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Chapter 5

11:373:121 Chapter Notes - Chapter 5: Public Choice, Political Corruption, Avoidance Speech

Environmental and Business Economics
Course Code
Professor Lipman

of 5
Chapter 5: Government’s Role and Government Failure
I.Government’s Economic Role
Government has important roles to play in the economy.
It sets laws that govern and direct economic activity.
It provides public goods and services and redistributes income.
It also assumes responsibility for promoting economic stability and growth.
Government’s Right to Coerce:
One of the major differences between the powers of government and those of private
business is that government has the right to force or coerce people to do things whereas
private businesses must rely on voluntary exchanges in its transactions.
Force and Economic Efficiency:
This power to coerce can be beneficial for economy efficiency in an economy in several
The Problem of Directing and Managing Government:
It can correct for market failures that cause misallocation of resources and occur because of
positive or negative externalities.
It can increase economic security for individuals and businesses by establishing a legal
framework that promotes productive activity and outlaws harmful practices such as bribery,
extortion, theft, deception, and discrimination.
Government faces a number of challenges that make it complex to manage and direct.
No Invisible Hand:
Unlike the private sector, its policies are not subject to competition and are not self-
correcting when they go bad.
Massive Size and Scope:
It has a massive size and scope of activity that make programs difficult to administer
and control.
The Need for Bureaucracy:
It requires a large bureaucracy that is hierarchical, is multilayered, and has
communication problems.
The Need for Paperwork and Inflexibility:
The bureaucracy must follow rules and regulations to provide uniformity to its
activities and policies, but it creates inflexibility.
The Information Aggregation Problem:
Top officials will tend to make many inefficient choices because they do not have
enough information to sensibly compare the marginal benefits and marginal costs of
individual programs and because they are unable to comprehensively assess
opportunity costs and where to best spend funds across a variety of programs run by the
Lack of Accountability:
There is a lack of accountability in the bureaucracy because the supervising officials
change with elections and individual bureaucrats have civil service protections that
essentially give them a job for life.
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II.Government Failure
Government failure refers to those situations where the political process used to make public
decisions is inherently weak and the decisions result in an economical inefficient allocation of
Representative Democracy and the Principal-Agent Problem:
Representative democracy is subject to a principal-agent problem that occurs when there
are differences between the positions of the principals (voters) and the actions taken by
their agents (elected officials).
Once elected, political representatives may pursue their own goals and objectives to suit
their personal interests (gaining power or getting reelected) at the expense of
representing the broader interests of their constituents.
Another example of a principal-agent problem is found in the business world when the
interests of stockholders (principals) differ from the interests of corporate managers
Special-Interest Effect:
The weakness of the decision-making process in the public sector and the resulting
inefficient allocation of resources is often the result of pressures exerted on Congress
and the government bureaucracy by special interests and other groups.
Special-Interest Effect- A small number of people obtain a government program or
policy giving them large gains at the expense of a large number of people who
individually suffer small losses.
This effect is also present in pork-barrel politics, where a government program will
mostly benefit one constituency.
An example of pork-barrel politics is earmarks, which are specific authorizations
for government expenditures to benefit a group or organization in the legislators
Rent-Seeking Behavior:
Rent-Seeking Behavior- Reflected in appeals to government for special benefits or
treatment at the tax payers’ or someone else’s expense.
Government can dispense such rents through laws, rules, hiring, and purchases.
Businesses, labor unions, professional associations and other groups lobby for
government legislation, or policies that give them extra profit, income, or benefits.
Clear Benefits, Hidden Costs:
Those seeking election to public office frequently favor programs whose benefits are clear
and immediate and whose costs are uncertain and deferred, even when the benefits are less
than the costs.
Conversely, they frequently oppose programs whose costs are clear and immediate and
whose benefits are uncertain and deferred, even when the benefits are greater than the
Unfunded Liabilities:
Unfunded Liability- Establishment of a program that will require future expenditures but
does not at the same time allocate tax revenues to pay for the future costs.
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Social Security and Medicare are examples.
Chronic Budget Deficits:
Budget Deficit- Result of government spending more in a year than it receives in tax
When these budget deficits occur year after year, they become chronic.
Chronic Budget Deficits- Contribute to economic inefficiency because government
controls a larger proportion of the nation’s resources.
In the extreme, chronic budget deficits also can lead to a debt crisis, which is a situation
where government finds it difficult or impossible to borrow money because investors fear
they will not be paid back.
Misdirection of Stabilization Policy:
Politicization of Fiscal and Monetary Policy:
Fiscal Policy- Taxation and spending actions.
Monetary Policy- Changes in interest rates.
These policies are used to stabilize or regulate the economy and smooth out swings in
the business cycle, but in practice such policies can be subject to political influence and
special-interest lobbying that can weaken their intended stabilization effects.
Limited and Bundled Choice:
There are limited and bundled choices in political decisions.
When citizens must vote for candidates who represent different but complete programs, the
voters are unable to select those parts of a program that they favor and reject the other parts
of the program.
Bureaucracy and Inefficiency:
It is argued that the public sector is inefficient because those employed there are offered no
incentive to be efficient.
There is no way to measure efficiency in the public sector.
Government bureaucrats can join with the special-interest groups to block budget cuts or
lobby for increased funding.
Inefficient Regulation and Intervention:
Regulatory Capture:
Regulatory Capture- Result of government agency that is responsible for regulating
(for economic outcomes) an economic activity being influenced in its work by an
industry or group that it is supposed to be regulating.
The industry or group influences the government agency in their favor.
A potential solution to regulatory action is deregulation.
Deregulation- An action taken by government to end its regulation and encourage
more competition within an industry.
Government’s Poor Investment Track Record:
Government has a poor track record when it comes to intervening in the economy by
investing in businesses or making loans to them.
Many of the businesses are inefficient and would not survive in the competitive
marketplace without government support.
Loan Guarantees:
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