THE ROLE OF THE STATE

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The role of Government

Market failure – the invisible hand pushes in such a way that individual decisions do not lead to socially desirable outcomes

A market failure occurs when the market outcome is not the socially efficient outcome. Some action by the government is sometimes necessary to ensure that the market does work well.

This topic examines the relationship between business and government, and in particular, the government’s role in influencing business.

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Government’s Role in Influencing Business

1. Prescribes the rules of the game for business.2. Purchases business’ products and services.3. Uses its contracting power to get business to do things it wants.4. Is a major promoter and subsidizer of business.5. Is the owner of vast quantities of productive equipment and wealth. 6. Is an architect of economic growth.7. Is a financier.8. Is the protector of various interests in society against business

exploitation.9. Directly manages large areas of private business.10. Is the repository of the social conscience and redistributes

resources to meet social objectives.

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Business Beliefs Government Beliefs

Individualistic ethic Maximizes concession to

self-interest Minimizes the load of

obligations society imposes on the individual (personal freedom)

Emphasizes inequalities of individuals

Collectivistic ethic Subordinates individual goals

and self-interest to group goals and group interests

Maximizes obligations assumed by the individual and discouraging self-interest

Emphasizes equality of individuals

Clash of Ethical Systems

Figure 11-1

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Interaction Among Business, Government, and the Public

Lobbying

Regulations and Other Forms of Persuasion

• Advertising• Public Relations

• Political Process• Voting• Interest Groups• Contributions

Public

Business Government

• Interest groups

• Not buying products

• Protests

• Politicking• Political

influence

Figure 11-2

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Government / Business Relationship• Lobbying

Public / Government Relationship• Voting• Electing officials

Business / Public Relationship• Advertising• Public Relations• Other forms of communication

Interaction Among Business, Government, and the Public

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Privatization

PrivatizationThe process of “turning over to” the private sector some function that was previously handled by government.

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Major employer Standard setter Largest purchaser Use of Subsidies Transfer payments

Major competitor Loans and loan guarantees Taxation Monetary policy Moral suasion

Other Nonregulatory Government Influences

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Government’s Regulatory Influence on Business

Factors to Consider Regarding Government Regulation

Fair treatment Protection Scope Cost Burden

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Reasons for Regulation

Controls negative externalities

Achieves social goals

Controls excess profits

Controls natural monopolies

Controls excessive competition

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Types of Regulation

TCAA

TCRA

EWURA

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Types of Regulation

Occupational Safety and Health Administration

TBS

NEMC

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Benefits of Regulation

Fair treatment of employees Safer working conditions Safer products Cleaner air and water

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Direct costs Indirect costs Induced costs

• Effects1. Innovation may be affected.2. New investments in plant and equipment may be

affected.3. Small business may be adversely affected.

Costs of Regulation

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Deregulation

Purpose

Intended to increase competition with the expected benefits of greater efficiency, lower prices, and enhanced innovation.

Dilemma

Many competitors are unable to compete with the dominant firms.

Must enhance competition without sacrificing applicable social regulations (e.g., health and safety requirements).

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Externalities

An externality is present when the activity of one entity (person or firm) directly affects the welfare of another entity in a way that is outside the market mechanism.• Negative externality: These activities impose

damages on others.• Positive externality: These activities benefits on

others.

Externality

If externalities exist, it means that those involved in the demand and supply in the market are not considering all the costs and benefits when making their market decisions.

As a result, the market fails to yield optimal results.

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When there is a negative externality, marginal social cost is greater than marginal private cost.• A steel plant benefits the owner of the plant and the

buyers of steel.• The plant’s neighbors are made worse off by the

pollution caused by the plant.

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Examples of Externalities Negative Externalities

• Pollution• Cell phones in a movie theater• Congestion on the internet• Drinking and driving• Student cheating that changes the

grade curve• The “Club” anti-theft device for

automobiles

Positive Externalities• Research & development• Vaccinations• A neighbor’s nice landscape• Students asking good questions in

class• The “LoJack” anti-theft device for

automobiles Not Considered Externalities

• Land prices rising in urban area• Known as “pecuniary” externalities

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Nature of Externalities

Arise because there is no market price attached to the activity

Can be produced by people or firms Can be positive or negative Public goods are special case

• Positive externality’s full effects are felt by everyone in the economy

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Graphical Analysis:Negative Externalities

For simplicity, assume that a steel firm dumps pollution into a river that harms a fishery downstream.

Competitive markets, firms maximize profits• Note that steel firm only cares about its own profits, not the

fishery’s profits.• Fishery only cares about its profits, not the steel firm’s

profits.

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Graphical Analysis, continued

MB = marginal benefit to steel firm MPC = marginal private cost to steel firm MD = marginal damage to fishery MSC = MPC+MD = marginal social cost

Pollution Tax One class of solutions to the externality

problems involve internalizing the costs and benefits, so that the market can work better.

Pollution Tax: if a firm is creating a negative externality in the form of pollution, create a tax on the polluting firm equal to the cost of cleaning up the pollution.

Regulation Through Taxation*

Marginal social benefit

Marginal private cost

Marginal social costCost

Quantity0 Q0

P0

Q1

P1 Efficient tax

Pollution Tax

Command Another approach is command—rather than

imposing a tax or offering a subsidy, the government simply requires or commands the activity.• For a negative externality like pollution, the

government simply requires the company to stop polluting.

• For a positive externality, like inoculation, the government requires certain classes of citizens to be inoculated.

Marketable Pollution Permits

Another approach to pollution is the introduction of marketable pollution permits.• The government sells the permits, which in total

allow the amount of pollution that the government believes to be acceptable.

• Demanders, typically firms, purchase the permits, allowing them to pollute up to the amount specified by the permits they own.

• If a firm is able to employ a cleaner technology, then it can enjoy additional revenues by selling its pollution rights to someone else.