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MARKETS VERSUS GOVERNMENTAL ALLOCATION Normative Discussions.

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1 MARKETS VERSUS GOVERNMENTAL ALLOCATION Normative Discussions

2 Historical Synopsis Our historical treatment of government and the economy should have produced the understanding that the market economy is not the only means of allocating the scarce goods and resources of society. Indeed, in order for exchange and accumulation to occur in the first place, it was necessary for government to exist and establish the parameters of exchange. Indeed, market allocation systems such as we have today were preceded by other types of systems. Allocation by Tradition Allocation by Hierarchy Combinations of Tradition and Hierarchy Fully developed market allocation systems only developed with the industrial revolution in the early 19 th century.

3 We can view the method of allocating scarce resources of a society as evolving through time. It has been a social learning process. Prior to the development of nation-states there was only the community, either clans, tribes, or other local units. Nation states evolved over time. The claim to power was often religious. Prior to the 18 th century the only large organizations were the church and the state. The church and the state discouraged the development of large organizations that would compete for power. Power centers in Europe and elsewhere continued to discourage the development of large organizations that would compete for power. However, a weak national government in the U.S. was unable or unwilling to discourage the development of large organizations.

4 At the beginning of the 19 th century most exchange was local and most production was agricultural. Most production was for home consumption; what little surplus there was was sold in market towns. Elites in the American colonies turned states could only grow in economic power by developing large economic organizations to support their desire to accumulate surplus and extract resources from society. They kept government weak through most of the 19 th century to enable the development of economic power, which not coincidentally resulted in economic power. By the latter part of the 19 th century the economy had become less communal and more hierarchical. There were no companies employing more than 1000 employees in Now that is the dominant mode of employment. Where in 1787 there was very little wage labor, in 2009 virtually everyone works in wage labor.

5 What has been dubbed by sociologists as “wage slavery” has evolved. In the 18 th and 19 th centuries the idea of selling one’s labor was viewed as a detestable practice. The ideas of freedom and liberty meant that one should work for ones self, rather than sell one’s labor to a business or elite. Obviously, now America is fully inculcated in the tradition of “wage slavery”. We do it so routinely that it is done without thinking or question. Governments have become increasingly involved in market economies to adjust anomalies resulting from the increasingly hierarchical nature of the American economy. Government has increasingly become a counter balance to market hierarchy. The modern economy is not characterized by the ideal of pure market competition depicted by Adam Smith in the Wealth of Nations. Rather, it is characterized by economic hierarchy.

6 What Hierarchies? Large economic organizations relative to workers. Large economic organizations relative to communities. Large economic organizations relative to production chains.  pricing Large economic organizations relative to small economic organizations. Large economic organizations relative to government. All participants in these hierarchies are driven by self-interest. Large and small economic organizations want higher profits. Workers want higher wages. The community wants economic stability and growth. Intervention in economic hierarchies is made possible in the U.S. by democracy and popular government. We intervene in markets for a variety of reasons to be discussed below. The overarching question facing citizens and what divides the parties is “how much intervention?”

7 Rationale for Government Intervention: Summary 1) Markets are inherently unstable. Show graph on GDP here, as well as the graphs on unemployment and inflation. Note the wild fluctuations prior to ) Markets do miserably at promoting development. Why? There is a collective action problem for individual producers. 3) Markets sometimes arrive at equilibrium solutions that are socially or politically unacceptable. Slavery, tainted drugs or food, child labor, white slave trade, pornography, discrimination, illegal drugs, etc. 4) Markets stress efficient outcomes, but efficiency is only one value that a polity is interested in achieving. In particular, other political values include fairness, accountability, participation, equity. Markets often result in the perpetuation of structural inequities among social and economic classes and groups. They can also produce what we consider unfair outcomes.

8 5) The market price of a good may not reflect the true cost or benefit to producers or consumers. Hence the market is Pareto inefficient. Said differently, someone is made worse off by selecting the particular market equilibrium. Negative exernalities imply that society pays costs intrinsic to the producer. Positive externalities imply that society pays costs intrinsic to the consumer. The Brown and Green lines reflect the price equilibrium when there is a perfectly competitive market. Producers produce unencumbered by anything other than market forces. However, their production imposes external costs on society, such as pollution, etc. Government intervenes to make the producer pay the costs to society. This produces a new equilibrium at the intersection of the Brown and Dark Brown lines. At this solution, the price is higher, while quantity supplied and demanded is lower.

9 Again, the Red and Blue lines reflect the price equilibrium when there is a perfectly competitive market. Producers produce unencumbered by anything other than market forces. However, they generally produce too little of the good to produce maximum benefits to society, such as the effects of vaccines, education, etc. Government intervenes in the market to cause more production and increase the benefits to society of more production. This produces a new equilibrium at the intersection of the blue and green lines. At this solution, the price (given to producers) is moved higher to induce more production, while quantity demanded and supplied are also generally higher.

10 6) More generally, markets tend to under-produce some goods, especially those involving collective action and free rider problems. Pure public goods and other goods having the characteristics of a) Indivisibility and b) Free Riding possibilities due to common consumption. National defense, economic development policies, security, etc. Discuss mixed goods such as highways, garbage collection, police protection, electric power.

11 7) Competition may not always be optimal where cooperation is necessary for the good of society. 8) Markets may be uncompetitive or too competitive due to demand or supply inelasticity. In other words, consumers and producers have little ability to affect prices

12 9) Other Market imperfections. The pure competition model assumes a number of other things for markets to be efficient. Markets assume: --perfect information --competition --free entry conditions --a strong relation between price and demand/supply --no restrictions on technology. Market imperfections occur for various reasons including --information asymmetries --barriers to entry --collusion in competition --other factors setting price or demand/supply such as discrimination --technological restrictions such as patents or copyrites --disparate bargaining power.

13 10) Markets may under some circumstances underemphasize issues of dynamic efficiency in preference for allocative/static, x, or technological efficiency. Hence, under investment in products that would enhance social and economic efficiency over the long term. Hence, we rely on governments to support infrastructure such as roads, canals, transportation systems, the internet, etc. Clean energy and the Obama administration? Rationale for government investment.

14 Supply and Demand Conditions for Governmental Allocation We may think of political, as opposed to market, allocation systems as having similar sorts of demand/supply conditions as markets. In political allocation systems: 1) Demand occurs at a more aggregate level than for markets. Citizens, voters, political parties, interest groups, and other aggregates do the demanding. 2) Supply also occurs at a more aggregate level than for markets. Politicians, legislators, executives, bureaucracies, government contractors, and other public organizations do the supplying. 3) Demand is not a simplistic function of price, any more than demand is simply a function of price in standard economic analyses. Rather, it is a complex function of many factors.

15 The Demand Determinants: D i =f(Y, T, P, X, M, I, G, Q, F, R) where: D i =Demand for the i th Governmental Activity Y=National Income T=Tax Rate P=Price of Governmental Product or Service X=Perceived Externalities M=Degree of Monopoly or Increasing Returns I=Perceived Market Imperfections G=Perceived Need for Pure Public Goods Q=Perceived Inequities F=Perceived Unfairness or Undesirability of Market Outcome R=Rent Seeking Behavior of Economic Entities

16 The Supply Determinants: S i =f(Y, T, P, A, E, V) where: S i =Supply of the i th governmental activity Y=National Income T=Tax Rate P=Price of Governmental Product or Service A=Accuracy of Measurement of the Product or Service E=Exclusivity of Government Production V=Variance in Input/Output Relations Associated with Product or Service Technology Given these supply and demand conditions we expect an equilibrium to develop between supply and demand for governmental production and services.

17 Rationale for Rejecting Governmental Allocation Systems 1) Market allocation systems generally provide greater freedom of choice. 2) Market allocation systems are generally more efficient than systems with government intervention or government provision. Indeed, governmental allocation systems are never Pareto efficient because of the high level of aggregation at which demand occurs. In a market allocation system each individual selects how much of a commodity to purchase. Such systems are Pareto efficient because all individual choices are satisfied. No one is made worse off by the market equilibrium. However, in democratic allocation systems, the collectivity selects how much of a commodity to purchase. Such systems are not Pareto efficient because the minority’s preferences are “violated” by the majoritarian equilibrium.

18 For example, majoritarian demand for policies such as environmental protection, consumer protection, antitrust, highway programs, etc. imply that there is still a minority who might oppose such programs. Yet those who oppose these programs pay taxes, and have their taxes going for things they do not prefer. This implies a loss of Pareto efficiency, because someone is made worse off by paying taxes for things they don’t want, i.e., the democratic equilibrium solution. More generally, taxation always implies a loss of choice and liberty over how to spend a portion of one’s income. So by definition, all governmental programs that are supported by taxation imply a loss of Pareto efficiency.

19 3) Governmental output is often difficult to measure. This is inherent to governmental allocation systems because of the nature of the problems that government is called upon to solve. The more difficult it is to measure the more difficult it is to know whether governmental action is efficient or successful. Governmental action may result in an endless quagmire. 4) Governmental technologies for product and service provision may be uncertain due to the nature of problems taken on by public actors. We may not know how to address or solve the problem. Therefore the time may not be “ripe for governmental intervention.

20 5) Movement to an equilibrium is generally “stickier” than movement to a market equilibrium. Because demand is at a more aggregate level, and because U.S. political institutions are designed for inaction, rather than action, it may take some time for preferences to percolate upward through the system to create action. Therefore, there may be substantial periods when demand is out of kilter with supply. 6) Movement away from or to a new equilibrium is also generally “stickier” than movement to a market equilibrium. Because supply is at a more aggregate level, and because U.S. political institutions are designed for inaction, rather than action, it may take some time for producers to respond to changing demand. Here we argue that government programs may be inertial. Therefore, there may be substantial periods when supply is out of kilter with demand.

21 7) Supply in a government oriented system may sometimes reflect the self-interest of providers. That is, politicians and bureaucrats may have their own motivations which may or may not coincide with those of demanders (citizens, voters, political parties, interest groups, etc.). These motivations of governmental actors may either increase or decrease supply. Over the long term the supply may not perfectly correspond with actual demand. Note that this is no different than in a market oriented system. Note that this is not an overall critique. Many bureaucrats are good people who put the self interest of their clients first. However, it can happen. 8) Governmental provision is typically through a monopoly, which may or may not be more efficient than private provision. Economies of scale versus competition effects. The alternative is privatization and contracting. Yet, there are principal-agent problems with contracting that are not present in a governmental system.

22 9) Unlike market systems where quantity supplied and cost of production are directly related to revenues and profits, there is a disjuncture between quantity supplied, costs, and revenues in governmental allocation systems. In a private system Revenue=Price*Quantity Supplied. Profits=Revenue-Costs. However, in a public system revenue is provided in a lump sum for provision of products and services. They do not depend critically on quantity supplied. This may result in static inefficiency in the various forms. While there are no profits in a public allocation system, there may be slack resources. Slack resources would be calculated Slack=Revenues-Costs. Costs are difficult to measure for some outputs. “Slack resources” may be used to promote dynamic efficiency, they may be used to return “dividends” to taxpayers, or they may be considered “waste”. In a perfectly operating governmental allocation system there are no profits, implying the potential for reduced costs and price.

23 10) Internalities sometimes develop that move bureaucracies away from original goals. Example: Goal displacement. This may be either good or bad. It may be bad to the extent that the original goals are desirable. It may be good to the extent that bureaucracies should be adaptable to changing preferences and task requirements. 11) Derived externalities occur when there are unanticipated consequences to government intervention. Derived externalities can either be negative or positive. For example, regulation of illegal drugs may lead to increased crime and black market activities. This negative consequence was not intended. Conversely, environmental regulation has led to the development of a massive industry that relates to environmental protection. This is a positive for the economy. Derived externalities may make government action more or less efficient.

24 12) Governmental action or inaction may produce inequities. Rent seeking activities often perpetuate the self interest of private actors through public means. Rent seeking refers to private actors using the apparatus of government to their own advantage. For example, some would argue that regulation creates barriers to entry and is a form of rent-seeking by regulated industries. Similarly, the granting of a license is a form of rent seeking.

25 Overview of the Arguments As a democratic polity we are sovereign over markets. Because America is a system governed by majoritarian principles, with protections for the minority, we have a right to “override” and reject the market allocation and substitute a governmental allocation. Governmental allocations are the legitimate outcome of democratic processes. However, in choosing between the market allocation and democratic allocation we should probably weigh the preceding considerations concerning the disadvantages of the market allocation versus the disadvantages of the governmental allocation. In making these calculations, we don’t have to adhere rigidly to a set of rules. Indeed, as a sovereign polity we don’t have to consider them at all. However, prudence suggests that we should.


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