional cost.

3. Additional users of public goods do not deprive other of

any of the services of the good. E.g. if you use a street

light, additional users are not deprived.

4. It is very difficult to charge people for a public good on

the basis of how much of it they use. E.g. It is very

difficult to determine how much a person uses or values

national defense. It is not sold in the mkt place

Merit and Demerit Goods

• Goods provision of which society wants to encourage (in the case of merit goods) or discourage– merit

• education

• housing

• health care

– demerit• tobacco

• alcohol

• Various subsidies and taxes are used by government to encourage the consumption of merit goods or discourage consumption of demerit goods.– housing allowances

– sin taxes on tobacco and alcohol

– National health insurance

• Direct provision– Subsidies on education

Merit Goods• A good can be described as a merit good if it is provided for

the benefit of the whole society at no direct cost to the user.

• Merit goods can have characteristics of both private and

public goods depending on the situation.

– sometimes characteristics depend on circumstances

• highways are nonrival as long as few drivers are on them but

become rival with congestion.

– sometimes a nonexcludable good becomes excludable when

technology changes

• Distance education

• Merit goods do not have any special characteristics, what is

a merit good varies from country to country.

• Merit goods are political decisions and different government

may classify different goods as merit and provide them free.

Demerit Goods

• Goods whose consumption is considered

harmful the consumer. E.g. Cigarette,

Alcohol, Cocaine etc.

• They could be goods classified by the

laws of a country as demerit. E.g.

Prostitution in Ghana.

• The only identifying feature of demerit

goods is that it is medically confirmed as

harmful to the user.

Redistribution of Income and

Welfare

• Society cares about equity or

fairness as well as efficiency

• Thus a role of government is to

create a more fair distribution than

the market produces

– distribution of income

– distribution of opportunity• education

• health

What is Fair?

• We know what an efficient allocation is

• We have no idea what a fair distribution is– equal income for all?

• The limitation is that many analyst believe that Redistribution creates inefficiency– distorts returns to productivity

– drives wedge between cost and value i.e. encourages equity at the expense of productivity

Mechanisms to Redistribute

• Via the tax structure

– progressive taxation

– negative income tax

• Transfers

– cash

– in-kind