Introduction to Economics

ECONOMICS Markets and

Chapter 7
Government
contents

7.1 Roles Markets Play

7.2 Efficient Allocation of Resources
7.3 Roles Government Plays
7.4 Public Goods
7.5 Problems of Environment
7.6 Welfare State
 7.1 Roles Markets Play

market - one of the most important institutions that have

been ever made

market • from the viewpoint of efficiency, no other system is

economy superior to market economy system
system • but market economy system has its own limits
- no guarantee of equitable distribution
- sometimes instability in employment and price
- it could have some problem in terms of efficiency
- to make up for these limits, government may
intervene → mixed economy system
 7.1 Roles Markets Play

• problems in a mixed economy

mixed
economy – how to divide the roles between markets and
government?
– how to coordinate the roles of markets and
government?
– even though markets are not perfect, we cannot
say government should intervene
– sometimes government intervention could make
the situation worse
 7.1 Roles Markets Play

Are Markets Omnipotent?

M. Sandel, What Money Can’t Buy?
- asks whether it is desirable that the logics of the market is applied
to everything

• some examples
(1) express tickets of amusement parks
(2) substitution of military service
(3) room upgrades at prisons
 7.2 Efficient Allocation of Resources

Pareto • strictly speaking, efficiency in economics

efficiency means Pareto efficiency
- cannot make someone better-off without making others
worse-off by reallocation of resources → Pareto efficient
- suppose there are two persons(A, B) and 100kg of rice
and 20 clothes in a certain economy
- initial state of allocation : A has 70kg of rice and 5
clothes, and B has 30kg of rice and 15 clothes
- suppose A wants more clothes while B wants more rice
 7.2 Efficient Allocation of Resources

Pareto • reallocation : A gives 10kg of rice to B in return for 3 clothes

efficiency
• new state of allocation after the exchange : A has 60kg of rice
and 8 clothes, B has 40kg of rice and 12 clothes

• if both persons come to enjoy higher levels of utility through

this exchange, we can say that the initial state of distribution
was not Pareto efficient

• if any kind of reallocation from this state cannot make both A

and B better-off, this state is Pareto efficient
 7.2 Efficient Allocation of Resources

efficient • perfectly competitive markets allocate resources

allocation of efficiently
resources
• because the conditions for efficient resource allocation
are automatically satisfied in perfectly competitive
markets

• this is what A. Smith called ‘invisible hand’ of the

market

• but, in some case, resource allocation could be

inefficient even in the presence of perfect competition
→ market failure
 7.2 Efficient Allocation of Resources

Market Failure
• if market failure occurs, resource allocation in the market economy
will be inefficient

• causes of market failure

(1) imperfect competition
- efficiency of the market economy presupposes perfect competition

(2) public goods

- non-rivalry in consumption and non-excludability
- due to these two characteristics, people try to free ride when it comes
to public goods → free-rider problem
 7.2 Efficient Allocation of Resources

시장의
Market실패
Failure
원인

(3) externalities
– a certain action causes incidental benefits or damages to others, and no
corresponding compensation is provided or paid → externality
– negative externality
ex) environmental pollution
– positive externality
ex) education and research of basic science
– problem : too much negative externality and too little positive
externality
 7.3 Roles Government Plays

• should government intervene in the presence of market failure?

- if market failure occurs, government intervention might be
necessary
- but government intervention is not automatically justified
• government intervention itself can be the cause of
inefficiency

• in some cases, government failure can occur

- government intervention makes the situation worse →
government failure
 7.3 Roles Government Plays

Causes of Government Failure

(1) incomplete knowledge and information
- due to incomplete knowledge and information, it is difficult to
foresee the consequences of a certain policy
(2) difficult to control the actions of the private sector
(3) constraints in the political process
- a good policy can turn into a bad one in the negotiation processes
of politicians
(4) problems of bureaucracy
- moral hazard of bureaucrats can occur
 7.3 Roles Government Plays

Means of Government Intervention

(1) direct action

- production and supply of specific commodities
• public goods
ex) national defense service, police service, roads, parks
• merit goods
- not a kind of public goods
- government thinks it desirable that all the people
consume a certain commodity equally and sufficiently
ex) compulsory education, housing service, health care
service
 7.3 Roles Government Plays

Means of Government Intervention

(2) provision of incentives

- tax or financial incentives to promote investment
- high taxes on gasoline or diesel oil to reduce their consumption
- has the characteristic that market mechanism is utilized
• can avoid the problem of inefficient resource allocation caused by
direct government intervention
• but no guarantee that the private sector responds to the given
incentives as expected
 7.3 Roles Government Plays

Means of Government Intervention

(3) regulation of the private sector

- regulation for the purposes of income redistribution, protection
of consumers, environmental protection, fair trade
- problems of regulation
• basically inflexible and arbitrary
• actual consequences of regulation could be different from what was
expected
• gains could go to special interest groups → capture theory of
regulation
• makes rent seeking activities more rampant
 7.3 Roles Government Plays

Measures to Cure Government Failure

• institutional reforms
- inefficiency mainly comes from too much bureaucratization,
unclear distribution of roles, insufficiency of check and balance

• provision of appropriate incentives

- inflexibility in promotion and pay is the main cause of laziness

• introduction of competition
- lack of effective competition leads to the inefficiency of the
government sector
 7.4 Public Goods

• free-rider problem
- people want to consume public goods, but are reluctant to share
the cost of producing them
- closely related to non-excludability of public goods
- if markets assume the task of providing public goods markets,
the level of actual provision will be far lower than socially optimal
level

• Question: Do people actually try to free-ride in connection

with public goods?
- according to the results of experiments by behavioral economists,
people do not necessarily free-ride in actuality
 7.4 Public Goods

• one more difficulty related to public goods is the difficulty in

figuring out the appropriate level of production
- the appropriate level of production of public goods depend on
the preferences of people
- but people may act strategically and do not reveal true
preferences in order to reduce their tax burdens
- to figure out the appropriate level of public goods, it is necessary
to induce people to reveal their true preferences for public goods
 7.5 Problems of Environment

• problems of environment can be understood basically in the

framework of ‘The Tragedy of the Commons’
- commons used by all people tend to be overused and
become wasteland sooner or later
• unclear definition of ownership is the crux of the matter
• economic development and environment
- the problems of environmental pollution existed even
before the time of industrial revolution
- water and air pollution in the Roman empire (B.C. 1c)
- true that the problem became much more serious with
industrialization
- ‘zero growth’?
 7.5 Problems of Environment

Solution of Environmental Problem

• Why is it difficult to solve the problem of environment?

- environmental problems are closely related to externalities
• market failure inevitable
- environmental problems tend to get serious to a dangerous
level all of a sudden
ex) ‘The Great Smog’ that broke out in London in October 1952
- conflicts of interest among various groups make it difficult to
find rational solutions
 7.5 Problems of Environment

Solution of Environmental Problem

• government intervention
(1) command-and-control
• direct control of the amount of effluents, mandatory cleaning
facilities, mandatory adoption of clean technology
(2) market based approach
• effluent charge or emission rights system induces the private
sector to clean up voluntarily through price incentives
- policies of environmental protection in Korea are basically
command-and-control
 7.5 Problems of Environment

Solution of Environmental Problem

• Coase theorem argues that government intervention in the

presence of externalities is undesirable
- he says that reciprocity is an essential feature of externalities
- government intervention could lead to a worse outcome
- a better solution can be found by voluntary negotiations of
interested parties
- Coase theorem presupposes that transaction cost is nor large
- not a practical solution in actuality
 7.6 Welfare State

• government plays a central role in the efforts to improve

people’s economic and social welfare → welfare state
• in modern societies, the model of welfare state is closely
related with liberalism
• those who presented the model of welfare state in the early
stages, however, were conservative politicians
• the first example of welfare state could be found in Prussia
(O. von Bismarck)
• welfare state in the modern sense first appeared in Britain in
1948
 7.6 Welfare State

Core Programs of Welfare State

• contents of welfare state differ from country to country, but
basically consist of the following three core programs

(1) reduction in distributional inequality with the expectation

such a decrease will improve social welfare
(2) reduction in economic instability by various social insurance
programs
(3) anti-poverty measures : poverty is the most serious threat to
social welfare, but its total eradication is a difficult task
 7.6 Welfare State

Controversy over Welfare State

• welfare state tries to improve the state of social welfare through
redistribution, but persons with conservative belief argue that
government’s redistribution efforts cannot be justified on ethical
grounds
ex) R. Nozick, M. Friedman
• some argues that too much social welfare dampens the vitality of
economy
• too much tax burden could also be a problem
• but too little social welfare leads to inequitable state of distribution,
and this would also be an important reason for dampening the vitality
of economy
 ECONOMICS

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