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Answer in 150 words or more. Only use the attached Chapters 5 and 6 for reference.
What is the difference between market failure and government failure?
Is it difficult for markets to allocate scarce resources efficiently on its own?
What are some of the problems the political system faces in overseeing markets
C h a p t e r F o c u s
■ What is economic efficiency and how can it be used to evaluate
markets?
■ Why is it generally undesirable to pursue any goal to perfection?
■ What is the role of government in a market economy?
■ What are externalities? What are public goods?
■ Why might markets fail to allocate goods and services efficiently?
■ If the market has shortcomings, does this mean the government should
intervene?
The principal justification for
public policy intervention lies
in the frequent and numerous
shortcomings of market
outcomes.
—Charles Wolf 1
Difficult Cases for the Market
and The Role of Government 5
C H A P T E R
1Charles Wolf, Jr., Markets or Government (Cambridge: MIT Press, 1988), 17.
110
As we previously discussed, markets and government planning are the two main alternatives for the organization ofeconomic activity. Chapters 3 and 4 introduced you to how markets work and demonstrated how the invisiblehand of the market process directs the self-interest of individuals toward activities in the best interest of society.
Throughout, we noted that some qualifications were in order, both in terms of the “rules of the game” that must be in place for
markets to work well and the existence of special cases, in which the invisible hand might not function effectively. In this chap-
ter, we turn our attention to discussing these potential problem areas for the market and consider their implications with regard
to the role of government. In the following chapter, we will analyze how the political process works more directly. ■
Economic efficiency
A situation that occurs when
(1) all activities generating
more benefit than cost are
undertaken, and (2) no
activities are undertaken
for which the cost exceeds
the benefit.
2Note to students who may pursue advanced study in economics: Using the concept of efficiency to compare alternate policies
typically requires that the analyst estimate costs and benefits that are difficult or impossible to measure. Costs and benefits are
the values of opportunities forgone or accepted by individuals, as evaluated by those individuals. Then these costs and benefits
must be added up across all individuals and compared. But does a dollar’s gain for one individual really compensate for a
dollar’s sacrifice by another? Some economists simply reject the validity of making such comparisons. They say that neither the
estimates by the economic analyst of subjectively determined costs and benefits nor the adding up of these costs and benefits
across individuals is meaningful. Their case may be valid, but most economists today nevertheless use the concept of efficiency
as we present it. No other way to use economic analysis to compare policy alternatives has been found.
A CLOSER LOOK AT ECONOMIC EFFICIENC
Y
Economists use the standard of economic efficiency to assess the desirability of economic
outcomes. We briefly introduced the concept in Chapter 3. We now want to explore it in
more detail. The central idea of economic efficiency is straightforward. For any given level
of cost, we want to obtain the largest possible benefit. Alternatively, we want to obtain any
particular benefit for the least possible cost. Economic efficiency means getting the most
value from the available resources—making the largest pie from the available set of ingre-
dients, so to speak.
Economists acknowledge that individuals generally do not regard the efficiency of the
entire economy as a primary goal for themselves. Rather, each person is interested in
enlarging the size of his or her own slice. But if resources are used more efficiently, the
overall size of the pie will be larger, and therefore, at least potentially, everyone could have
a larger slice. For an outcome to be consistent with ideal economic efficiency, two condi-
tions are necessary:
Rule 1. Undertaking an economic action is efficient if it produces more benefits than
costs. To satisfy economic efficiency, all actions generating more benefits than
costs must be undertaken. Failure to undertake all such actions implies that a
potential gain has been forgone.
Rule 2. Undertaking an economic action is inefficient if it produces more costs than
benefits. To satisfy economic efficiency, no action that generates more costs than
benefits should be undertaken. When such counterproductive actions are taken,
society is worse off because even better alternatives were forgone.
Economic efficiency results only when both of these conditions have been met. Either
failure to undertake an efficient action (Rule 1) or the undertaking of an inefficient
action (Rule 2) will result in economic inefficiency. To illustrate, consider Exhibit 1,
which shows the benefits and costs associated with expanding the amount of any particu-
lar activity. We have avoided using a specific example here to ensure you understand the
general idea of efficiency without linking it to a specific application. As we will show, the
concept has wide-ranging applications—from the evaluation of government policy to how
long you choose to brush your teeth in the morning.2
In Exhibit 1, the marginal benefit curve shows the additional benefit associated with
expanding the activity. The marginal cost curve shows the cost—including any opportu-
nity costs—of spending additional time, effort, and resources on the activity. At
Q1
, the
height of the marginal benefit curve exceeds the height of the marginal cost curve. Thus,
at that point, the additional benefits of expanding the activity past Q1 exceed the additional
costs. According to Rule 1 of economic efficiency, we should continue to expand the
activity until we reach Q2. Beyond Q2 (at Q3, for example), the height of the marginal ben-
efit curve is less than the height of the marginal cost curve. The additional benefits from
expanding activity to that point are smaller than the additional costs. According to Rule 2,
at Q3, we have gone too far and should cut back on the activity. Q2 is the only point con-
sistent with both rules of economic efficiency.
IF IT’S WORTH DOING, IT’S WORTH DOING IMPERFECTLY
Eliminating pollution. Earning straight As. Being completely organized. Cleaning your
apartment until it sparkles. Making automobiles completely safe. Making airplanes fully
secure against terrorist attacks. All of these are worthwhile goals, right? Well, they are un-
til you consider the costs of actually achieving them. The heading for this section is, of
course, a play on the old saying, “If it’s worth doing, it’s worth doing to the best of your
ability.” Economics suggests, however, that this is not a sensible guideline. At some point,
the gains from doing something even better will not be worth the cost. It will make more
sense to stop short of perfection.
Exhibit 1 can also be used to illustrate this point. As more resources are dedicated to
an activity, the marginal improvements (benefits) will become smaller and smaller, while
the marginal costs will rise. The optimal time and effort put into the activity will be
achieved at Q2, and this will nearly always be well below one’s best effort. Note that inef-
ficiency results when either too little (for example, Q1) or too much (for example Q3) time
and effort are put into the activity.
Do you make decisions this way? Last time you cleaned your car or apartment, why
did you decide to leave some things undone? Once the most important areas were clean,
you likely began to skip over other areas (like on top of the refrigerator or under the bed),
figuring that the benefits of cleaning these areas were simply not worth the cost. Very few
If It’s Worth Doing, It’s Worth Doing Imperfectly 111
Marginal cost
Economic�
efficiency
Inefficient
Q2 Q3
Marginal benefit
All points other�
than Q2 are�
inefficient
Q1
As we use more time and resources to expand the level of an activity, the marginal benefits will generally decline and the mar-
ginal costs rise. From the viewpoint of efficiency, the activity should be expanded as long as the marginal benefits exceed the
marginal cost. Thus, quantity Q2 is the economically efficient level of this activity. Q1 is inefficient because some production
that could generate more benefits than costs is not undertaken. Q3 is also inefficient because some units are produced even
though their costs exceed the benefits they create. Thus, both too much and too little of an activity will result in inefficiency.
EXHIBIT 1
Economic Efficiency
people live in a perfectly organized and clean house, wash their hands enough to prevent
all colds, brush their teeth long enough to prevent all cavities, or make their home as safe
as Fort Knox. They recognize that the benefit of perfection in these, and many other areas,
is simply not worth the cost.
Economics is about trade-offs; it is possible to pursue even worthy activities beyond
the level that is consistent with economic efficiency. People seem to be more aware of this
in their personal decision-making than when evaluating public policy. It is not uncommon
to hear people say things like, “We ought to eliminate all pollution” or “No price is too
high to save a life.”
If we want to get the most out of our resources, we need to think about both marginal
benefits and marginal costs and recognize that there are alternative ways of pursuing ob-
jectives. Consequently, economists do not ask whether eliminating pollution or saving
lives is worth the cost in terms of dollars per se, but whether it is worth the cost in terms
of giving up other things that could have been done with those dollars—the opportunity
cost. Spending an extra $10 billion on worker safety requirements to save 100 lives isn’t
efficient if the funds could have been spent differently and saved 500 lives. Furthermore,
it makes no more sense to have the government pursue perfection than it does for each of
us personally to pursue it. Regardless of sector, achievement of perfection is virtually
never worth the cost.
THINKING ABOUT THE ECONOMIC ROLE OF GOVERNMENT
For centuries, philosophers, economists, and other scholars have debated the proper role
of government. While the debate continues, there is substantial agreement that at least two
functions of government are legitimate: (1) protecting individuals and their property
against invasions by others and (2) providing goods that cannot easily be provided through
private markets. These two functions correspond to what Nobel laureate James Buchanan
conceptualizes as the protective and productive functions of government.
Protective Function of Government
The most fundamental function of government is the protection of individuals and their
property against acts of aggression. As John Locke wrote more than three centuries ago, in-
dividuals are constantly threatened by “the invasions of others.” Therefore, each individual
112 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
Along Came Polly (2004)
Ben Stiller and Jennifer Aniston struggle to
find the efficient (optimal) amount of orga-
nization in their lives. In one scene they
use a knife to destroy pillows after Aniston
convinces Stiller that the 8 minutes a day
he spends arranging decorative pillows on
his bed (that nobody else sees) isn’t worth
the effort. In the next scene, Aniston’s in-
efficiently low level of organization is illus-
trated when she spends a lot of time
searching for her car keys. At the margin,
Stiller’s time spent arranging his pillows isn’t generating enough benefit to justify
the cost. Meanwhile, if Aniston were to spend just a little more time getting orga-
nized, the benefits to her would exceed the costs. The two of them would both be
more efficient, and they’d probably get along better, too!
E C O N O M I C S A T
T H E M O V I E
S
K
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“is willing to join in society with others, who
are already united, or have a mind to unite, for
the mutual preservation of their lives, liber-
ties, and estates.”3 The protective function of
government involves the maintenance of a
framework of security and order—an infra-
structure of rules within which people can
interact peacefully with one another. Protec-
tion of person and property is crucial. It
entails providing police protection and prose-
cuting aggressors who take things that do not
belong to them. It also involves providing for
a national defense designed to protect against
foreign invasions. The legal enforcement of
contracts and rules against fraud are also cen-
tral elements of the protective function. Peo-
ple and businesses that write bad checks,
violate contracts, or knowingly supply others
with false information, for example, are there-
fore subject to legal prosecution.
It is easy to see the economic importance of the protective function. When it is per-
formed well, the property of citizens is secure, freedom of exchange is present, and con-
tracts are legally enforceable. When people are assured that they will be able to enjoy the
benefits of their efforts, they will be more productive. In contrast, when property rights
are insecure and contracts unenforceable, productive behavior is undermined. Plunder,
fraud, and economic chaos result. Governments set and enforce the “rules of the game”
that enable markets to operate smoothly.
Productive Function of Government
The nature of some goods makes them difficult to provide through markets. Sometimes it
is difficult to establish a one-to-one link between the payment and receipt of a good. If this
link cannot be established, the incentive of market producers to supply these goods is
weak. In addition, high transaction costs—particularly, the cost of monitoring use and col-
lecting fees—can sometimes make it difficult to supply a good through the market. When
either of these conditions is present, it may be more efficient for the government to supply
the good and impose taxes on its citizens to cover the cost.
One of the most important productive functions of government is providing a stable
monetary and financial environment. If markets are going to work well, individuals have
to know the value of what they are buying or selling. For market prices to convey this
information, a stable monetary system is needed. This is especially true for the many mar-
ket exchanges that involve a time dimension. Houses, cars, consumer durables, land,
buildings, equipment, and many other items are often paid for over a period of months or
even years. When the purchasing power of money fluctuates wildly, previously determined
prices do not represent their intended values. Under these circumstances, exchanges
involving long-term commitments are hampered, and the smooth operation of markets
undermined.
The government’s tax, spending, and monetary policies exert a powerful influence on
the stability of the overall economy. If properly conducted, these policies contribute to
economic stability, full and efficient utilization of resources, and stable prices. However,
improper stabilization policies can cause massive unemployment, rapidly rising prices, or
both. For those pursuing a course in macroeconomics, these issues will be central to that
analysis.
Thinking About the Economic Role of Government 113
3John Locke, Treatise of Civil Government, 1690, ed. Charles Sherman (New York: Appleton-Century-Crofts, 1937), 82.
The English philosopher John
Locke argued that people
own themselves and, as a
result of this self-ownership,
they also own the fruits of
their labor. Locke stressed
that individuals are not sub-
servient to governments. On
the contrary, the role of
governments is to protect the
“natural rights” of individuals
to their person and property.
This view, also reflected in
the “unalienable rights” sec-
tion of the U.S. Declaration
of Independence, is the basis
for the protective function of
government.
©
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POTENTIAL SHORTCOMINGS OF THE MARKET
As we previously discussed, the invisible hand of market forces generally gives resource
owners and business firms a strong incentive to use their resources efficiently and under-
take projects that create value. Will this always be true? The answer to this question is
“No.” There are four major factors that can undermine the invisible hand and reduce the
efficiency of markets: (1) lack of competition, (2) externalities, (3) public goods, and (4)
poorly informed buyers or sellers. We will now consider each of these factors and explain
why they may justify government intervention.
Lack of Competition
Competition is vital to the proper operation of the pricing mechanism. The existence of
competing buyers and sellers reduces the power of both to rig or alter the market in their
own favor. Although competition is beneficial from a social point of view, individually
each of us would prefer to be loosened from its grip. Students do not like stiff competitors
in their social or romantic lives, at exam time, or when they’re trying to get into graduate
school. Buyers on eBay hope for few competing bidders so they can purchase the items
they’re bidding on at lower prices. Similarly, sellers prefer fewer competing sellers so they
can sell at higher prices.
Exhibit 2 illustrates how sellers can gain from restricting competition. In the absence
of any restrictions on competition in the market, the price P1 and output Q1 associated with
the competitive supply curve (S1) will prevail. Here, Q1 is the level of output consistent
with economic efficiency. If a group of sellers was able to restrict competition, perhaps by
forcing some firms out of the market and preventing new firms from entering, the group
will be able to gain by raising the price of the product. This is illustrated by the price
P2
and output Q2 associated with the restricted supply (S2). Even though the output is smaller,
the total revenue (price P2 times quantity Q2) derived by the sellers at the restricted output
level is greater than at the competitive price P1. Clearly, the sellers gain because, at the
higher price, they are being paid more to produce less.
The restricted output level, however, is clearly less efficient. . At the competitive out-
put level Q1, all units that were valued more than their cost are produced and sold. But this
is not the case at Q2. The additional units between Q2 and Q1 are valued more than their
cost. Nonetheless, they will not be produced if suppliers are able to limit competition and
restrict output. When competition is absent, there is a potential conflict between the inter-
ests of sellers and the efficient use of resources.
114 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
EXHIBIT 2
Lack of Competition
and Problems for the
Market
If a group of sellers can
restrict competition, it may
be able to gain by reducing
supply (to S1, for example)
and raising the price (to P2,
for example) rather than
charging the competitive
market price of P1. Under
these circumstances, out-
put will be less than the
economically efficient
level.
P
ri
ce
D
S2 (restricted supply)
Q2
S1 (competitive supply)
P2
P1
Q1
Quantity/ time
What can the government do to ensure that markets are competitive? The first guide-
line might be borrowed from the medical profession: Do no harm. A productive govern-
ment will refrain from using its powers to impose licenses, discriminatory taxes, price
controls, tariffs, quotas, and other entry and trade restraints that lessen the intensity of
competition. In the vast majority of markets, sellers will find it difficult or impossible to
limit the entry of rival firms (including rival producers from other countries). The only
means by which they can limit competition is lobbying the government to impose restric-
tions or controls that limit competition on their behalf. In the interest of efficiency, gov-
ernments should refrain from giving in to these demands.
When entering a market is very costly and there are only a few existing sellers, it may
be possible for these sellers by themselves to restrict competition. In an effort to deal with
cases like this, the United States has enacted a series of “antitrust laws,” most notably the
Sherman Antitrust Act (1890) and the Clayton Act (1914), making it illegal for firms to
collude or attempt to monopolize a market.
For the most part, economists favor the general principle of government action to en-
sure and promote competitive markets. There is considerable debate, however, about the
effectiveness of actual government policy in this area. Many economists believe that, by
and large, government policy in this area has been ineffective. Others stress that govern-
ment policies have often been misused to actually limit competition, rather than promote
it. These laws have been used as a basis for restricting entry into markets, protecting
existing producers from competitors, and limiting price competition. This is counterpro-
ductive. For those taking a microeconomics course, non-competitive markets and related
policy alternatives will be analyzed in greater detail later.
Externalities—A Failure to Account for All Costs and Benefits
When property rights are unclear or poorly enforced, the actions of an individual or group
may “spill over” onto others and thereby affect their well-being without their consent.
These spillover effects are called externalities. You are probably familiar with externali-
ties. For example, when your neighbor’s loud stereo makes it hard for you to study, you
are experiencing an externality firsthand. Although your neighbors do not have a right to
come in to your apartment and turn on your stereo, they do have a right to listen to their
own stereo, and their listening may interfere with the quietness in your apartment. Their
actions impose a cost on you, and they also raise an issue of property rights. Do your
neighbors have a property right to play their stereo as loud as they please? Or do you have
a property right to quietness in your own apartment? When questions like these arise, how
should the boundaries of property rights be determined, and what steps should be taken to
ensure adequate enforcement? Although the volume of your neighbor’s stereo may not be
a major economic issue, it nonetheless illustrates the nature of the problems that arise
when property rights are unclear and externalities are present.
The spillover effects may either impose a cost or create a benefit for third parties—
people not directly involved in the transaction, activity, or exchange. Economists use the
term external cost to describe a situation in which the spillover effects harm third parties.
If the spillover effects enhance the welfare of the third parties, an external benefit is pre-
sent. We will analyze both external costs and external benefits and consider why both of
them can lead to problems.
External Cost Why should economists worry about external cost? Answer: external
cost may result in economic inefficiency. For example, resources may be used to produce
goods that are valued less than their production costs, including the costs imposed on the
nonconsenting third parties. Consider the production of paper. The firms in the market
operate mills and purchase labor, trees, and other resources to produce the paper. But they
also emit pollutants into the atmosphere that impose costs on residents living around the
mills. The pollutants cause paint on buildings to deteriorate more rapidly. They make it
difficult for some people to breathe normally, and perhaps cause other health hazards. If
the residents living near a pulp mill can prove they have been harmed, they could take the
mill to court and force the paper producer to cover the cost of their damages. But it might
Potential Shortcomings of the Market 115
Externalities
Spillover effects of an activity
that influence the well-being of
nonconsenting third parties.
External costs
Spillover effects that reduce
the well-being of nonconsent-
ing third parties.
External benefits
Spillover effects that generate
benefits for nonconsenting
third parties.
be difficult to prove that they were harmed and that the pulp mill is responsible for the
damage. As you can see, the residents’ property rights to clean air may be difficult to
enforce, particularly if there are many parties emitting pollutants into the air.
If the residents are unable to enforce their property rights, the production of paper will
generate an external cost that will be ignored by markets. Exhibit 3 illustrates the impli-
cations of these external costs within the supply and demand framework. As the result of
the external cost, the market supply curve S1 will understate the true cost of producing pa-
per. It reflects only the cost actually paid by the firms, and ignores the uncompensated
costs imposed on the nearby residents. Under these circumstances, the firm will expand
output to Q1 (the intersection of the demand curve D and supply curve S1) and the market
price P1 will emerge. Are this price and this output consistent with economic efficiency?
The answer is clearly “No.” If all of the costs of producing the paper, including those im-
posed on third parties, were taken into account, the supply curve S2 would result. From an
efficiency standpoint, only the smaller quantity Q2 should be produced. The units beyond
Q2 on out to Q1 cost more than their value to consumers. People would be better off if the
resources used to produce those units (beyond Q2) were used to produce other things.
Nonetheless, profit-maximizing firms will expand output into this range. Thus, when
external costs are present, the market supply curve will understate production costs, and
output will be expanded beyond the quantity consistent with economic efficiency. More-
over, resources for which property rights are poorly enforced will be overutilized and
sometimes polluted. This is often the case with air and water when the property rights to
these resources are poorly enforced.
What should be done about external costs? These costs arise because property rights
are poorly defined or imperfectly enforced. Initially, therefore, it makes sense to think se-
riously about how property rights might be better defined and enforced. However, the
nature of some goods will make the defining and enforcement of property rights extremely
difficult. This will certainly be the case for resources like clean air and many fish species
in the ocean. In cases that involve a relatively small number of people, the parties involved
may be able to agree to rules and establish procedures that will minimize the external
effects. For example, property owners around a small lake will generally be able to control
access to the lake and prevent each other, as well as outsiders, from polluting or overfish-
ing the lake.
However, in cases that involve large numbers of people, the transactions costs of
arriving at an agreement will be prohibitively high, so it is unrealistic to expect that private
contracts among the parties will handle the situation satisfactorily. For example, this will be
the case when a large number of automobiles and firms emit pollutants into the atmosphere.
In these “large number” cases, government regulations may be the best approach. At this
116 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
EXHIBIT 3
External Costs and
Output That Is Greater
Than the Efficient Level
When an activity such as
paper production imposes
external cost on noncon-
senting third parties, these
costs will not be registered
by the market supply curve
(S1). As a result, output will
be beyond the economically
efficient level. The units be-
tween Q2 and Q1 will be pro-
duced, even though their
cost exceeds the value they
provide to consumers.
D
S2 (restricted supply)
Q2
S1 (competitive supply)
P2
P1
Q1
point, we want you to see the nature of the problem when external costs are present. As we
proceed, we will analyze a number of problems in this area in detail and consider alternative
approaches that might improve economic efficiency.
External Benefits As we mentioned, sometimes the actions of individuals and firms
generate external benefits for others. The home owner who keeps a house in good
condition and maintains a neat lawn improves the beauty of the entire community. A
flood-control dam built by upstream residents for their benefit might also generate gains
for those who live downstream. Scientific theories benefit their authors, but the knowledge
can also help others who did not contribute to the development of them.
From the standpoint of efficiency, why might external benefits be a problem? Here,
inefficiency may arise because potential producers are unable to capture fully the benefits
that their actions create for others. Suppose a pharmaceutical company develops a vaccine
protecting users against a contagious virus or some other communal disease. Of course,
the vaccine can easily be marketed to users who will benefit directly from it. However,
because of the communal nature of the virus, as more and more people take the vaccine,
nonusers will also be less likely to get the flu. But it will be very difficult for the pharma-
ceutical companies to capture any of the benefits derived by the nonusers. As a result, too
little of the vaccine may be supplied.
Exhibit 4 illustrates the impact of external benefits like those generated by the vac-
cine within the framework of supply and demand. The market demand curve reflects the
benefits derived by the users of the vaccine, while the supply curve reflects the opportu-
nity cost of providing it. Market forces result in an equilibrium price of P1 and output of
Q1. Is this outcome consistent with economic efficiency? Again, the answer is “No.” The
market demand curve D1 will register only the benefits derived by the users. Those bene-
fits that accrue to nonusers, who are now less likely to contract the flu, will not be taken
into account by decision-makers. The producer of the vaccine makes it more likely these
people will not get sick, but it doesn’t derive any benefit (sales revenue) from having done
so. Thus, market demand D1 understates the total benefits derived from the production and
use of the vaccine. Demand D2 provides a measure of these total benefits, including those
that accrue to the nonusers. The units between Q1and Q2 are valued more highly than what
it costs to produce them. Nonetheless, they will not be supplied because the suppliers of
the vaccine will be unable to capture the benefits that accrue to the nonusers. Thus, when
external benefits are present, market forces may supply less than the amount consistent
with economic efficiency.
Potential Shortcomings of the Market 117
External costs resulting from
poorly defined and enforced
property rights underlie the
problems of excessive air and
water pollution.
G
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While external benefits are a potential source of inefficiency, entrepreneurs have a
strong incentive to figure out ways to capture more fully the gains their actions generate
for others. In some cases, they are able to capture what would otherwise be external bene-
fits by extending the scope of the firm. The accompanying Application in Economics,
“Capturing External Benefits: The Case of Walt Disney World,” provides an interesting
and informative illustration of this point.
Public Goods and Why They Pose a Problem for the Market
What are public goods? Public goods have two distinguishing characteristics: (1) nonri-
valry in consumption and (2) nonexcludability. Let’s take a closer look at both of these
characteristics.
Nonrivalry in consumption means that making the good available to one consumer
does not reduce its availability to others. In fact, providing it to one person simultaneously
makes it available to other consumers. Thus, a consumer has no reason to compete with
others for the good. A radio broadcast signal provides an example. The same signal can be
shared by everyone within the listening range. Having additional listeners tune in does not
detract from the availability of the signal. Clearly, most goods do not have this shared con-
sumption characteristic, but are instead rivals-in-consumption. For example, two individu-
als cannot simultaneously consume the same pair of jeans. Further, if one person
purchases a pair of jeans, there is one less pair available for someone else.
The second characteristic of a public good—nonexcludability—means that it is im-
possible (or at least very costly) to exclude nonpaying customers from receiving the good.
Suppose an antimissile system were being built around the city in which you live. How
could some people in the city be protected by the system and others excluded? Most peo-
ple will realize there is no way the system can protect their neighbors from incoming mis-
siles without providing similar protection to other residents. Thus, the services of the
antimissile system have the nonexcludability characteristic.
It is important to note that it is the characteristic of the good, not the sector in which it
is produced, that determines whether it qualifies as a public good. There is a tendency to
think that if a good is provided by the government, then it is a public good. This is not the
case. Many of the goods provided by governments clearly do not have the characteristics
118 C H A P T E R 5 Difficult Cases for the Market and The Role of Government118 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
Ideal
output
D2
Quantity/ time
P
ri
ce
P1
P2
Q1 Q2
S
Actual price and output
(includes external benefits)
D1
External benefits
A vaccine that protects users against the flu will also help nonusers by making it less likely that they will catch it. But this
benefit will not be registered by the market demand cur ve (D1). In cases where external benefits like this are present, output
will be less than the economically efficient level. Even though the units between Q1 and Q2 generate more benefits than
costs, they will not be supplied because sellers are unable to capture the value of these external benefits.
Public goods
Goods for which rivalr y among
consumers is absent and
exclusion of nonpaying
customers is difficult.
EXHIBIT 4
External Benefits and
Output That Is Less
Than the Efficient Level
Potential Shortcomings of the Market 119
A P P L I C AT I O N S I N E C O N O M I C S
Capturing External Benefits:
The Case of Walt Disney World
Sometimes projects that generate more benefits than cost
are still unattractive because a substantial share of the
benefits are external and therefore difficult to capture. If an
entrepreneur could figure out a way to capture more of
these benefits, an other wise unprofitable project might be
transformed into a profitable one. Sometimes this can be
done by extending the scope of a project.
The development of golf courses is an example. Be-
cause of the beauty and openness of the courses, many
people find it attractive to live nearby. Thus, constructing a
golf course typically generates an external benefit—an in-
crease in the value of the nearby proper ty. In recent years,
golf course developers have figured out how to capture this
benefit. Now, they typically purchase a large tract of land
around the planned course before it is built. This places
them in a position to resell the land at a higher price after
the golf course has been completed and the surrounding
land has increased in value. By extending the scope of their
activities to include real estate as well as golf course devel-
opment, they are able to capture what would other wise be
external benefits.
Florida’s Walt Disney World is an interesting case study
in entrepreneurial ingenuity designed to capture external
benefits more fully. When Walt Disney developed Disney-
land in California, the market value of the land in the imme-
diate area soared as a result of the increase in demand for
ser vices (food, lodging, gasoline, and so on). Because the
land in the area was owned by others, the developers of
Disneyland were unable to capture these external benefits.
In addition, Disney felt as if some of the adult nightclubs
that had opened around his existing Disneyland park were
imposing external costs on him by detracting from the fam-
ily image his park was tr ying to attain.
Because of his experience with these externalities,
when Walt Disney World was developed outside of Orlando,
Florida, in the mid 1960s, Walt Disney purchased far more
land than was needed for the amusement park. This en-
abled him to capture the increased land value surrounding
his development (when he resold the land for a higher
price), and reduce the negative externalities imposed on
him via his control of the surrounding property.
The purchases were made as secretly as possible to pre-
vent speculators from driving up the land prices if Disney’s
actions were detected. Disney even created a handful of
smaller companies, with names like the Latin-American De-
velopment and Managers Corporation and the Reedy Creek
Ranch Corporation, to purchase the land. After his first major
land purchase of 12,400 acres, Walt Disney was at a meet-
ing at which he was offered an oppor tunity to purchase an
additional 8,500 acres. Walt Disney’s assistant was ru-
mored to have said, “But Walt, we already own 12,000
acres, enough to build the park.” Disney replied, “How would
you like to own 8,000 acres around our existing Disneyland
facility right now?” His assistant immediately responded,
“Buy it!”
After another major acquisition of 1,250 acres, Disney
began concentrating on buying smaller land parcels around
his main proper ty. By June 1965, Disney had purchased
27,400 acres, or about 43 square miles—an area 150
times larger than his existing Disneyland park, and about
twice as big as Manhattan. In October 1965, when an
Orlando newspaper finally broke the stor y that Disney was
behind the land purchases, the remaining land prices
around his proper ty jumped from $183 an acre to $1,000
an acre overnight. But by then, except for several small
parcels he was unable to acquire, Walt Disney had pur-
chased all of the land he wanted.
Florida eventually gave Walt Disney permission to create
an autonomous Reedy Creek Improvement District, outside
the authority of any local government in Florida. In a very real
sense, Walt Disney World is a jurisdiction of its own, sepa-
rate from any other local government authority. Because
of this, Walt Disney World can write its own zoning
Potential Shortcomings of the Market 119
(continued)
120 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
of public goods. Medical services, education, mail delivery, trash collection, and electric-
ity come to mind. Although these goods are often supplied by governments, they do not
have either nonrivalry or nonexcludability characteristics. Thus, they are not public goods.
Why are public goods difficult for markets to allocate efficiently? The nonexcludabil-
ity characteristic provides the answer. Since those who do not pay cannot be excluded,
sellers are generally unable to establish a one-to-one link between the payment and receipt
of these goods. Realizing they cannot be excluded, potential consumers have little incen-
tive to pay for these goods. Instead, they have an incentive to become free riders, people
who receive the benefits of the good without helping to pay for its cost. But, when a large
number of people become free riders, not very much of the good is supplied. This is pre-
cisely the problem: markets will tend to undersupply public goods, even when the popula-
tion in aggregate values them highly relative to their cost.
Suppose national defense were provided entirely through the market. Would you vol-
untarily help to pay for it? Your contribution would have little impact on the total supply
of defense available to each of us, even if you made a large personal contribution. Many
citizens, even though they might value defense highly, would become free riders, and few
funds would be available to finance national defense.
For most goods, it is easy to establish a link between payment and receipt. If you do
not pay for a gallon of ice cream, an automobile, a television set, a DVD player, and liter-
ally thousands of other items, suppliers will not provide them to you. Thus, there are very
few public goods. National defense is the classic example of a public good. Radio and TV
signals, software programs, flood-control projects, mosquito abatement programs, and
perhaps some scientific theories also have public good characteristics. But beyond this
short list, it is difficult to think of additional goods that qualify.
Just because a good is a public good does not necessarily mean that markets will fail
to supply it. When the benefit of producing these goods is high, entrepreneurs will attempt
to find innovative ways to gain by overcoming the free-rider problem. For example, radio
and television broadcasts, which have both of the public good characteristics, are still pro-
duced well by the private sector. The free-rider problem is overcome through the use of
advertising (which generates indirect revenue from listeners), rather than directly charging
listeners. Private entrepreneurs have developed things like scrambling devices (so nonpay-
ing customers can’t tune into broadcasts free of charge) copy protection on DVDs, and tie-
in purchases (for example, tying the purchase of a software instruction manual to the
purchase of the software itself) to overcome the free-rider problem. The marketing of
computer software provides an interesting illustration. Since the same software program
can be copied without reducing the amount available, and it is costly to prevent consump-
tion by nonpayers, software clearly has public good characteristics. Nonetheless, Bill
Gates became the richest man in the world by producing and marketing it!
In spite of the innovative efforts of entrepreneurs, however, the quantity of public
goods supplied strictly through market allocation might still be smaller than the quantity
consistent with economic efficiency. This creates a potential opportunity for government
action to improve the efficiency of resource allocation.
(continued)
restrictions and building codes. It can also plan its own road-
ways, lakes, security, sidewalks, airpor ts, and recreational
areas. Walt Disney World is able to provide goods and ser-
vices like these—that might normally be considered public
goods—by charging general admission fees to its park. This
helped Disney overcome the potential free-rider problems
sometimes associated with producing these goods.
Just as Disney expected, the value of the land surround-
ing Walt Disney World soared as the demand for hotels,
restaurants, and other businesses increased along with the
development of the the amusement park. Through the years,
the resale of land near the park has been a major source of
revenue for the company. To a large degree, the success of
the Disney Corporation reflects Walt Disney’s entrepreneur-
ial ability to deal with externality and public-good problems.
Free rider
A person who receives the
benefit of a good without
paying for it. Because of their
nonexcludable nature, public
goods are subject to free-rider
problems.
A P P L I C AT I O N S I N E C O N O M I C S
Potential Information Problems
Like other goods, information is scarce. Thus, when making purchasing decisions, people
are sometimes poorly informed about the price, quality, durability, and side effects of
alternate products. Imperfect knowledge is not the fault of the market. In fact, the market
provides consumers with a strong incentive to acquire information. If they mistakenly pur-
chase a “lemon,” they will suffer the consequences. Furthermore, sellers have a strong
incentive to inform consumers about the benefits of their products, especially in compari-
son to competing products. However, circumstances will influence the incentive structure
confronted by both buyers and sellers.
The consumer’s information problem is minimal if the item is purchased regularly.
Consider the purchase of soap. There is little cost associated with trying different brands.
Since soap is a regularly purchased product, trial and error is an economical means of
determining which brand is most suitable to one’s needs. Regularly purchased items such
as toothpaste, most food products, lawn service, and gasoline provide additional examples
of repeat-purchase items. When purchasing items like these, the consumer can use past
experience to acquire accurate information and make wise decisions.
Furthermore, the sellers of repeat-purchase items also have a strong incentive to
supply consumers with accurate information about them because failing to do so will
adversely affect future sales. Because future demand is directly related to the satisfaction
level of current customers, sellers of repeat-purchase items will want to help their
customers make satisfying long-run choices. This helps harmonize the interests of buyers
and sellers.
But harmany will not always occur. Conflicting interests, inadequate information, and
unhappy customers can arise when goods are either (1) difficult to evaluate on inspection
and seldom repeatedly purchased from the same producer or (2) potentially capable of
serious and lasting harmful side effects that cannot be predicted by a typical consumer.
Under these conditions, consumers might make decisions they will later regret.
When customers are unable to distinguish between high-quality and low-quality
goods, business entrepreneurs have an incentive to cut costs by reducing quality. Busi-
nesses that follow this course may survive and even prosper. Consider the information
problem when an automobile is purchased. Are consumers capable of properly evaluating
the safety equipment? Most are not. Of course, some consumers will seek the opinion of
experts, but this information will be costly and difficult to evaluate. In this case, it might
be more efficient to have the government regulate automobile safety and require certain
safety equipment.
Similar issues arise with regard to product effectiveness. Suppose a new wonder drug
promises to reduce the probability a person will be stricken by cancer or heart disease.
Even if the product is totally ineffective, many consumers will waste their money trying it.
Verifying the effectiveness of the drug will be a complicated and lengthy process. Conse-
quently, it may be better to have experts certify its effectiveness. The federal Food and
Drug Administration was established to perform this function. However, letting the
experts decide is also a less than ideal solution. The certification process is likely to be
costly and lengthy. As a result, the introduction of products that are effective may be
delayed for years, and they are likely to be more costly than they would be otherwise.
Information as a Profit Opportunity
Consumers are willing to pay for information that will help them make better decisions.
This presents a profit opportunity. Entrepreneurial publishers and other providers of
information help consumers find what they seek by offering product evaluations by
experts. For example, dozens of publications provide independent expert opinions about
automobiles and computers at a low cost to potential purchasers. Laboratory test results
and detailed product evaluations on a wide variety of goods are provided by Consumer
Reports, Consumer Research, and other publications.
Franchises are another way entrepreneurs have responded to the need of consumers
for more and better information. A franchise is a right or license granted to an individual
Potential Shortcomings of the Market 121
Repeat-purchase item
An item purchased often by
the same buyer.
Franchise
A right or license granted to
an individual to market a
company’s goods or ser vices
or use its brand name. The
individual firms are indepen-
dently owned but must meet
certain conditions to continue
to use the name.
to market a company’s goods or services (or use their brand name). Fast-food restaurants
like McDonald’s, Wendy’s, and Burger King are typically organized as franchises. The in-
dividual restaurants are independently owned, but the owner pays for the right to use the
company name and must offer specific products and services in a manner specified by the
franchiser. Franchises help give consumers reliable information. The tourist traveling
through an area for the first time with very little time to search out alternatives may find
that eating at a franchised restaurant and sleeping at a franchised motel are the cheapest
ways to avoid annoying and costly mistakes that might come from patronizing an un-
known local establishment. The franchiser sets the standards for all firms in the chain and
establishes procedures, including continuous inspections designed to maintain the stan-
dards. Franchisers have a strong incentive to maintain their reputation for quality, because
if it declines, their ability to sell new franchises and to collect ongoing franchise fees is
adversely affected. Even though the tourist may visit a particular establishment only once,
the franchise turns that visit into a “repeat purchase,” since the reputation of the entire
national franchise operation is at stake.
Similarly, advertising a brand name nationally puts the brand’s reputation at stake
each time a purchase is made. How much would the Coca-Cola Company pay to avoid the
sale of a dangerous bottle of Coke? Surely, it would be a large sum. Interbrand, a branding
consulting agency that evaluates and ranks the top brand names in the world, estimates
that Coke’s brand name is worth $67.4 billion. The value of that brand name is a hostage
to quality control. The firm would suffer enormous damage if it failed to maintain the
quality of its product. For example, in 2000 and 2001, Firestone’s brand name suffered an
immense reduction in value after only a few Firestone tires were suspected of being defec-
tive. Firestone is still attempting to recover from its loss in brand name value.
Enterprising entrepreneurs have found ways to assure buyers that products meet high
standards of quality, even when the producer is small and not so well known. Consider the
case of Best Western Motels.4 Best Western owns no motels; however, building on the fran-
chise idea, it publishes rules and standards with which motel owners must comply if they
are to use the Best Western brand name and the reservation service that the company also
operates. To protect its brand name, Best Western sends out inspectors to see that each Best
Western Motel meets these standards. Every disappointed customer harms the reputation
and reduces the value of the Best Western name, and reduces the willingness of motel own-
ers to pay for use of the name. The standards are designed to keep customers satisfied. Even
though each motel owner has only a relatively small operation, renting the Best Western
name provides the small operator with the kind of international reputation formerly avail-
able only to large firms. In effect, Best Western acts as a regulator of all motels bearing its
name. It profits by requiring efficient standards—those that produce maximum visitor sat-
isfaction for every dollar spent by the motels utilizing the franchise name. As it does so, it
helps eliminate problems in the market that result from imperfect information.
Underwriters Laboratories, Inc., is another example of private-sector regulation aimed
at overcoming potential information problems. UL, as it is better known, is a private-
sector corporation that has been testing and certifying products for more than 100 years
based on its own set of quality standards. You have probably seen the UL mark on many
of your household appliances. Sellers pay a fee to have UL evaluate their products for pos-
sible certification. The value of the UL brand depends on their careful evaluation of every
product they certify. If UL allows defective products to carry its mark, its brand value will
diminish.
Information published by reliable sources, franchising, and brand names can help
consumers make better-informed decisions. Although these options are effective, they will
not always provide an ideal solution. Government regulation may sometimes be able to
improve the situation, but this, too, has its shortcomings. As with other things, there is no
general solution to imperfect information problems.
122 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
4This section draws from Randall G. Holcombe and Lora P. Holcombe, “The Market for Regulation,” Journal of Institutional
and Theoretical Economics 142, no. 4 (1986): 684–696.
Pulling Things Together 123
Brand names (like Coca-
Cola), franchises (like
McDonald’s), private sector
certification firms (like
Underwriters Laboratories,
Inc.), and consumer-ratings
magazines (like Consumer
Reports) are ways the private
sector helps buyers overcome
potential information
problems.
Political decision-making is complex, but the tools of economics can enhance our
understanding of how it works. This is the subject matter of the next chapter.
L O O K I N G A H E A D
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PULLING THINGS TOGETHER
Throughout this textbook, we have stressed that a sound legal system—one that protects
individuals and their property and provides access to evenhanded courts for the enforce-
ment of contracts and settlement of disputes—is vitally important for the smooth opera-
tion of markets. So, too, is a monetary regime that provides people with access to a sound
currency—money that maintains its value across time periods. Beyond these functions,
however, there is little justification for government action when there is reason to expect
that markets will allocate resources efficiently. But a lack of competition, externalities,
public goods, and information problems often pose challenges and sometimes undermine
the efficient operation of markets. Market shortcomings due to these factors raise the pos-
sibility that government intervention beyond the protective function might improve things.
But before jumping to that conclusion, we need better knowledge about how the political
process works. We are now ready to move on to that topic.
124 C H A P T E R 5 Difficult Cases for the Market and The Role of Government
▼ Economists use the standard of economic efficiency
to assess the desirability of economic outcomes.
Efficiency requires both: (1) that all actions generat-
ing more benefit than cost be undertaken, and (2)
that no actions generating more cost than benefit be
undertaken.
▼ Although perfection is a noble goal, it is rarely worth
achieving because additional time and resources
devoted to an activity generally yield smaller and
smaller benefits and cost more and more. Ineffi-
ciency can result when either too little or too much
effort is put into an activity.
▼ Governments can enhance economic well-being by
performing both protective and productive functions.
The protective function involves (1) the protection of
individuals and their property against aggression and
(2) the provision of a legal system for the enforce-
ment of contracts and settlement of disputes. The
productive function of government can help people
obtain goods that would be difficult to supply
through markets.
▼ When markets fail to meet the conditions for ideal
economic efficiency, the problem can generally be
traced to one of four sources: absence of competi-
tion, externalities, public goods, or poor information.
▼ Externalities reflect a lack of fully defined and en-
forced property rights. When external costs are
present, output can be too large—units are produced
even though their costs exceed the benefits they
generate. In contrast, external benefits can lead to an
output that is too small—some units are not pro-
duced even though the benefits of doing so would
exceed the cost.
▼ Public goods are goods for which (1) rivalry in con-
sumption is absent and (2) it is difficult to exclude
those who do not pay. Because of the difficulties
involved in establishing a one-to-one link between
payment and receipt of such goods, the market
supply of public goods will often be less than the
economically efficient quantity.
▼ Entrepreneurs in markets have an incentive to find
solutions to each market problem, and new solutions
are constantly being discovered. But problems
remain that can potentially be improved through
government action.
K E Y P O I N T S!
*1. Why is it important for producers to be able to pre-
vent nonpaying customers from receiving a good?
2. In response to the terrorist attacks of September 11,
2001, airline security screening has increased
dramatically. As a result, travelers must now spend
considerably more time being screened before
flights. Would it make economic sense to devote
enough resources to completely prevent any such
future attacks? Why or why not?
3. What are the distinguishing characteristics of
“public goods?” Give two examples of a public
good. Why are public goods difficult for markets
to allocate efficiently?
*4. Which of the following are public goods? Explain,
using the definition of a public good.
a. an antimissile system surrounding Washington,
D.C.
b. a fire department
c. tennis courts
d. Yellowstone National Park
e. elementary schools
5. Explain in your own words what is meant by exter-
nal costs and external benefits. Why may market
outcomes be less than ideal when externalities are
present?
6. English philosopher John Locke argued that the
protection of each individual’s person and property
(acquired without the use of violence, theft, or
fraud) was the primary function of government.
Why is this protection important to the efficient
operation of an economy?
7. “If it’s worth doing, it’s worth doing to the best of
your ability.” What is the economic explanation for
why this statement is frequently said but rarely
followed in practice? Explain.
C R I T I C A L A N A L Y S I S Q U E S T I O N S?
Critical Analysis Questions 125
8. “The traveler in a market economy has no chance
for a fair deal. Local people may be treated well, but
the traveler has no way to know, for example, who
offers a good night’s lodging at a fair price, if the
quality and price are not regulated by government.”
Is this true or false? Explain.
*9. If sellers of toasters were able to organize themselves,
reduce their output, and raise their prices, how would
economic efficiency be affected? Explain.
10. What are external costs? When are they most likely
to be present? When external costs are present, what
is likely to be the relationship between the market
output of a good and the output consistent with ideal
economic efficiency?
*11. “Elementary education is obviously a public good.
After all, it is provided by the government.” Evalu-
ate this statement.
12. What are the necessary conditions for economic ef-
ficiency? In what four situations might a market fail
to achieve ideal economic efficiency?
13. Suppose that Abel builds a factory next to Baker’s
farm, and air pollution from the factory harms
Baker’s crops. Is Baker’s property right to the land
being violated? Is an externality present? What if
the pollution invades Baker’s home and harms her
health? Are her property rights violated? Is an exter-
nality present? Explain.
*14. Apply the economic efficiency criterion to the role
of government. When would a government interven-
tion be considered economically efficient? When
would a government intervention be considered
economically inefficient?
*Asterisk denotes questions for which answers are given in Appendix B.
[Public choice] analyzes the mo-
tives and activities of politicians,
civil servants and government
officials as people with personal
interests that may or may not
coincide with the interest of the
general public they are supposed
to serve
.
It is an analysis of how
people behave in the world as it
is.
—Arthur Seldon
1
It does not follow that whenever
laissez faire falls short govern-
ment interference is expedient;
since the inevitable drawbacks of
the latter may, in any particular
case, be worse than the short-
comings of private enterprise.
—Harr y Sidgwick, 1887
2
C h a p t e r F o c u s
■ How large is the government sector, and what are the main activities
undertaken by government?
■ What are the differences and similarities between market and
government actions?
■ What insights can economics provide about the behavior of voters,
politicians, and bureaucrats? How will their actions affect political
outcomes?
■ When is democratic representative government most likely to lead to
economic efficiency?
■ Why will there sometimes be a conflict between winning politics and
economic efficiency?
■ How does economic organization influence the efficiency of resource
use?
6
C H A P T E R
The Economics of Collective
Decision-Making
1Preface to Gordon Tullock, The Vote Motive (London: Institute of Economic Affairs, 1976), x.
2Quoted in Charles Wolf, Jr., Markets or Government (Cambridge: MIT Press, 1988), 17.
As we have previously discussed, the protection of property rights, evenhanded enforcement of contracts, andprovision of a stable monetary environment are vital for the smooth and efficient operation of markets. Gov-ernments that perform these functions well will help their citizens prosper and achieve higher levels of income.
Governments may also help allocate goods difficult for markets to handle. However, it is crucially important to recognize
that government is simply an alternative form of economic organization. In most industrialized nations, the activities of
governments are directed by the democratic political process. In this chapter, we will use the tools of economics to analyze
how this process works. ■
THE SIZE AND GROWTH OF THE U.S. GOVERNMENT
What exactly does government do? Has its role in the economy shrunk or grown over
time? Data on government spending sheds light on these questions. As Exhibit 1 illus-
trates, total government expenditures (federal, state, and local combined) were only
9.
4
percent of the U.S. economy in 1930. (Note: GDP is generally how economists measure
the size of the economy. The term will be explained more fully in a macroeconomics
course.) In that year, federal government spending by itself was only 3 percent of the
economy. At the time, this made the federal government about half the size of all state and
local governments combined.
However, between 1930 and 1980, the size of government grew very rapidly. By
1980, government expenditures had risen to 32.8 percent of the economy, more than three
times the level of 1930. Moreover, the federal government grew to about twice the size of
all state and local governments combined—despite the fact that they were growing
rapidly, too. Over the last two decades, total government spending as a share of the econ-
omy has been relatively constant at approximately one-third of GDP.
Exhibit 2 shows the major categories of government spending for both the federal
government and state and local governments. The major categories of federal spending are
health care, national defense, Social Security, and other income transfers. Education, ad-
ministration, and public welfare and health constitute the largest areas of spending for
state and local governments.
127
Percentage of GDP
1930
State and local
1940
1950
1960
1970
1980
1990
2000
0 10 20 30 40
Federal
Percentage of GDP
9.4
State and local
1940
1950
1960
1970
1980
1990
2000
0 10 20 30 40
3.0 6.
5
15.78.4 7.
3
21.114.7 6.3
24.116.5 7.6
30.219.4 10.9
32.821.0
11.8
34.221.6 1
2.6
31.919.0 12.9
2003 34.320.6 13.7
Federal
EXHIBIT 1
The Growth of
Government Spending
between 1930 and
2003
U.S. government expendi-
tures as a share of the
economy’s gross domestic
product have risen dramati-
cally over the past 70
years.
Source: Bureau of Economic Analysis, www.bea.gov.
Grants to state and local governments are in-
cluded in federal expenditures.
128 C H A P T E R 6 The Economics of Collective Decision-Making
Transfer payments are transfers of income from some individuals (who pay taxes) to
others (who receive government payments). Social Security, unemployment benefits, and
welfare are examples of transfer payments. Direct income transfers now account for almost
40 percent of the total spending of the government. As Exhibit 3 illustrates, government
spending on income transfers has grown rapidly. In 1930, income transfers summed to only
Social�
security�
22%
�
�
�
�
Police and fire�
protection�
7.9%�
�
�
�
�
Income�
security�
15.5%
Defense�
18.8%
Net interest�
7.1%
Transportation�
3.1% Other�
11.8% Medicare�
and health�
21.7%
Utilities and�
liquor stores�
7.1%
Interest�
on debt�
4.3%
Administration�
and other�
expenditures�
12.2%
Education�
32.2%�
�
�
�
Insurance trusts�
7.7%
Transportation�
6.3%
Public�
Welfare�
and Health�
22.3%
(a) Federal government, 2003 (b) State and local governments, 2000
Federal spending = $2158 billion State and local spending = $1743 billion
Source: Economic Report of the President, 2004, and Statistical Abstract of the United States, 2003.
Transfer payments
Payments to individuals or in-
stitutions that are not linked
to the current supply of a good
or ser vice by the recipient.
Tr
a
n
sf
e
r
p
a
ym
e
n
ts
�
a
s
a
p
e
rc
e
n
t
o
f
n
a
tio
n
a
l i
n
co
m
e
1930 1940 1950
Year
1960 1970 1980 1990 2000
1.1
0.2 0.8
2.6
1.4
1.2
5.1
1.2
3.9
5.2
1.0
4.2
7.7
1.7
6.0
11.1
2.1
9.0
11.3
2.5
8.8
11.8
5
10
15.0
3.1
8.8
2002
13.4
3.6
9.9
State and local governments
Federal government alone
EXHIBIT 3
The Growth of Government Transfer Payments
The government taxes approximately 13 percent of national income away from some people and transfers it to others.
Means-tested income transfers—those directed toward the poor—account for only about one-sixth of all income transfers.
Government income-transfer activities have grown substantially over the past 70 years.
EXHIBIT 2
Government Spending by Category
The major categories of federal government spending are health care, Social Security, national defense, and income security
(welfare programs). The major categories of state and local government spending are education, health care, and welfare
programs.
Source: Bureau of Economic Analysis, www.bea.gov.
The Differences and Similarities between Governments and Markets 129
1.1 percent of total income. By 1970, the figure had jumped to 7.7 percent, and by 2002 it
had risen to 13.4 percent of national income. Obviously, the government has become much
more involved in tax-transfer activities during the last several decades.
Given the size and growth of government, analyzing how the political process works
and what impact it is likely to have on the economy is a vitally important topic. The re-
mainder of this chapter will address this issue.
THE DIFFERENCES AND SIMILARITIES BETWEEN
GOVERNMENTS AND MARKETS
When political decisions are made democratically, the choices of individuals will influ-
ence outcomes in the government sector—just as they do in the market sector. Therefore,
when we analyze the political process, we focus on individuals and how incentives influ-
ence their choices, just as we do when we analyze markets. There are both differences and
similarities between political and market decision-making. Let’s take a look at several
of them.
1. Competitive behavior is present in both the market and public sectors. The
nature of the competition and the criteria for success differ between the two sectors,
but people compete in both. Politicians compete for elective office. Bureau chiefs and
agency heads compete for taxpayer dollars and the authority to regulate others to
meet their bureau or agency goals. Public-sector employees compete for promotions,
higher incomes, and additional power, just as they do in the private sector. Lobbyists
compete for program funding, for favorable bureaucratic rulings, and for legislation
favorable to the interest groups they represent—including both private and government
clients. The nature of the competition may differ between the two sectors, but it is
present in both. (See Applications in Economics: Perspectives on the Cost of Political
Competition.)
2. Public-sector organization can break the individual consumption-payment link.
In the market sector, goods are allocated to those who are willing to pay the price: there is
A P P L I C AT I O N S I N E C O N O M I C S
Perspectives on the Cost of Political Competition:
What Does It Cost to Get Elected?
Competition for elective office is fierce and campaigns are
expensive. For example, in recent years, candidates for
U.S. House and Senate positions raised and spent more
than $1 billion. This amounts to approximately $2 million
per congressional seat
!
Highly contested seats are often
far more expensive.
During and after an election, lobbying groups compete for
the attention of elected officials. In fact, the greatest portion
of campaign funds raised by incumbents is not raised at
election time; rather, it accrues over their entire term in of-
fice. A large campaign contribution may not be able to “buy”
a vote, but it certainly enhances the lobbyist’s chance to sit
down with the elected official to explain the power and
“beauty” of the contributor’s position. In the competitive
world of politics, the politician who does not at least listen to
helpful “friends of the campaign” is less likely to survive.
The U.S. Congress controls approximately $2 trillion in
spending annually and imposes regulations that cost an-
other $800 billion. That’s a huge amount of money. As long
as Congress wields the power to spend these sums, huge
expenditures designed to influence the policies representa-
tives make will continue.1
1More details on campaign finance can be found in Michael Barone and Grant Uji-
fusa, The Almanac of American Politics (Washington, D.C.: National Journal, an-
nual), or at the Federal Election Commission’s Web site.
a one-to-one relationship between a person’s payment and receipt of a good. This is often
not the case when decisions are made politically. Sometimes people receive very large
benefits from the government even though they do not pay much of the cost to cover them.
In other cases, individuals are required to pay dearly for a government program even
though they derive few, if any, benefits.
3. Scarcity imposes the aggregate consumption-payment link in both sectors.
Although the government can break the link between a person’s payment for a good and
the right to consume it, the reality of the aggregate consumption—aggregate payment link
remains. Resources used by the government have alternative uses. Therefore, it is costly
to provide goods and services through the government. This is true even if the good is
provided “free of charge” to certain consumers.
4. Private-sector action is based on mutual agreement; public-sector action is
based on majority rule. In the market sector, when two parties engage in trade, they do
so voluntarily. Corporations like General Motors and Microsoft, no matter how large or
powerful, cannot take income from you or force you to buy their products. On the other
hand, when collective action occurs in a democratic setting, majority rule is the key, either
through direct voting or through legislative procedures involving elected representatives. If a
legislative majority decides on a particular policy, the minority must accept the policy and
help pay for it, even if they strongly disagree. Similarly, if government regulators mandate
that private parties must provide a wildlife habitat, wetlands, or housing at below-market
prices, for example, both providers and potential buyers must comply. Although market
action is based on mutual benefit, government action through the political process generates
losers as well as winners.
5. When collective decisions are made legislatively, voters must choose among
candidates who represent a bundle of positions on issues. On election day, the
voter cannot choose the views of one politician on poverty and business welfare and
simultaneously choose the views of a different politician on national defense and tariffs.
This greatly limits the voter’s power to make his or her preferences count on specific
issues. Since the average representative is asked to vote on roughly 2,000 different issues
during a two-year term, the size of the problem is obvious. The situation in markets,
however, is quite different. A buyer can purchase some groceries or clothing from one
store, while choosing related items from different suppliers. There is seldom a bundle-
purchase problem in markets.
6. Income and power are distributed differently in the two sectors. People who
supply more highly valued resources in the marketplace have larger incomes. The number
of these dollar “votes” earned by a person in the marketplace will reflect his or her
abilities, ambitions, skills, past savings, inheritance, good fortune, and willingness to
produce for others, among other things. Bill Gates is a good example. Many people have
“voted” for his products. Consequently, Gates has become quite wealthy. This process
results in an unequal distribution of income and power in the market sector.
On the other hand, in a democratic government, one citizen, one vote is the rule.
But there are ways other than voting to influence political outcomes. People can donate
both their money and their time to help a campaign. They can also try to influence
friends and neighbors, write letters to legislators, and speak in public on behalf of a can-
didate or cause. The greatest rewards of the political process go to those best able and
most willing to use their time, persuasive skills, organizational abilities, and financial
contributions to help politicians get votes. People who have more money and skills of
this sort—and are willing to spend them in the political arena—can expect to benefit
more handsomely for themselves and their favorite causes. Thus, while the sources of
success and influence differ, there is an unequal distribution of influence and power in
both sectors.
130 C H A P T E R 6 The Economics of Collective Decision-Making
Political Decision-Making: An Overview 131
POLITICAL DECISION-MAKING: AN OVERVIEW
Public-choice analysis is a branch of economics that applies the principles and methodol-
ogy of economics to the operation of the political process. Public-choice analysis links the
theory of individual behavior to political action, analyzes the implications of the theory,
and tests them against events in the real world. Over the past 50 years, research in this area
has greatly enhanced our understanding of political decision-making.3 Just as economists
have used the idea of self-interest to analyze markets, public-choice economists use it to
analyze political choices and the operation of government. After all, the same people make
decisions in both sectors. If self-interest and the structure of incentives influence market
choices, there is good reason to expect that they will also influence choices in a political
setting.
The collective decision-making process can be thought of as a complex interaction
among voters, legislators, and bureaucrats. Voters elect a legislature, which levies taxes
and allocates budgets to various government agencies and bureaus. The bureaucrats in
charge of these agencies utilize the funds to supply government services and income trans-
fers. In a representative democracy, voter support determines who is elected to the legisla-
ture. A majority vote of the legislature is generally required for the passage of taxes,
budget allocations, and regulatory activities. Let’s take a closer look at the incentive struc-
ture confronting the three primary political players—voters, legislators, and bureaucrats—
and consider how they affect the operation of the political process.
Public-choice analysis
The study of decision-making
as it affects the formation and
operation of collective organi-
zations, such as governments.
In general, the principles and
methodology of economics are
applied to political science
topics.
Voters, politicians, and
bureaucrats are the primary
decision makers in the
political arena.
3The contributions of Kenneth Arrow, James Buchanan, Duncan Black, Anthony Downs, Mancur Olson, Robert Tollison, and
Gordon Tullock have been particularly important. Public choice is something of a cross between economics and political science.
Thus, advanced courses are generally offered in both departments.
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132 C H A P T E R 6 The Economics of Collective Decision-Making
James Buchanan is a key figure in the development of public-choice theor y.
Buchanan’s most famous work, The Calculus of Consent (1962), coauthored with
Gordon Tullock, argues that unless constitutional rules are structured in a man-
ner that will bring the self-interests of the political players into harmony with the
wise use of resources, government action will often be counterproductive.1 This
and related contributions won him the 1986 Nobel Prize in economics. Buchanan
is the founder of the Center for the Study of Public Choice and a longtime profes-
sor of economics at George Mason University.
1J. M. Buchanan and G. Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).
O U T S T A N D I N G
E C O N O M I S T
James Buchanan
(b. 1919)
Incentives Confronted by the Voter
How do voters decide whom to support? Self-interest dictates that voters, like market con-
sumers, will ask, “What can you do for me and my goals, and how much will it cost me?”
The greater the voter’s perceived net personal gain from a particular candidate’s election,
the more likely it is that the voter will favor that candidate. In contrast, the greater the per-
ceived net economic cost imposed on the voter by the positions of a candidate, the less in-
clined the voter will be to support the candidate. Other things equal, voters will tend to
support those candidates whom they believe will provide them the most government ser-
vices and transfer benefits, net of personal costs.
How well will voters be informed about political issues and candidates? When deci-
sions are made collectively, the choices of a single person will not be decisive. The proba-
bility that an individual vote will decide a city, state, or national election is virtually zero.
Realizing that their votes will not affect the outcome, individual voters have little incen-
tive to spend much effort seeking the information needed to cast an informed ballot. Econ-
omists refer to this lack of incentive as the rational ignorance effect.
As the result of the rational ignorance effect, most voters simply rely on information
supplied to them freely by candidates (via political advertising) and the mass media, as
well as conversations with friends and coworkers. Surveys, in fact, indicate that huge num-
bers of voters are unable to even identify their own congressional representatives, much
less know where they stand on issues like Social Security reform, tariffs, and agricultural
price supports. Given that voters gain little from casting a more informed vote, their mea-
ger knowledge of political candidates and issues is not surprising.
On the other hand, when people can put information to good use, they will put forth
the effort to acquire it. Consider the incentive of an automobile purchaser to make a well-
informed choice. The model, the dealer, and the financial terms are a matter of personal
preference. If a bad choice is made, the individual consumer will bear the consequences.
As a result, auto consumers have a strong incentive to make informed decisions. Thus,
they often take different models for test drives, review consumer publications, and consult
with various car experts about them. On the other hand, the voter gains little or nothing in
terms of a changed result from a more informed political choice. Because the person is not
in a position to decide the outcome of an election, if he or she makes a mistake by casting
an uninformed ballot, it won’t make much difference. Thus, it is actually reasonable to
expect people to be far better informed when choosing a car than a senate, congressional,
or other political candidate.
The fact that citizens realize their individual votes will not sway the outcome of an
election also explains why so many of them don’t vote. Even in a presidential election,
Rational ignorance effect
Because it is highly unlikely
that an individual vote will
decide the outcome of an
election, a rational individual
has little or no incentive to
search for and acquire the
information needed to cast
an informed vote.
Political Decision-Making: An Overview 133
only about half of all voting-age Americans take the time to register and vote. The turnout
for state and local elections is generally still lower. Given the low probability that one’s
vote will be decisive, low voter turn-out is an expected result.
Incentives Confronted by the Politician
What motivates political candidates and officeholders? Economics indicates that the pur-
suit of votes will primarily shape politicians’ actions and political positions. No doubt,
many of them genuinely care about the “public interest” and the quality of government,
but they need to get elected to achieve their objectives, whatever they might be. To be suc-
cessful, a candidate’s positive attributes must be brought to the attention of rationally ig-
norant voters focused on their families, jobs, various civic activities, and local sports
teams (which are probably more entertaining). The successful candidate needs an expert
staff, sophisticated polling techniques to uncover popular issues and positions, and high-
quality advertising to favorably shape his or her image. This, of course, will be costly. It is
not unusual for an incumbent candidate to the U.S. Senate to spend more than $15 million
or more to get reelected. In other words, votes are the ultimate objective of politicians, but
money helps them get those votes. Predictably, the pursuit of campaign contributions
therefore shapes the actions of politicians, too.
Are we implying that politicians are selfish, caring only for their pocketbooks and re-
election chances? The answer is “No.” Factors other than personal political gain, narrowly
defined, may well influence their actions. Sometimes an elected official may feel so
strongly about an issue that he or she will knowingly take a position that is politically un-
popular and damaging to his or her future electoral prospects. None of this is inconsistent
with the economic view of the political process we just described. Over time, however, the
politicians most likely to remain in office are the ones who focus on how their actions will
influence their reelection prospects. Just as profits are the lifeblood of the market entre-
preneur, votes are the lifeblood of the politician.
Politicians face competition for elected office from other candidates. Just like mar-
ket suppliers, political suppliers have an incentive to find ways to gain an advantage
over their competitors. Catering to the views of voters and contributors is one way of
doing that. Enacting rules that put potential challengers at a disadvantage is another.
When geographic political districts are redrawn, for example, politicians frequently
manipulate the process to increase their chances of reelection—a process known as
“gerrymandering.” Incumbents can also attempt to use government resources for their
reelection campaigns, an advantage challengers do not have. Campaign finance
“reforms” that make it more difficult for a challenger to raise funds may also provide
incumbents with an additional advantage.
Incentives Confronted by the Government Bureaucrat
Like other people, bureaucrats who staff government agencies have narrowly focused
interests.4 They usually want to see their own agency’s goals furthered. Many bureaucrats
believe strongly in what they are trying to do. Furthering these goals, however, usually
requires larger budgets. In turn, larger budgets lead to more prestige and career opportuni-
ties for the bureaucrats. Economic analysis suggests there is a strong tendency for gov-
ernment bureaucrats and employees to want to expand their budgets to sizes well beyond
what is economically efficient.
Legislative bodies are in charge of overseeing these bureaus, but the individual legis-
lators themselves are generally not very knowledgeable about the true costs of running
these agencies. This makes it even more likely that bureaucrats will be able to get funding
beyond what’s economically efficient.
4The economic analysis of bureaucracy was pioneered by William Niskanen. Reprints of some of his classic articles along with
recent updated material can be found in William A. Niskanen, Jr., Bureaucracy and Public Economics (Aldershot, U.K.: Edward
Elgar Publishing, 1994).
134 C H A P T E R 6 The Economics of Collective Decision-Making134 C H A P T E R 6 The Economics of Collective Decision-Making134 C H A P T E R 6 The Economics of Collective Decision-Making
The political process, which begins with voter-driven elections and proceeds to leg-
islative decisions and bureaucratic actions, brings about results that please some vote
rs
and displease others. The goals of the three major categories of participants—voters,
politicians, and bureaucrats—frequently conflict with one another. Each group wants more
of the government’s limited supply of resources. Coalitions form and the members of each
coalition hope to enhance their ability to get the government to do what they want. Some-
times this results in productive activities on the part of the government, and sometime it
does not.
WHEN THE POLITICAL PROCESS WORKS WELL
Under what conditions are voting and representative government most likely to result in
productive actions? People have a tendency to believe that support by a majority makes a
political action productive. However, if a government project is truly productive, it will al-
ways be possible to find a way to allocate the cost so that all voters gain. This would mean
that, even if voting rules required unanimity or near-unanimity, all truly productive gov-
ernment projects would pass if the costs were allocated in the right manner. Exhibit 4
helps illustrate this point. Column 1 presents hypothetical data on the distribution of bene-
fits from a government road construction project. These benefits sum to $40, which
exceeds the $25 cost of the road, so the project is productive. But if the project’s $25 cost
were allocated equally among the voters (plan A), Adams and Chan gain substantially, but
Green, Lee, and Diaz lose. If the fate of the project is decided by majority vote, the project
will be defeated by the “no” votes of Green, Lee, and Diaz. The reason ??? this productive
government project fails to obtain a majority vote, however, is because of the way that the
costs have been allocated.
Just as the general does not
want his Camp Swampy Bud-
get cut, most heads of agen-
cies want expanded budgets
to help them do more and do
it more comfortably.
VOTER
Adams
Chan
Green
Lee
Diaz
Total
TAX PAYMENT
BENEFITS
RECEIVED
(1)
$20
12
4
2
2
$40
PLAN A
(2)
$5
5
5
5
5
$25
PLAN B
(3)
$12.50
7.50
2.50
1.25
1.25
$25.00
When taxes are levied in proportion to benefits received (tax plan B), any efficient project can pass unanimously (and any
inefficient project will fail unanimously). When taxes are not levied in accordance with benefits received (tax plan A), efficient
projects can fail to win a majority vote (or inefficient projects can pass in a majority vote).
EXHIBIT 4
The Benefits Derived
by Voters from a
Hypothetical Road
Construction Project
BEETLE BAILEY BY MORT WALKER. REPRINTED BY SPECIAL PERMISSION OF KING FEATURES SYNDICATE.
When the Political Process Works Well 135
Because the project is indeed productive, there is an alternate way to allocate its costs
so that Adams, Chan, Green, Lee, and Diaz all benefit. This can be accomplished by allo-
cating the cost of the project among voters in proportion to the benefits that they receive
(plan B). Under this arrangement, Adams would pay half ($12.50) of the $25 cost, since
he receives half ($20) of the total benefits ($40). The other voters would all pay in propor-
tion to the benefits they receive. Under this plan, all voters would gain from the proposal.
Even though the proposal could not secure a majority when the costs were allocated
equally among voters, it will be favored by all five voters when they are taxed in propor-
tion to the benefits they receive (plan B).
This simple illustration highlights an extremely important point about voting and
the efficiency of government action. When voters pay in proportion to benefits received,
all voters will gain if the government action is productive, and all will lose if it is
unproductive.5 When the benefits and costs derived by individual voters are closely re-
lated, the voting process will enact efficient projects while rejecting inefficient ones.
When voters pay in proportion to the benefits they receive, there will tend to be harmony
between good politics and sound economics.
How might the cost of a government service be linked to the benefits received?
User charges, which require people who use a service more to pay a larger share of the cost,
provide one way. User charges are most likely to be levied at the local level. Local services
such as electricity, water, and garbage collection are generally financed with user charges.
Sometimes the intensity of the use of a service and the amount paid for it can be linked by
specifying that the revenue from a specific tax be used for a designated purpose. For exam-
ple, most states finance road construction and maintenance with the revenue collected from
taxes on gasoline and other motor fuels. The more an individual drives, the more he or she
benefits from the roads—and the more he or she pays.
Exhibit 5 provides a useful way to look at the possible linkage between the benefits
and costs of government programs. The benefits from a government action may be either
widespread among the general public or concentrated among a small subgroup (for exam-
ple, farmers, students, business interests, senior citizens, or members of a labor union).
Similarly, the costs may be either widespread or highly concentrated among voters. Thus,
as the exhibit shows, there are four possible patterns of voter benefits and costs: (1) wide-
spread benefits and widespread costs, (2) concentrated benefits and widespread costs, (3)
concentrated benefits and concentrated costs, and (4) widespread benefits and concen-
trated costs.
When both the benefits and costs are widespread among voters (type 1 issue), essen-
tially everyone benefits and everyone pays. Although the costs of type 1 measures may not
be precisely proportional to the benefits individuals receive, there will be a rough relation-
ship. When type 1 measures are productive, almost everyone gains more than they pay.
There will be little opposition, and political representatives have a strong incentive to sup-
port such proposals. In contrast, when type 1 proposals generate costs in excess of bene-
fits, almost everyone loses, and representatives will face pressure to oppose such issues.
Thus, for type 1 projects, the political process works pretty well. Productive projects will
tend to be accepted and unproductive ones rejected.
Similarly, there is reason to believe that the political process will work fairly well
for type 3 measures—those for which both benefits and costs are concentrated on one or
more small subgroups. In some cases, the concentrated beneficiaries may be the same
group of people paying for the government to provide them a service. In other cases, the
subgroup of beneficiaries may differ from the subgroup footing the bill. Even in this
case, however, when the benefits exceed the costs, the concentrated group of beneficia-
ries will have an incentive to expend more resources lobbying for the measure than
5The principle that productive projects generate the potential for political unanimity was initially articulated by Swedish econo-
mist Knut Wicksell in 1896. See Wicksell, “A New Principle of Just Taxation,” in Public Choice and Constitutional Economics,
James Gwartney and Richard Wagner (Greenwich, Ct.: JAI Press, Inc., 1988). Nobel laureate James Buchanan has stated that
Wicksell’s work provided him with the insights that led to his large role in the development of modern public-choice theory.
User charges
Payments that users (con-
sumers) are required to make
if they want to receive certain
ser vices provided by the
government.
those harmed by it will expend opposing it. Thus, when the benefits and costs are both
concentrated, there will be a tendency for productive projects to be adopted and unpro-
ductive ones to be rejected.
WHEN THE POLITICAL PROCESS WORKS POORLY
Although the political process yields reasonable results when there is a close relationship
between the receipt of benefits and the payment of costs (type 1 and type 3 projects), the
harmony between good politics and sound economics breaks down when there is not (type
2 and type 4 projects). Inefficiency may also arise from other sources when governments
undertake economic activities. In this section, we consider four major reasons why the po-
litical allocation of resources will often result in inefficiency.
Special-Interest Effect
Trade restrictions that limit the import of steel and lumber from abroad; subsidies for
sports stadiums, the arts, and various agricultural products; federal spending on an indoor
rain forest in Coralville, Iowa; a tattoo-removal program in San Luis Obispo County, Cali-
fornia; the Rock and Roll Hall of Fame in Cleveland, Ohio; a golf awareness program in
St. Augustine, Florida; and therapeutic horseback riding in Apple Valley, California. These
seemingly diverse programs funded by the federal government have one thing in common:
They reflect the attractiveness of special interests to vote-seeking politicians. A special-
interest issue is one that generates substantial personal benefits for a small number of
constituents while spreading the costs widely across the bulk of citizens (type 2 projects).
Individually, a few people gain a great deal, but many others lose a small amount. In ag-
gregate, the losses may exceed the benefits.
136 C H A P T E R 6 The Economics of Collective Decision-Making136 C H A P T E R 6 The Economics of Collective Decision-Making
D
is
tr
ib
u
tio
n
o
f
co
st
s
a
m
o
n
g
v
o
te
rs
Distribution of benefits among voters
1
Type
2
Type
4
Type
3
Type
Widespread
Widespread
Concentrated
Concentrated
EXHIBIT 5
Distribution of Benefits
and Costs among
Voters
Special-interest issue
An issue that generates sub-
stantial individual benefits to a
small minority while imposing
a small individual cost on
many other citizens. In total,
the net cost to the majority
might either exceed or fall
short of the net benefits to
the special-interest group.
It is useful to visualize four possible combinations for the distribution of benefits and costs among voters to consider how
the alternative distributions affect the operation of representative governments. When the distribution of benefits and costs
is both widespread among voters (1) or both concentrated among voters (3), representative government will tend to under-
take projects that are productive and reject those that are unproductive. In contrast, when the benefits are concentrated and
the costs are widespread (2), representative government is biased toward the adoption of inefficient projects. Finally, when
benefits are widespread but the costs concentrated (4), the political process may reject projects that are productive.
When the Political Process Works Poorly 137When the Political Process Works Poorly 137
How will a vote-seeking politician respond to special-interest issues? Since their per-
sonal stake is large, members of the interest group (and lobbyists representing their inter-
ests) will feel strongly about such issues. Many of the special-interest voters will vote for
or against candidates strictly on the basis of whether they are supportive of their positions.
In addition, interest groups are generally an attractive source of campaign resources—in-
cluding financial contributions. In contrast, most other rationally ignorant voters will ei-
ther not know or will care little about special-interest issues. Even if voters know about
some of these programs, it will be difficult for them to punish their legislators because
each politician represents a bundle of positions on many different issues. While there is
little to be gained from the support of the disorganized majority, organized interest groups
provide politicians with vocal supporters, campaign workers, and, most important, finan-
cial contributions.
As a result, politicians have a strong incentive to support legislation giving concen-
trated benefits to special-interest groups at the expense of disorganized groups (like the
bulk of taxpayers and consumers). Even if supporting such legislation is counterproduc-
tive, politicians will often still be able to gain by supporting programs favored by special
interests. For a real-world illustration of how the special-interest effect works, see Appli-
cations in Economics, “Sweet Subsidies to Sugar Growers: A Case Study of the Special
Interest Effect.”
A P P L I C AT I O N S I N E C O N O M I C S
Sweet Subsidies to Sugar Growers:
A Case Study of the Special-Interest Effect
For many years, the price of sugar in the United States has
been two or three times as high as the world price. For ex-
ample, in Februar y 2004, the domestic price of sugar was
20 cents per pound while the world price was less than 6
cents a pound. Why? Because the U.S. government se-
verely restricts the quantity of sugar impor ted. This keeps
the domestic price of sugar high. As a result, the roughly
60,000 sugar growers in the United States gain about $1.9
billion. That’s more than $30,000 per grower! Most of
these benefits are reaped by large growers with incomes
far above the national average. On the other hand, these
subsidies cost the average American household about $20
in the form of higher prices for products containing sugar.
Even more impor tant, the resources of Americans are
wasted producing a good we are ill-suited to produce and
one that could be obtained at a substantially lower cost
through trade. As a result, Americans are worse off.
Why does Congress suppor t this program year after
year? Given the sizable impact the restrictions have on the
personal wealth of sugar growers, it is per fectly sensible for
them, par ticularly the large ones, to use their wealth and
political clout to help politicians who suppor t their inter-
ests. This is precisely what they have done. During the
2000 election cycle, the sugar lobby contributed almost
$13 million to candidates and political action committees.
In contrast, it makes no sense for the average voter to in-
vestigate this issue or give it any significant weight when
deciding for whom to vote. In fact, most voters are unaware
that this program is costing them money. Here, as in sev-
eral other areas, the incentive structure provides politicians
with a strong incentive to suppor t policies favored by spe-
cial interests, solicit those par ties for political contribu-
tions, and use the funds to attract the suppor t of other
voters, most of whom know nothing about the sugar pro-
gram. Even though the sugar program is counterproductive,
it is still a political winner.
The sugar growers are not the only ones benefiting from
government programs that are economically inefficient. Tax-
payers and consumers spend approximately $20 billion an-
nually to suppor t grain, cotton, tobacco, peanut, wool, and
dair y programs, all of which have structural characteristics
similar to those of the sugar program. The political power of
special interests also explains the presence of tariffs and
quotas on steel, textiles, lumber, and many other products.
Federally funded irrigation projects, subsidized agricultural
grazing rights, subsidized business loans, numerous pork-
barrel spending projects (the list goes on and on) are all
policies rooted in the special-interest effect rather than
economic efficiency and net benefits to Americans. Al-
though each such program individually imposes only a
small drag on the economy, together they exer t a sizeable
negative impact on our income levels and living standards.
The power of special interests is further strengthened by logrolling and pork-barrel
legislation. Logrolling involves the practice of trading votes by a politician to get the nec-
essary support to pass desired legislation. Pork-barrel legislation is the term used to de-
scribe the bundling of unrelated projects benefiting many interests into a single bill. Both
logrolling and pork-barrel legislation will often make it possible for special-interest pro-
jects to gain legislative approval, even though these projects themselves are counter-
productive and individually would be unable to muster legislative approval.
Exhibit 6 provides a numeric illustration of the forces underlying logrolling and pork-
barrel legislation. Here we consider the operation of a five-member legislature considering
three projects: construction of a post office in district A, dredging of a harbor in district B,
and spending on a military base in district C. For each district, the net benefit or cost is
shown—that is the benefit to the district minus the tax cost imposed on it. The total cost of
each of the three projects exceeds the benefits (as shown by the negative number in the total
row at the bottom of the table), and therefore each is counterproductive. If the projects were
voted on separately, each would lose by a 4-to-1 vote because only one district would gain,
and the other four would lose. However, when the projects are bundled together through ei-
ther logrolling (representatives A, B, and C could agree to trade votes) or pork-barrel legisla-
tion (all three programs put on the same bill), they can all pass, despite the fact that all are
inefficient.6 When the number of districts (or projects) is large, the cost imposed on voters
harmed by the legislation will be small. Given the weak incentive for voters to acquire infor-
mation, those harmed by pork barrel and other special-interest policies are unlikely to even
be aware aof them. Thus, the incentive to support projects like these is even stronger than is
implied by the simple numeric example in Exhibit 6.
Why don’t representatives oppose measures that force their constituents to pay for
projects that benefit others? There is some incentive to do so, but the constituents of any
one elected representative can capture only a small portion of the benefits of tax savings
from improved efficiency, since the savings would be spread nationwide among all tax-
payers. We would not, for example, expect the president of a corporation to devote any of
the firm’s resources to projects not primarily benefiting its stockholders. Neither should
we expect an elected representative to devote political resources to projects like defeating
pork-barrel programs when the benefits of spending reductions and tax savings will be de-
rived mostly by constituents in other districts. Instead, each representative has a strong
incentive to work for programs that concentrate benefits among his or her own con-
stituents—especially organized interest groups that can help the representative be re-
elected. Heeding such incentives is a survival (reelection) tactic.
138 C H A P T E R 6 The Economics of Collective Decision-Making138 C H A P T E R 6 The Economics of Collective Decision-Making
Logrolling
The exchange between politi-
cians of political support on
one issue for political support
on another.
Pork-barrel legislation
A package of spending pro-
jects benefiting local areas
financed through the federal
government. The costs of the
projects typically exceed the
benefits in total, but the pro-
jects are intensely desired by
the residents of a particular
district who get the benefits
without having to pay much of
the costs.
CONSTRUCTION OF
POST OFFICE
IN A
DREDGING
HARBOR
IN B
VOTERS OF
DISTRICT a
A
B
C
D
E
Total
NET BENEFITS (1) OR COSTS (2) TO VOTERS IN DISTRICT
1$10
2$ 3
2$ 3
2$ 3
2$ 3
2$ 2
2$ 3
1$10
2$ 3
2$ 3
2$ 3
2$ 2
2$ 3
2$ 3
1$10
2$ 3
2$ 3
2$ 2
CONSTRUCTION OF
MILITARY BASE
IN C
1$4
1$4
1$4
2$9
2$9
2$6
TOTAL
aWe assume the districts are of equal size.
EXHIBIT 6
Trading Vote
and Passing
Counterproductive
Legislation
All three projects are ineffi-
cient, and would not pass
majority vote individually.
However, representa-
tives from districts A, B,
and C could trade votes
(logrolling) or put together
pork-barrel legislation that
would result in all three
projects passing.
6Logrolling and pork-barrel policies can sometimes lead to the adoption of productive measures. However, if a project is produc-
tive, there would always be a pattern of finance that would lead to its adoption even if logrolling and pork-barrel policies were
absent. Thus, the tendency for logrolling and pork-barrel policies to result in the adoption of inefficient projects is the more
significant point.
When the Political Process Works Poorly 139When the Political Process Works Poorly 139
On the other hand, when the benefits of a governmenta action are widespread and the
costs are highly concentrated (type 4 of Exhibit 5), special-interest groups—those who
stand to bear the cost—will strongly oppose and lobby against it. Most other voters will
be largely uninformed and uninterested. Once again, politicians will have an incentive to
respond to the views of the concentrated interests. A proposal to reduce or eliminate a tar-
iff (tax) on an imported good would be an example of this type of legislation. Although
many thousands of consumers would benefit from the lower prices that result, the domes-
tic firms that compete with the imported good would devote substantial resources toward
lobbying to keep the tariff in place. Projects of this type will tend to be rejected even when
they are productive, that is, when they would generate larger benefits than costs.
The bottom line is clear: Public-choice analysis indicates that majority voting and
representative democracy work poorly when concentrated interests benefit at the ex-
pense of the general public. In the case of special interest issues, there is a conflict be-
tween good politics—getting elected—and the efficient use of resources. The special-in-
terest effect helps explain the presence of numerous government programs that increase
the size of government and reduce the overall size of the economic pie. As we discuss di-
verse topics throughout this text, counterproductive political action athat has its founda-
tion in the special-interest effect will arise again and again.
Shortsightedness Effect
Because voters have a weak incentive to acquire information, current economic conditions
will have a major impact on their choices at election time. Complex issues, like reforming
Social Security or restructuring health care programs that involve future benefits and
costs, will be difficult for voters to assess. Thus, incumbent politicians will want to make
sure economic conditions look good on election day. To accomplish this, they will favor
policies that provide current benefits voters can easily identify at the expense of future
costs that are complicated and difficult to identify. Similarly, they will tend to oppose leg-
islation that involves immediate and easily identifiable costs (and higher taxes) but yield
future benefits that are complex and difficult to identify. Economists refer to this bias in-
herent in the political process as the shortsightedness effect.
As a result of the shortsightedness effect, politicians will tend to favor programs
that generate highly visible current benefits, even when the true cost of these programs
outweighs the benefits. In contrast, their incentive is weak to support efficient programs
that generate future benefits but involve current costs.
The shortsightedness effect sheds light on why legislators find debt financing so at-
tractive. Debt financing makes it possible for officeholders to provide visible benefits to
their constituents without having to levy an equivalent amount of taxes. During the last 45
years, the federal budget has been in deficit 40 times; there have been only five surpluses
(1969 and 1998–2001). The bias toward budget deficits is a predictable result; it reflects
the shortsighted nature of the political process. Similarly, the shortsightedness effect indi-
cates that vote-seeking politicians will find it attractive to promise future benefits without
levying a sufficient amount of taxes to finance them. This has been the case with both the
Social Security and Medicare programs. The unfunded liabilities of these two programs
are nearly three times the size of the official outstanding federal debt. By the time the
higher taxes (or benefit cuts) for these programs are confronted, the politicians who gained
votes from the promised benefits will be long gone.
It is worth taking a moment to consider the differences between the public and private
sectors in terms of how future benefits and costs are considered in current decisions. As
we explained in Chapter 2, private property rights provide a means by which the value of
future benefits can be immediately captured (or costs borne) by a property owner. Owners
who do not invest now to properly maintain their homes or cars, for example, will bear the
consequences of the reduced value of those assets. Correspondingly, the value of a firm’s
stock will immediately rise (or fall), depending on the shareholders’ perception of the ex-
pected future benefits and costs of an action taken by the company’s executives today. In
contrast, the public sector tends to place more weight on current benefits and costs and
Shortsightedness effect
The misallocation of resources
that results because public-
sector action is biased (1) in
favor of proposals yielding
clearly defined current
benefits in exchange for diffi-
cult-to-identify future costs and
(2) against proposals with
clearly identifiable current
costs that yield less concrete
and less obvious future
benefits.
less weight on the future. In areas where the primary benefits are in the future, and prop-
erty rights can be well defined and enforced, there is good reason to believe that the pri-
vate sector will do a better job than the government sector.
Rent-Seeking
There are two ways individuals can acquire wealth: production and plunder. When indi-
viduals produce goods or services and exchange them for income, they not only enrich
themselves but they also enhance the wealth of the society. Sometimes the rules—or lack
of rule enforcement—also allow people to get ahead by taking, or plundering, what others
have produced. This method not only fails to generate additional income—the gain of one
is a loss to another—but it also consumes resources and thereby reduces the wealth of the
society.
Rent-seeking is the term economists use when they refer to actions taken by individ-
uals and groups seeking to use the political process to take the wealth of others.8 Perhaps
“favor-seeking” would be a more descriptive term for this type of activity, which gener-
ally involves “investing” resources in lobbying and other activities designed to gain favors
from the government. The incentive for individuals to spend time and effort in rent-
seeking will be determined by how rewarding it is. Rent-seeking will be unattractive when
constitutional constraints prevent politicians from taking the property of some and trans-
ferring it to others (or forcing some to pay for things desired by others).
When a government fails to allocate the costs of public-sector projects to the primary
beneficiaries (through user fees, for example), or when it becomes heavily involved in
transfer activities, people will spend more time organizing and lobbying politicians and
less time producing goods and services. Resources that would otherwise be used to create
wealth and generate income are wasted as people fight over slices of the economic pie—a
pie that is smaller than it could be if they were engaged in productive activities instead.
When the government grants favors to some people at the expense of others (instead of
simply acting as a neutral force protecting property rights and enforcing contracts),
counterproductive activities will expand while productive activities will shrink. As a re-
sult, the overall income level will fall short of its potential.
There is ample evidence that rent-seeking consumes a substantial amount of re-
sources. Washington D.C. is full of organizations seeking subsidies and other favors from
the federal government. More than 3,000 trade associations have offices in Washington,
and they employ nearly 100,000 people seeking to alter the actions of Congress. Of
course, business and labor organizations are well represented, but so, too, are agricultural
interests, health-care providers, trial lawyers, senior citizens, export industries, and many
others.
140 C H A P T E R 6 The Economics of Collective Decision-Making
When buying and selling
are controlled by legisla-
tion, the first things
bought and sold are
legislators.
—P. J. O’Rourke7
Rent-seeking
Actions by individuals and
groups designed to restruc-
ture public policy in a manner
that will either directly or indi-
rectly redistribute more in-
come to themselves or the
projects they promote.
7Quoted in P. J. O’Rourke, Insight Magazine, Jan. 15–25: 35.
8See the classic work of Charles K. Rowley, Robert D. Tollison, and Gordon Tullock, The Political Economy of Rent-Seeking
(Boston: Kluwer Academic Publishers, 1988), for additional details on rent-seeking.
To get elected (or reelected),
politicians have a strong in-
centive to provide transfers to
important interest groups to
secure their support.
F
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When the Political Process Works Poorly 141
As we noted earlier, income transfers have grown substantially during the last several
decades. The government now taxes approximately one out of every seven dollars citizens
earn, and transfers it to someone else. Rent-seeking is the political “fuel” for most of these
transfer activities. Interestingly, means-tested transfers, those directed toward the poor,
constitute only about one-sixths of all transfers. No income test is applied to the other five-
sixths of income transfers. These transfers are generally directed toward groups that are
either well organized (like businesses and labor union interests) or easily identifiable (like
the elderly and farmers). The people receiving these transfers often have incomes well
above the average person.
Within the framework of public-choice analysis, the relatively small portion of in-
come transfers directed toward the poor is not surprising. There is little reason to believe
that transfers to the poor will be particularly attractive to vote-seeking politicians. After
all, in the United States, the poor are less likely to vote than middle- and upper-income re-
cipients. They are also less likely to be well informed on political issues and candidates.
They are not an attractive source of political contributions. Politicians often argue that
their proposed policies will help the poor, but there is little reason to believe that this will
be a high priority for most of them.
There are three major reasons why government transfer activity will reduce the size
of the economic pie. First, income redistribution weakens the link between productive
activity and reward. When taxes take a larger share of a person’s income, the reward
from hard work and productive activity is reduced. Second, as public policy redistrib-
utes a larger share of income, more resources will flow into wasteful rent-seeking activ-
ities. Resources used for lobbying and other rent-seeking activities will not be available
to increase the size of the economic pie. Third, higher taxes to finance income redistrib-
ution and an expansion in rent-seeking will induce taxpayers to focus less on income-
producing activities, and more on actions to protect their income. More accountants,
lawyers, and tax-shelter experts will be retained as people seek to limit the amount of
their income redistributed to others. Like the resources allocated to rent-seeking, re-
sources allocated to protecting one’s wealth from the reach of government will also be
unavailable for productive activity. Predictably, the incentives created by government
redistribution policies will exert a negative impact on the level of economic activity.
Inefficiency of Government Operations
Will government goods and services be produced efficiently? The pride of a job well done
is likely to motivate both public- and private-sector suppliers. However, the incentive to
reduce costs and operate efficiently differs substantially between the two. In the private
sector, there is a strong incentive to produce efficiently because lower costs mean higher
profits, and high costs mean losses and going out of business. This index of performance
(profit) is unavailable in the public sector. Missing also are signals from the capital mar-
ket. When a corporation announces a strategy or a plan that vigilant personally committed
investors believe to be faulty, the price of the corporation’s stock will drop. There is no
mechanism similar to the stock market in the public sector. Furthermore, direct competi-
tion in the form of other firms trying to woo the customers of a government agency or en-
terprise is largely absent in the public sector. As a result, bureaucrats have more freedom
to pursue their narrow goals and interests without a strong regard for the control of costs
relative to the benefits the public derives.
Bankruptcy weeds out inefficiency in the private sector, but there is no parallel mech-
anism to eliminate inefficiency in the public sector. In fact, failure to achieve a targeted
objective (for example, a lower crime rate or improvement in student achievement scores)
is often used as an argument for increased public-sector funding. Furthermore, public-
sector managers are seldom in a position to gain personally from measures that reduce
costs. The opposite is often true, in fact. If an agency fails to spend its entire budget for a
given year, not only does it have to return the extra money, but its budget for the next year
is likely to be cut. Because of this, government agencies typically go on a spending spree
near the end of a budget period, if they discover they have failed to spend all the current
year’s funds appropriated to them.
It is important to note that
the argument of internal ineffi-
ciency is not based on the as-
sumption that employees of a
bureaucratic government are
lazy or less capable. Rather, the
emphasis is on the incentives
and opportunities that govern-
ment managers and workers
confront. Government firms do
not have owners that have risked
their wealth on the future suc-
cess of the firm. There is no en-
tity that will be able to reap sub-
stantial economic gain if the
firm produces more efficiently
or incorporates a new product or
service highly valued relative to
its costs. The operation of the
firm and the appointment of
high-level managers might be
influenced by political rather
than economic considerations.
Because the profitability criteria are absent, performance is difficult to evaluate. There are
no tests to define economic inefficiency or measure it accurately—much less eliminate it.
These perverse incentives are bound to affect efficiency.
The empirical evidence is consistent with this view. Economies dominated by gov-
ernment control, like those of the former Soviet bloc, India, Syria, and Nigeria (and many
other African countries) have performed poorly. The level of output per unit of resource
input in countries with numerous government enterprises is low. Similarly, when private
firms are compared with government agencies providing the same goods or services (like
garbage collection, hospitals, electric and water utilities, weather forecasting, and public
transportation), studies indicate that private firms generally provide the services more
economically.
ECONOMIC ORGANIZATION: WHO PRODUCES, WHO PAYS,
AND WHY IT MATTERS
The structure of production and consumption will influence economic outcomes. Goods
and services can either be produced by private enterprises or supplied by the government.
They can be paid for either by the consumer directly or by the taxpayer or some other third
party. As Exhibit 7 shows, there are four possible combinations of production and con-
sumption. Let’s take a closer look at each and consider its impact on the allocation of re-
sources and the incentive to economize.
In quadrant 1, goods are produced by private firms and purchased by consumers with
their own money. Clearly, consumers will have a strong incentive to economize in this
case. They will compare value with cost, and will make purchases only when they value
items more than their purchase price. Correspondingly, the owners of private enterprises
have a strong incentive to both cater to the views of consumers and supply goods effi-
ciently. Net revenues can be increased if the output can be produced at a lower cost. Pro-
ducers will continue supplying goods only if consumers are willing to pay an amount
sufficient to cover their production costs. Essentially, the supply and demand analysis of
Chapter 3 focused on quadrant 1 cases.
Quadrant 2 represents the case in which goods are produced privately but are paid for
by the taxpayer or some other third party. Providing health care to citizens financed pri-
marily by government (Medicare and Medicaid) or insurance is an example. If someone
142 C H A P T E R 6 The Economics of Collective Decision-Making
Just as the boy considers the
quarter (his quarter) more im-
portant than the far greater
cost (to the father) of the
metal detector, so, too, does
the leader of a bureau often
consider the bureau’s goals
more important than the
costs, even if the latter are
far greater.
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Economic Organization: Who Produces, Who Pays, and Why It Matters 143
G
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is
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ro
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ce
d
b
y:
Good is paid for by:
(1)
Examples: apples,�
oranges, television�
sets, food, housing,�
most other goods
Examples: health-�
care, food pur-�
chased with food �
stamps
(2)
(3)
Examples: Post�
Office, water and�
electricity in many�
cities, toll roads, �
many hospitals
Examples: public�
schools, streets�
and roads,�
national defense,�
law enforcement
(4)
Private�
Enterprises
Consumer-�
Purchaser
Government�
Enterprises�
or contracting
Taxpayer or other�
Third party
EXHIBIT 7
The Private and
Government Sector
Matrix of Production
and Payment
The incentive to economize
is influenced by who pro-
duces a good and who
pays for it. Economizing
behavior will be strongest
when consumers purchase
goods produced by private
firms (quadrant 1). The in-
centive to economize is re-
duced when payment is
made by a third party and
when production is han-
dled by the government.
else is paying the bill, consumers have little incentive to care much about the price of their
health-care services. Instead of economizing, many consumers will simply purchase from
suppliers they believe offer the highest quality, regardless of the price. The behavior of
producers will also be affected. If consumers are largely insensitive to prices, producers
have little reason to control costs and offer services at attractive prices. This can dramati-
cally affect economic efficiency.
Quadrant 3 represents the situation in which consumers pay for a good or service, but
production is handled by the government. First-class mail delivery via the U.S. Postal Ser-
vice, water and electricity by municipal governments, and the operation of toll roads are
examples that fall into this category. When consumers pay for a good or service directly,
they will economize and seek the most value per dollar they spend. This will be true
whether their purchases are from private or government enterprises. As we just discussed,
however, there is reason to believe that government-operated firms will generally be less
efficient than private enterprises. Cost consciousness is also likely to be reduced if the
government firm is a monopolist—if it is protected from competition with potential pri-
vate rivals. Competition, however, is difficult to maintain in some markets. When this is
the case, government enterprises may offer a reasonable alternative. As we proceed, we
will investigate this issue in more detail.
Quadrant 4 represents the case in which the government both provides the service
and covers its costs through taxation. In this case, the political process determines what
will be produced, how it will be produced, and how it will be allocated among the gen-
eral public. Under these circumstances, consumers are in a very weak position to either
discipline the suppliers or alter their production. The incentive to produce efficiently is
weak, and there is likely to be a disconnect between the goods produced and the prefer-
ences of consumers. As we discussed in the previous chapter, the nature of public
goods—items such as national defense—makes it difficult, if not impossible, to supply
them through markets. In these cases, there may be little alternative to having the gov-
ernment provide them. In other instances, however, there are feasible alternatives. This
is true for education.
Most goods and services in the United States are allocated under conditions approxi-
mating those of quadrant 1. Thus, most of our analysis focuses on this case. However, a
sizable portion of economic activity takes place under conditions present in quadrants 2,
3, and 4, where the incentive structure often creates problems. As a result, our analysis
also considers modifications that might improve the efficiency of activities currently un-
dertaken in these quadrants.
THE ECONOMIC WAY OF THINKING ABOUT GOVERNMENT
Given its monopoly power over the legitimate use of force, people have a tendency to be-
lieve that the government, particularly a democratic representative government, can solve
all types of problems. Further, if things do not go well, people tend to think that it is be-
cause the “wrong” people won the last election. Public-choice analysis suggests that the
problem is more fundamental: there is sometimes a conflict between winning elections
and following sound policies. For some types of activities, there is reason to believe that
the political action that will help get one elected will, at the same time, reduce income lev-
els and living standards.
Both the market and the political process have shortcomings. In Chapter 5, we fo-
cused on the shortcomings of the market and explained why markets sometimes result in
the in efficient use of resources. This chapter provides a parallel analysis for the political
process. The accompanying Thumbnail Sketch lists the major deficiencies of both sectors.
Understanding the strengths and weaknesses of both sectors is important if we are go-
ing to improve our current economic institutions. As we have stressed throughout this text-
book, when the government protects property rights, enforces contracts, and provides a
stable monetary environment, economic prosperity is more likely to ensue. The basic
problem, however, is how a society can obtain the benefits of the protective functions of
government and at the same time constrain it to those activities where it is a productive
force. As the analysis of this chapter illustrates, this is not an easy task.
Could Constitutional Changes Help Promote Prosperity?
When we think about how to get the most out of our government, it is important to distin-
guish between ordinary politics and constitutional rules. Constitutions establish the proce-
dures utilized to make political decisions. Constitutions can also limit the activities of
government.
The framers of the U.S. Constitution were aware that even a democratic government
might undertake counterproductive actions. Thus, they incorporated restraints on the eco-
nomic role of government. They enumerated the permissible tax and spending powers of
the central government (Article I, Section 8) and allocated all other powers to the states
and the people (Tenth Amendment). They also prohibited states from adopting legislation
“impairing the obligation of contracts” (Article I, Section 10). Furthermore, the Fifth
Amendment specifies that private property shall not be “taken for public use without just
compensation.” Over time, however, these restraints have been significantly eroded, due
in part to Supreme Court decisions that have effectively reinterpreted the Constitution. To-
day, it is difficult to think of an economic activity that is beyond the reach of majority rule
or normal legislative procedure.
Public-choice analysis highlights the importance of constitutional rules and proce-
dures capable of restraining government activities to those areas in which it will promote
144 C H A P T E R 6 The Economics of Collective Decision-Making
What Weakens the Case for Market-Sector Allocation
versus Public-Sector Intervention, and Vice Versa?
These factors weaken the case for market-sector allocation:
1. Lack of competition
2. Externalities
3. Public goods
4. Poor information
These factors weaken the case for public-sector intervention:
1. The special-interest effect
2. The shortsightedness effect
3. Rent-seeking
4. Weak incentives for operational efficiency
T H U M B N A I L S K E T C H
Key Points 145
prosperity. If left alone, even democratic governments will tend to cater to special-interest
groups and draw significant resources into rent-seeking. If we can figure out how to
constrain the activities of government to those areas in which it is most likely to be pro-
ductive, higher income levels can be achieved. The challenge before us is to develop con-
stitutional rules and political institutions more consistent with economic efficiency and
prosperity. The theory of public choice and its applications can help us do that. Needless
to say, this topic is one of the most exciting and potentially fruitful areas of research in
economics.
Cases involving potential government intervention will be discussed repeatedly throughout
this book. The tools presented in this chapter and the previous one will help us better un-
derstand both the potential and limitations of public policy as a source for economic
progress.
L O O K I N G A H E A D
K E Y P O I N T S
▼ In recent years, government spending has been about
one-third the size of the U.S. economy.
▼ There are both similarities and differences between
markets and governments. Competition is present in
both sectors. The government can use its taxing
power to break the link between payment and receipt
of a good for an individual, but not for the economy
as a whole. In the public sector, voters face a “bun-
dle” purchase problem; they are unable to vote for
some policies favored by one candidate and other
policies favored by the candidate’s opponent. Power
and income are distributed differently in the public
sector than in the private sector.
▼ In a representative democracy, government is con-
trolled by voters who elect politicians to set policy
and hire bureaucrats to run government agencies.
The incentives faced by all three classes of partici-
pants influence political outcomes.
▼ Voters have a strong incentive to support the candi-
date who offers them the greatest gain relative to
their personal costs. Because collective decisions
break the link between the choice of the individual
and the outcome of the issue, voters are likely to be
poorly informed on political matters.
▼ Politicians have a strong incentive to follow a strat-
egy that will enhance their chances of getting
elected (and reelected). Political competition more
or less forces them to focus on how their actions in-
fluence their support among voters and potential
contributors.
▼ The distribution of the benefits and costs among
voters influences how the political process works.
When voters pay in proportion to the benefits they
receive from a public-sector project, productive
projects tend to be approved and counterproductive
ones rejected. When the costs of a policy are dis-
tributed among voters differently than are the bene-
fits, democratic decision-making will tend to be
less efficient.
▼ Government actions will often lead to economic in-
efficiency as the result of (1) the special-interest ef-
fect, (2) the shortsightedness effect, (3) rent-seeking,
and (4) weak incentives to keep cost low within gov-
ernment enterprises and agencies. Thus, just as the
market sometimes fails to allocate goods efficiently,
so, too, will the government.
▼ Economic organization influences efficiency. The in-
centive to economize is strong when consumers use
their own money to purchase goods and services
from private firms. Both the payment by a third party
and production by the government weaken the incen-
tive to economize.
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146 C H A P T E R 6 The Economics of Collective Decision-Making146 C H A P T E R 6 The Economics of Collective Decision-Making146 C H A P T E R 6 The Economics of Collective Decision-Making
1. Are voters likely to be well informed on issues and
the positions of candidates? Why or why not?
*2. “The government can afford to take a long view
when it needs to, while a private firm has a short-
term outlook. Corporate officers, for example, typi-
cally care about the next three to six months, not the
next 50 to 100 years. Government, not private firms,
should own things like forests, that take decades to
develop.” Evaluate this view.
3. “If there are problems with markets, government
will generally be able to intervene and correct the
situation.” Is this statement true or false? Explain
your response.
*4. “The political process sometimes leads to economic
inefficiency because we elect the wrong people to
political office. If the right people were elected, a
democracy governed by majority rule would allo-
cate resources efficiently.” Evaluate this statement.
5. What is rent-seeking? When is it likely to be wide-
spread? How does it influence economic efficiency?
Explain.
*6. “The average person is more likely to make an in-
formed choice when he or she purchases a personal
computer than when he or she votes for a congres-
sional candidate.” Evaluate this statement.
7. “Government action is based on majority rule,
whereas market action is based on mutual consent.
The market allows for proportional representation of
minorities, but minorities must yield to the views of
the majority when activities are undertaken through
government.” In your own words, explain the mean-
ing of this statement. Is the statement true? Why or
why not?
*8. “Voters should simply ignore political candidates who
play ball with special-interest groups and vote instead
for candidates who will represent all the people when
they are elected. Government will work far better
when this happens.” Evaluate this view.
9. If a project is efficient (if its total benefits exceed its
total costs), would it be possible to allocate the cost
of the project in a manner that would provide net
benefits to each voter? Why or why not? Explain.
Will efficient projects necessarily be favored by a
majority of voters? Explain.
*10. “When an economic function is turned over to the
government, social cooperation replaces personal self-
interest.” Is this statement true? Why or why not?
11. What is the shortsightedness effect? How does the
shortsightedness effect influence the efficiency of
public-sector action?
*12. What’s wrong with this way of thinking? “Public
policy is necessary to protect the average citizen
from the power of vested interest groups. In the ab-
sence of government intervention, regulated indus-
tries, like airlines, railroads, and trucking, will
charge excessive prices, products will be unsafe,
and the rich would oppress the poor. Government
curbs the power of special-interest groups.”
13. “Since government-operated firms do not have to
make a profit, they can usually produce at a lower
cost and charge a lower price than privately owned
enterprises.” Evaluate this view.
14. What percentage of government income transfer
payments go to the poor? Do you think that the po-
litical process in general works to the advantage of
the poor? Why or why not?
15. Why does representative democracy often tax some
people in order to provide benefits to others? When
governments become heavily involved in tax-
transfer activities, how will this involvement affect
economic efficiency?
*16. The United States imposes highly restrictive sugar
import quotas that result in a domestic price that is
generally about three times as high as the world
price. The quotas benefit sugar growers at the ex-
pense of consumers. Given that there are far more
sugar consumers than growers, why aren’t the quotas
abolished? Has government action in this area im-
proved the living standards of Americans? Why or
why not?
17. “The United States is rich because it is a political
democracy where the people decide what policies
will be followed.” Is this statement true or false?
Discuss.
18. If the power of special interests were reduced, for
example through the adoption of a supra majority
voting rule, would economic efficiency improve?
How would contributions to political campaigns be
affected? Do you think politicians are very inter-
ested in curtailing the power of special interests?
Why or why not?
*Asterisk denotes questions for which answers are given in Appendix B.
C R I T I C A L A N A L Y S I S Q U E S T I O N S?
