Economic Scare Stories Market Failure Government Failure Previous

Economic Scare Stories • Market Failure • Government Failure

Previous four lectures: overview of role of government in the economy • Normative analysis • The economic rationales (tests): Competitive markets work amazingly well – But sometimes there is market failure: externalities, public goods, and monopoly power. • Could you show this with deadweight loss charts and how about telling a story too? – And the income distribution may be too unequal with need for a social safety net

Sometimes the market results in too little production: monopoly power, positive externalities

Sometimes the market results in too much production: negative externalities

Now for the story. Let me tell you about William Swain • He was a young man who traveled from New York to California in 1849 – See map for the route • His goal: Find gold and go back home • Thousands just like him: the Forty-Niners – Much like an army – No “supply corps” but news, food, tools, entertainment was supplied • The invisible hand at work

The story goes on. Let me tell you about hydraulic mining • high pressure water from the Sierra mountains • break down the canyon walls to get more gold – caused huge damage to landscape – impeded navigation downstream • an externality thwarting the invisible hand

Use of Economic Models • Models of firms and consumers form the basis of the normative analysis • Now it is time to consider models of government – positive analysis (asks what governments actually do rather than what they should do) • Why bother with models of government? – Normative recommendations not followed – government failure is common too – it’s fun!

Public Choice Models • Basic assumption: Politicians and government workers are motivated by personal gain, just like anyone else • Politicians want to get elected and re-elected – Even Abraham Lincoln? • Government workers want to increase their power or prestige

Application to Voting • The easiest case: single issue with unanimity – Politicians will choose the unanimous view – If they don’t, they will not get elected • Next easiest case: Single issue with differences of opinion – Median voter theorem applies

Voting paradoxes • Condorcet’s voting paradox • More than one issue • Easiest illustration: three voters, three issues – look at example in table • endless cycles – Softer versus same: Softer wins – Same versus louder: Same wins – Softer versus louder: Louder wins • depends on which vote was taken last

Condorcet’s Voting Paradox

Arrow Impossibility Theorem • Named after Kenneth Arrow of Stanford • No voting scheme for 3 or more alternatives can satisfy all these reasonable properties – transitivity (if A beats B and B beats C, then A beats C) – unanimity (A beats B if everyone prefers A to B) – independence of irrelevant alternatives – Non-dictatorship

Another Application: Special Interests • Exert heavy political pressure in favor of some spending or tax program – Benefits concentrated on a few, costs diffuse – sugar quota example: • costs each consumer about $5 per year • each grower gets over $100, 000 per year • Rent seeking (wasteful lobbying): skilled lobbyists could do something more useful – Anne Krueger of Stanford has shown that this is a serious problem for developing economies

Yet another example: Regulators Captured by Industry • Railroads originally regulated as a natural monopoly • Competition from trucks and airplanes eliminated the natural monopoly • But as competition put pressure on prices, regulation continued and indeed expanded to trucking • Eventually the regulation ended • Could the same thing happen to cable TV?

Application of public choice models to Russian economic crisis • Privatization of industry without antitrust enforcement created monopolies • Monopolies now lobby for continuation of lax antitrust policy • Perhaps greater awareness of political problems would have led economic advisors to focus on competition before privatization

Time Inconsistency • Incentive for government to change policy • example of a dam on a flood plain – promise not to build – people move to flood plane anyway – government ends up building the dam – everyone could (and probably did) expect as much; – example of next midterm exam

International Trade Policy: A Preview • Trade policy (tariffs, quotas, etc) is an area with many examples of government failure • Why is international trade policy so prone to policy mistakes? – Sovereign governments can and do restrict trade with other countries – Compare with commerce clause of the U. S. constitution prohibiting trade restrictions between states in the United States

Less of a legal constraint on bad trade policy than on policy within the confines of the U. S. • Hence, economists (Adam Smith, David Ricardo, Anne Krueger) have made strong efforts to demonstrate – the harms of government intervention in trade – the gains from trade between countries • natural extensions of microeconomic theory • take it up in the next lecture – Chapter 18 of textbook