The Role of Government in the Economy

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Overview

▪ Rationale for government involvement

▪ Stabilization of the economy

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Tragedy of the commons (Hardin, 1968)
Common Pool
Resources
• Rivalry
• Non excludable
• Limited for finite capacity
• Collective action problem
• Need for cooperation and governance
• Important for livelihoods and well being
• Free-rider problem
 Governing the Commons
Clear boundaries

Collective decision making

Monitoring and accountability

Conflict resolution mechanism

Local rights and norms

Flexibility in governance

Collaboration
Nobel Laureate in
Economics, 2009
Public Goods

Non-excludable and Non-Rival

Any example?

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Category of Goods

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Government involvement
in a market economy

Functions of government in a market economy

• Provide legal and social framework
• Maintain competition in markets by ensuring no
one seller dominates
• Redistribution of income and wealth
• Reallocation of resources
• Stabilization of the aggregate economy
• Regulation of natural monopolies

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Stabilization of the
aggregate economy

Policy aims to influence macroeconomic variables

such as inflation, output (GDP) and employment

Lags in the effect of the policy

◦ recognition of a problem
◦ implementation of the policy
◦ realization of benefits in the economy

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Doing business with the
government

What influences government purchases:

◦ government strategic plans
◦ budget and program input from federal
departments
◦ priorities set by the President
◦ availability of appropriated funds
◦ congressionally mandated requirements
◦ surplus/deficit conditions
◦ politics
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 Government deregulation,
mergers, and acquisitions

Deregulation has resulted in more competitive environment and many

companies have sought to merge with other firms in order to survive and
grow

From the late 1970’s the US government deregulated industries such as:
◦ telecommunications
◦ electric and gas utilities
◦ airlines
◦ commercial banks

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Questions

▪ Does government involvement work similarly in a

closed economy?
▪ How about the function of government in
Indonesia?
▪ What are the strategies to make a more efficient
government in Indonesia?

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Reagan: Government is the Problem
Obama vs Romney on the Role of Government
 Market vs Government Failure
Market Failure Government Failure
1. Lack of competition 1. Inability to define social welfare
2. Barriers to entry and exit 2. Limits to democracy and the paradox of voting
3. Restricted flow of 3. Inability to define the marginal benefts and costs of
information public goods
4. Externalities and social 4. Political constraints
cost 5. Cultural constraints
5. Rising service costs 6. Institutional constraints
7. Legal constraints
8. Knowledge constraints
9. Analytical constraints
10. Timing of policies
Government involvement
in a market economy

Antitrust laws: legal framework for competition

▪ Sherman Anti-Trust Act (1890)
▪ Clayton Act (1914)
▪ Federal Trade Commission Act (1914)
▪ Robinson-Patman Act (1936)
▪ Celler-Kefauver Act (1950)
▪ Hart-Scott-Rodino Act (1976)

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Government Involvement
in a Market Economy

The purpose of antitrust laws

◦ Economic efficiency
◦ Limit power of large firms and protect
smaller firms

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Free market system

In a free market system, governments take the view that markets are
best suited to allocating scarce resources

So, government should allow market forces of supply and demand to

set prices (and quantity) of goods and services

Competitive markets often deliver improvements in production of

goods and services as a whole
Market Failure

But, do we really live in the perfect world where market forces cannot
do wrong ?

There are occasions where market forces fail, when some segments of
the economy is plagued by Market Failure
 Market Failures
Market fails to produce the right amount
of the product
Resources may be:

• Over-allocated
• Under-allocated

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Why market forces can fail
occasionally ?

Monopoly : A market where one company is the sole supplier

Oligopoly : A market where only several large companies are the

suppliers

Asymmetric information : Only one or few entities have adequate

information
Government Involvement
in a Market Economy
Externalities: under perfect competition
resources are efficiently allocated and social
welfare is maximized, but market
externalities can cause efficiency failure and
welfare loss

◦benefit externality: certain benefits accrue

to third parties free of charge → producers
cannot recover all the revenue due, so too
little may be produced
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Government Involvement
in a Market Economy

Externalities

◦Cost externality: producer does not pay all

the costs generated by the product (e.g.
pollution) → the product’s price will be
lower than if it had included all cost, thus
too much will be produced

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Externalities

A cost or benefit accruing to a third party

external to the transaction
Positive externalities
•Too little is produced
•Demand-side market failures
Negative externalities
•Too much is produced
•Supply side market failures

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Efficiently Functioning Market

▪ Demand curve must reflect the consumers full

willingness to pay
▪ Supply curve must reflect all the costs of
production

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Government Intervention

Correct negative externalities

•Direct controls
•Specific taxes
Correct positive externalities
•Subsidies
•Government provision
Government Intervention

Methods for Dealing with Externalities

Resource Allocation
Problem Outcome Ways to Correct
Negative externalities Overproduction of output 1. Private bargaining
(spillover costs) and therefore 2. Liability rules and lawsuits
overallocation of 3. Tax on producers
resources 4. Direct controls
5. Market for externality rights

Positive externalities Underproduction of output 1. Private bargaining

(spillover benefits) and therefore 2. Subsidy to consumers
underallocation of 3. Subsidy to producers
resources 4. Government provision

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Government’s Role in the Economy

Government can have a role in correcting

externalities
Officials must correctly identify the existence
and cause
Has to be done in the context of politics

5-32
Government’s Role in the Economy

Government can have a role in correcting

externalities
Officials must correctly identify the existence
and cause
Has to be done in the context of politics

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Government Failure

Government failure refers to situations

where allocative efficiency may have been
reduced following government intervention
in markets designed to correct market
failure.
Government Failure

When does government step in?

◦ To correct shortages or surpluses
◦ To provide when the market does not or can not
◦ To regulate and correct where there is perceived
inequality or inefficiency
◦ To protect individuals and groups in society and provide a
safety net for those unable to help themselves
◦ To reduce poverty
◦ To influence property rights
Now, Work in Your Group

1. Pick any policy area (industry, education, transportation, energy,

SME, etc)
2. Discuss the government policy related to the selected area (subsidy,
regulation, tax, etc)
3. Discuss whether the government needs to intervene the market or
leave it to the market mechanism, why?
 Government Failure

Public Choice Theory:

◦ Politicians, bureaucrats and
others acting on behalf of
the ‘public’ may act in their
own self interest as ‘utility
maximisers’.
◦ The ‘invisible hand’ may not
work in the provision of
public goods.
Subsidies may be designed to correct a perceived
market failure but they do not always please
◦ ‘Rent seeking’ or ‘Log rolling’
everyone – public choice? - two important concepts.
Title: Czech farmer protest EU accession. Copyright: Getty Images,
available from Education Image Gallery
Government intervention

Government intervention is action taken by government to

“improve” economy beyond the basic regulation of fraud,
enforcement of contracts and providing public goods

The intended improvement are : promoting economic

growth or promoting economic fairness
Some tools of government
intervention
Price ceiling : Government imposed upper price limit

Price floor : Government imposed lower price limit

Subsidy : A financial aid from the government to

entities (individuals, industries, corporations,etc)

Tax : A financial charge imposed upon a taxpayer

Price ceiling
Price ceiling can lower the price of a product

Lower price of a product can reduce the supply of the

particular product because less producers or sellers are
willing to supply

Unintended consequence of price ceiling is a shortage

Shortage can create black market for the goods

 Price floor
Price floor can increase the price of a product

Higher price of a product can increase the supply of particular

product because more producers are willing to act as suppliers

Unintended consequence of price floor is wasteful surplus of the

particular product while many cannot afford to buy

In addition, some economic capacity that can be used for other

purposes is diverted to the production of the surplus
 Subsidy
Subsidy is using taxpayers money to pay some of the product’s
price

Subsidy makes the product more affordable (higher demand)

Subsidy encourages production of a good

Unintended consequence of subsidy is inefficient firms are

allowed to continue production (using taxpayers money)
Tax

Besides as a source of income for

government, tax can also be used to
influence supply/demand mechanism like
the other tools we have described
The real question is….

The real question currently is not whether

government intervention is justified, but how far
government should interfere…

It only can be answered on a case by case basis and

the issue will always be debatable…
Simpler: The future of
government
Many existing regulations are very complex,
costly, and hurting the economic sectors.

IT MIGHT MAKE THINGS A LOT WORSE

A disciplined analysis of costs and benefits is

indispensable to deciding what to do, and as a
nudge to move public officials in the right
directions.
There are 3 main Concept to make a better future of
government;

1. Nudge
Influence choice, but let people go as they see fit
1. Choice Architecture
All of our choice have architecture behind them “What we need is
1. Simpler fewer rules and more
Complexity is surprisingly harmful discretion”
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Government Involvement
in a Market Economy

Socially optimal price occurs where the price of

the product equals the marginal social cost

At this point, less pollution will be produced than

under competitive conditions

Social cost = sum of the MC of the product and the

MC of externalities (such as pollution)

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Social Optimum Price

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Exercise
Graph the following supply and demand curve:
Supply: P = 10 + .4Q
Demand: P = 50 – .4Q
What is the equilibrium price and quantity?
Suppose production of the good in question creates a
negative externality equal to $8. Draw a new supply curve
that represents the marginal cost to society. What is the
socially optimal price and quantity?

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Consumer Surplus
▪ Difference between what a consumer is willing to
pay for a good and what the consumer actually
pays
▪ Extra benefit from paying less than the maximum
price

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Consumer Surplus

Consumer
Surplus
Equilibrium
Price
Price

P1

Q1
Quantity
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Producer Surplus
▪ Difference between the actual price a
producer receives and the minimum
price they would accept
▪ Extra benefit from receiving a higher
price

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Producer Surplus

Producer S
surplus
Price

P1
Equilibrium
price

Q1
Quantity

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Efficiency Revisited
Efficient Allocation
Consumer
surplus
S
Price

P1

Producer D
surplus

Q1
Quantity
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Government Involvement
in a Market Economy

Socially optimal price

How can the optimal equilibrium be attained?

◦ Government can restrict production (eg can set

maximum pollution levels for the industry then
sell tradable pollution licenses)
◦ Government can impose a pollution tax

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Government Involvement
in a Market Economy

Coase Theorem: Government intervention

to eliminate the effect of externalities is not
necessary

If property rights (e.g. pollution permits) are

assigned → bargaining between the parties
involved would result in an optimal solution

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Government Involvement
in a Market Economy

Coase Theorem

Limitations of Coase Theorem

◦ normative issues
◦ transaction costs
◦ unfair bargaining
◦ incomplete information
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Stabilization of The
Aggregate Economy

Monetary Policy: Control of the quantity of money

in the economy and/or interest rates by the Central
Bank

Fiscal Policy: Changes in the level of taxation and

government spending

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