Week 11 - Incentives: Markets vs. Government
Day 1 - Getting Started
- According to Thomas Jefferson, “A wise and frugal government, [is one] which shall restrain men from injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvements, and shall not take from the mouth of labor the bread it has earned.” What characterizes a "wise and frugal" government?
- enforce justice (stable rule of law), don't impose a bunch of other laws (don't get involved in something you aren't supposed to), don't impose a bunch of taxes.
- Would people be better off if voting was more widely used to determine what goods should be produced and consumed? Why, or why not?
- no. because if the majority wanted manly perfumes, where does that leave the women? How about lettuce? what if the majority wants romaine? how about the spring mix type of people? where does that leave them?
Day 2 - The Functions of "A Wise and Frugal Government"
Protecting Rights and Providing Public Goods
- 1. What is economic efficiency?
- getting the most value from available resources.
- 2. Public choice is a term that in the last 50 years has become an integral part of economics. To what area of study does the term "public choice" refer?
- Government expenditures?
- 3. In what two ways can government promote social cooperation and enhance its citizens’ economic welfare?
- protecting the rights of individuals and supplying a few goods that are difficult to provide through markets.
- 4. What is the result of government performing its protective function well? Explain why.
- creates and maintains an infrastructure in which people can interact cooperatively and harmoniously. It lowers transaction costs and incentivizes developing resources.
- 5. Why is the provision of a stable monetary and price environment one of the most important productive functions of government?
- people invest in more, cooperate more fully, and achieve higher income levels
- 6. Why are government projects financed through taxes or through borrowing, difficult to measure in both their costs and their benefits?
- buyers and suppliers cannot provide assurance.
Day 3 - Market Failure
Monopoly, Public Goods, and Externalities
- 7. When does a monopoly exist?
- When "there is a firm that is the only producer of a good or service for which there are no good substitutes" (114), a monopoly exists.
- 8. What are two major sources of monopolies and when do they occur?
- The "two major sources of monopoly" (114) are "economies of scale and grants of privilege" (114). The former occurs "when large firms have lower per-unit costs than their smaller rivals" (114). The latter occurs when the government get involved in the economy through licensing, "taxes that favor one group over another, tariffs, quotas, and other grants of privilege that reduce the competitiveness of markets" (115).
- 9. What should the government do to ensure markets are, and remain, competitive?
- In order to ensure that markets are, and remain, competitive, the government should do two things, the first one being "borrowed from the medical profession: Do no harm. The government should refrain from making things worse through licensing requirements and discriminatory taxes" (115). The second is that the government should "prohibit anticompetitive actions such as collusion, the merger of dominant firms in an industry, and interlocking ownership of firms" (115-116).
- 10. What are two distinguishing characteristics of “public goods” provided by the “productive” function of government?
- The two distinguishing characteristics of "public goods" provided by the "productive" function of government are "(1) jointness in consumption---provision of the good to one party simultaneously makes it available to others; and (2) nonexcludability---it is difficult or virtually impossible to exclude nonpaying customers" (117).
- 11. What are some examples of “public goods” and why are they difficult for markets to provide?
- Examples of "public goods" include "flood control, national defense, municipal police protection, and mosquito abatement" (117). These goods are difficult for markets to provide because they possess the two distinguishing characteristics listed in the answer above; thus, consumers "will have an incentive to become "free riders"---to consume the good even though they do not help to pay for it. And when a large number of people become free riders, the good may not be produced (or too little of it may be produced) even when the value derived from its consumption exceeds the cost. In such cases, markets will often fail to produce a quantity of public goods consistent with economic efficiency" (117). Since "these goods are difficult to supply through markets, they are often provided by the government" (117).
- 12. Are all goods provided by the government public goods? Why, or why not?
- No, not all goods provided by the government are public goods because "it is the characteristic of a good, not the sector in which it is produced, that determines whether it qualifies as a public good" (117), and many "of the goods provided by governments clearly do not have the characteristics of public goods. Medical services, education, mail delivery, trash collection, and electricity come to mind. Although these goods are often supplied by governments, nonpaying customers could be easily excluded and providing them to one party does not make them available to others" (117).
- 13. Define externalities and give an example of one you have personally experienced.
- Externalities are the spillover "effects of an activity that influence the well-being of nonconsenting external parties. If the spillover effects are positive, they are also called external benefits. If the spillover effects adversely impact external parties, they are also called external costs" (240). An example of an externality that I have personally experienced is my siblings talking loudly, singing, or playing music while I am trying to do schoolwork.
Day 4 - All About Allocation
Political vs. Market
- 14. What are four reasons market allocation leads to greater economic progress than democratic political allocation?
- The four reasons are as follows: 1. In "a democracy, the basis for government action is majority rule. In contrast, market activity is based on mutual agreement and voluntary exchange" (122). We can see that in " a democratic setting, when a majority...adopts a policy, the minority is forced to pay for its support even if they strongly disagree...The power to tax and regulate makes it possible for the majority to coerce the minority" (122-123). On the flip side, there "is no such coercive power when resources are allocated by markets. Market exchanges do not occur unless all parties agree...Indeed, private firms must provide benefits that exceed the price charged in order to attract customers" (123). 2. There "is little incentive for voters to be well-informed about either candidates or issues. An individual voter will virtually never decide the outcome of an election...Recognizing this point, most voters spend little, if any, time and energy studying issues and candidates in order to cast a well-informed vote" (123). In contrast, market "consumers individually decide how to spend their money, and if they make bad choices, they personally bear the consequences. That fact gives them the motivation to spend their money wisely. When consumers consider the purchase of [a product], they have a strong incentive to acquire information and make informed choices" (123). 3. The "political process generally imposes the same outcome on everyone, while markets allow for diverse representation. Put another way, government allocation results in a "one size fits all" outcome, while markets allow different individuals and groups to "vote" for and receive desired options...Markets provide for a system of proportional representation and this makes it possible for more people to obtain goods and services more consistent with their preferences" (123-124). Furthermore, "markets...avoid the conflicts that inevitably arise when the majority imposes its will on various minorities" (124). 4. Market "and political decision-makers face different incentives" (124). The "profit-and-loss mechanism of a market economy tends to direct resources toward productive projects and away from counterproductive ones. But, the political process does not have a similar mechanism that can be counted on to direct resources toward productive activities. This is true even when controlled through voting" (124). Rather, "when unconstrained by constitutional limits, elected officials will tend to gain votes by providing favors to some at the expense of others. To a large degree, the modern political process can be viewed as a series of "exchanges" between coalitions and politicians. Concentrated interest groups provide votes, financial contributions, high-paying jobs in the future, and other forms of support in exchange for subsidies, spending programs, and regulatory favors often financed by taxpayers" (124). On top of this, the "rational ignorance effect---the fact that voters choose not to spend the time required to be well-informed---facilitates this process because a lot can happen in the halls of Congress of which voters are unaware. As a result, resources are moved toward lobbying and other favor-seeking activities and away from production and development of better products" (124-125).
- 15. What is the “rational ignorance effect”? Explain.
- The "rational ignorance effect" is the phenomena of "voters [being] poorly informed, but their lack of information [being] rational because an individual's vote is so rarely decisive" (123). How does this work? We can see that an "individual voter will virtually never decide the outcome of an election...Recognizing this point, most voters spend little, if any, time and energy studying issues and candidates in order to case a well-informed vote. Most simply decide on the basis of information acquired as the result of their activities (watching television, interaction with friends on social media, or discussions at the office)" (123). Therefore, given "these incentives, most voters have little or no idea where candidates stand or what impact government actions (such as agricultural subsidies and trade restrictions) have on the economy. Economist refer to this as the rational ignorance effect" (123).
- 16. Considering the “rational ignorance effect,” how do decisions made by consumers in the marketplace compare to decisions made by consumers regarding how they vote?
- When consumers make decisions regarding how they vote, they tend to behave in the ways described in the above answer. In contrast, market "consumers individually decide how to spend their money, and if they make bad choices, they personally bear the consequences. That fact gives them the motivation to spend their money wisely. When consumers consider the purchase of [a product], they have a strong incentive to acquire information and make informed choices" (123).
- 17. How is government failure similar to market failure?
- In both government failure and market failure, the system in play (the government or the market) "will fail to allocate resources efficiently" (125). As in "market failure, government failure reflects the situation where there is a conflict between what is best for individual decision-makers and getting the most value out of resources" (125). In the case of government failure, this mainly comes about because "the incentives confronted by political participants encourage counterproductive rather than productive use of resources" (125).
- 18. What did the framers of the Constitution include in order to place restraints on the government’s economic role and how have these restraints eroded over time?
- The framers of the Constitution "enumerated the permissible taxing 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"" (125). Unfortunately, over time, "Supreme Court decisions [have] eroded these restraints, and government control over both individuals and businesses [has] expanded, as [has] federal control over states" (125).
Day 5 - Government and Special-Interests
Pork-Barrel Politics and Trade
- 19. What is “the special-interest effect”?
- The "special-interest effect" is the "bias of the political process toward adoption of programs that provide substantial individual benefits to well-organized interest groups at the expense of small individual costs imposed on the bulk of voters. There is a tendency for such programs to be adopted even when they are inefficient" (247).
- 20. What are “logrolling” and “pork-barrel” legislation and how are both used?
- "Logrolling" is "the practice of trading votes between politicians to get the necessary support to pass desired legislation" (127). "Pork-barrel" legislation is "the bundling of unrelated projects benefiting many interests into a single bill" (127). Both are "often [used to] make it possible for counterproductive projects benefiting concentrated interests to gain legislative approval" (127).
- 21. Explain why special interest programs can retard or create a drag on the economy.
- Politicians "are under strong pressure to support special interests, tap them for campaign funds, and use the contributions to project a positive image on television and the Internet. Politicians unwilling to play [the] game [of using] the government treasury to provide well-organized interest groups with favors in exchange for political support...are seriously disadvantaged. Given these incentives, politicians are led as if by an invisible hand to reflect the views of special-interest groups, even though this often leads to policies that, summed across all voters, waste resources and reduce our living standards" (127). This is why special interest programs can retard or create a drag on the economy.
- 22. Unlike market exchanges, which are win-win activities, "political exchange" activities can be a win-lose activity. List three examples where the business of modern politics has been used to extract resources from the general public in order to provide favors to well-organized voting blocs.
- Example 1: The "price of sugar paid by American consumers has been 50 percent to 100 percent higher than the world sugar price [for many years] because of the federal government's price support program and highly restrictive quotas limiting the import of sugar" (129). This makes sugar growers richer and sugar consumers worse off. Why does the government continue with this program? The reason is that given "the sizable impact on their personal wealth, it is perfectly sensible for sugar growers, particularly the large ones, to use their wealth and political clout to help politicians who support their interests. This is precisely what they do...In contrast, it would be irrational for the average voter to investigate this issue or give it any significant weight when deciding for whom to vote" (129). Example 2: Consumers and taxpayers "spend approximately $20 billion annually to support grain, cotton, tobacco, peanut, wool, and dairy programs, all of which have a structure similar to the sugar program. The political power of special interests also explains the presence of tariffs and quotas on steel, shoes, textiles, and many other products. Federally funded irrigation projects, banking bailouts, and subsidies to sports stadiums, sugar and ethanol producers, and airports in specific districts---the list goes on and on---are all policies politically motivated by the special-interest effect rather than the net benefits to Americans" (130). Example 3: (This example deals with extracting resources from the general public in terms of innovation and competition.) The technology that Uber uses "reduces transaction costs and the process is often faster and cheaper than traditional taxi service. [However, as] Uber has sought to enter markets in large cities throughout the world, the traditional taxi industry has fought for and often achieved legislation prohibiting the use of the technology employed by Uber and similar firms seeking to enter the market. As a result, the gains from the innovative technology and expansion in the volume of exchange have been slowed" (131).
- 23. Why would workers employed by industries that benefit from trade protections be better off living in an economy with completely free trade?
- Workers employed by industries that benefit from trade protection would be better off living in an economy with completely free trade because even "though individuals may benefit from their industry’s protection, they would lose far more as consumers from the protections of everyone else" (2).
- 24. Typically, why don’t people realize the costs that are imposed on them through trade restrictions?
- Typically, people do not realize the costs that are imposed on them through trade restrictions for several reasons: First, with "the cost of a trade restriction spread over millions of consumers, few if any will be aware of the little extra they are paying for the protected product. After all, consumers buy hundreds of different products, and a little increase in the price of one product typically has little impact on the well-being of any one of them" (2). Second, even "if a consumer is aware of the extra cost [imposed on her through trade restrictions], she will seldom know that it is caused by a trade restriction" (2). Third, if "by some chance [a consumer] does know the reason for the extra cost, she has little motivation to respond politically. Even if she could eliminate the trade restriction, the effort might cost as much as or more than the restriction. While the total benefit from eliminating the restriction is huge, most of it would go to other consumers whether they took political action or not" (2). Her "political action is unlikely to do any good if she acts alone" (2). On this third point, we also see that "if a large percentage of the consumers act in unison they would surely have a decisive political influence. But because the number of consumers is so large, with each having such a small stake in the outcome, it is almost impossible to organize them for political action. As is often the case, the larger the number of people harmed by a policy, the weaker their political influence" (3).
Politics and Foreign Trade by Dwight Lee