UNIT 12

GOVERNMENTS ANDMARKETS IN A DEMOCRATIC

SOCIETY

INTRODUCTION

• Governments and markets, along with firms and families, are the majoreconomic institutions today; how they are organized and how theyinteract affect the extent to which economic outcomes are efficient andfair.

• Some economic activities are better organized primarily by markets,others by firms, families, and governments.

• Market competition allows large numbers of people to interact inmutually beneficial ways because prices convey important economicinformation that would be difficult, if not impossible, for a governmentto obtain and use in their absence.

• A government is distinct from other actors in society not because publicofficials are less self-interested than private economic actors, butbecause it has the capacity to act on behalf of all the people and requirecitizens to abide by its decisions, using force if necessary (for example,police powers).

• Governments also use tax funds to provide goods and services (such asthe courts or schooling and, in some countries, health care), that areusually free of charge.

• Ideally, democracy empowers citizens by extending voting rights incompetitive elections to everyone, and limits what governments andother powerful bodies can do by ensuring individual rights of speechand association.

• Even in cases in which public policies to address unfairness or marketfailures are economically feasible, they may still not be carried outbecause powerful groups, including the wealthy or government elites,pursue other objectives, or because governments do not have thecapacity to implement them.

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The Social Science 125 course at Harvard University was oversubscribed;more students had signed up for it than could be enrolled, given the95-student limit placed on class size. Students who crowded into thelecture hall on the first day of the semester were surprised when theprofessor announced that admission to the course would go to the 95 high-est bidders. The sums collected, he explained, would help to pay for the costof extra materials to be circulated to students. He then asked students towrite down their student ID numbers and the amount of US dollars theywere willing to pay for admission to the course.

‘Why should I pay to get into a class?’ one of the students asked politely.The professor replied that limiting the class size was regrettable butnecessary. In the circumstances, he said, the best way to allocate the scarceplaces was to identify the students most willing to pay for a place.

What other methods could he have considered?

• Randomly selecting students to be admitted by lot: This would mean thatsome students who really wanted to take the class would be excluded,while others who were barely interested would be enrolled.

• Asking students how interested they were: This would not work, heexplained to his students, because there would be no reason to tell thetruth if it meant you might not win a place. Each student would have anincentive to exaggerate.

As an economist, the professor proposed to allocate places in the class in asimilar manner to the way in which access to most goods and services isallocated in a capitalist economy, that is, by means of a market. Studentscould bid for their places. Imagine that you had been there, hoping to enrolin the class that day. Would you have accepted his logic? Most of thestudents did not. And when he tried the same thing in another class, somestudents shouted insults at him and walked out!

The professor wasn’t really going to auction places in his class to thehighest bidders; his experiment was simply a first lesson in economics forthe students. Nevertheless, every day school administrators, healthcareproviders, managers of food banks, and many others face the problem ofallocating scarce resources among individuals with differing needs. Theirdecisions are real.

Here is one of those real-life dilemmas. You must decide who willreceive an organ transplant, say, a kidney:

• Buying and selling kidneys is illegal in most places: An illegal (black) marketexists, in which the huge differences between the price received by organdonors (many of them very poor) and price paid by organ recipients(mostly rich) deliver profits to the criminals who organize thetransactions.

• Some generous people choose to donate a kidney: This is legal, and they areallocated according to medical professionals’ determination of medicalneed; possible beneficiaries are under the care of well-connectedphysicians.

Kidneys can be allocated using a combination of medical need andgenerosity. We know that many people waiting for kidney transplants dieevery day, because there are too few donors to save everyone who needs a

Who was this professor? SamuelBowles, one of our authors.

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Alvin Roth explains how matchingmarkets work. http://tinyco.re/8435358

transplant. So, might it be feasible to let people buy a kidney instead? If so,we can add a third option:

• Create a legal market for kidneys: Some people would prefer to be able tobuy and sell kidneys, if there were strict regulations to ensure the safetyof donor and recipient.

But letting kidneys be allocated by markets like any other good that issold—like clothes or cars—has been criticized on the grounds that, underthis arrangement, only rich people would get transplants. You might objectto this system, reasoning: ‘The difference between the people who getreplacement kidneys and the people who don’t, is not that one group valueslife more than the other; it is that only one group can afford it.’ In this case,‘willingness to pay’ is simply ‘ability to pay’.

There is yet another way to improve the way in which kidneytransplants can be organized:

• Create a matching platform for kidneys: This would use a digital techno-logy like Airbnb or Uber. The platform would connect potential donorsand recipients, but with a twist. Suppose your brother needed areplacement kidney, and you were willing to donate one of yours. Butyou are very unlikely to be able to donate your kidney to your brotherbecause matching between donors and recipients is complicated (bloodand tissue type must match). So, under this proposal, you wouldcontribute your kidney to the overall supply of available kidneys, and inreturn be entitled to a properly matched kidney for your brother.

A network of exactly this kind is providing replacement kidneys in theUS under the New England Program for Kidney Exchange (NEPKE),which you can hear more about in our ‘Economist in action’ videofeaturing Alvin Roth, a Nobel Laureate in economics and formerpresident of the American Economic Association. NEPKE is like a marketin that it allows exchanges to take place among total strangers who arematched by what they need or can provide. But unlike a market, who getswhat is not based on the willingness to pay. The key to getting areplacement kidney is not being wealthy enough to afford one, butinstead having some friend or family member (or even a stranger) who iswilling to contribute a kidney to the pool so that the person needing thereplacement gets a kidney matching his type.

Markets sometimes seem to be everywhere in the economy, but this isnot so.

• Firms are not markets: Recall Herbert Simon’s image (page 250) from Unit6 of a Martian viewing the economy. The Martian mainly sees greenfields, which are firms. They are connected by red lines representingbuying and selling in markets, but many resource allocation decisionsare made within the firms.

• Families are not markets: They do not allocate resources between parentsand children by buying and selling.

• Governments are not markets: They use the political process rather thanmarket competition to determine where, and by whom, schools are builtand roads maintained.

INTRODUCTION

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Why are some goods and services allocated in markets, while firms,families, and governments allocate others? This is an old question, and onethat is hotly debated. But the main reason is that some kinds of activitiesare better organized if they are regulated by the rules of the game thatcharacterize families, or governments, or firms, instead of by markets. It ishard to see, for example, how conceiving and raising children could beeffectively carried out by firms or markets. A combination of families andgovernments (schooling) does the job in most societies.

People disagree about the appropriate extent of the market. Some thinkthat things that are now to some extent for sale—like sex, or influence overpolitical decisions—should be allocated by other means. Others think thatmarkets should take a larger role in the economy. These disagreements areabout matters of fact (for example, do public schools or home schooling doa better job?) and matters of value (is the sale of sexual services or bodilyorgans immoral, even if these transactions are well regulated?).

In this unit, we consider why some economic activities are organizedprimarily by markets and some are organized in other ways, by firms,families and governments. Family is the main institution that organizeshow we give birth to infants and raise them in their first few years of life. Inthe rules of the game characteristic of families, parents teach and set limitsfor children, and these rules differ from the way markets determine out-comes. Similarly, as you learned in Unit 6, firms organize the process ofproduction through a top–down structure of command, from owners tomanagers at various levels, down to production workers. Here, we explorehow governments work, and how they interact with firms, families,markets and other institutions.

We have seen in the previous units that markets often fail toimplement efficient and fair outcomes, and we have shown how govern-ments can address market failures and unfairness. In this unit, we willalso explain why governments often fail to address the problems ofmarket failures and unfairness, and how these government failures canthemselves be addressed.

12.1 THE MARKET AND OTHER INSTITUTIONSMarkets are one way of organizing the production and distribution ofgoods and services. For example, you may hire a person on the labourmarket to take care of your child while you are at work. But your child’scaregiver could also be a relative who is not paid a wage. Or the infantcould be cared for in a government daycare centre that is free as a matterof right to any citizen, or by the firm you work for, as part of yourcompensation package. Each of these are examples of different economicinstitutions—markets, families, governments, and firms—organizingsome particular activity.

In Unit 2 you learned that our interactions with others can berepresented as games; for this reason, the institutions that organize theseinteractions can be described as the rules of the game. In Unit 5 you sawthat the way pirates interacted at sea was determined by the rules of thegame laid out in the constitution of The Royal Rover.

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In the introduction, we contrasted markets with firms, families, andgovernments. As economists, we can think of each situation as a differentgame with its own particular rules. In this sense, markets are just one ofthe ways that we organize our societies—you pay for what you get. Butwhat about the others?

• In firms: Your interaction with other members of the firm you work foris organized, in part using a contract that you (or your trade union)negotiated with the owners, and in part according to your position inthe firm’s organizational structure.

• In families: you get what you get as a matter of love, reciprocity andobligation among family members.

• In governments: What you give to and get from the government dependson your rights and responsibilities. A country’s constitution is typically awritten document that lays out the formal structure of a government,that is, the rules of the game for our interactions with the government.

Just like a country’s constitution, we can take all the rules of the game thatapply to us in our roles as parents, voters, employees, shoppers, and so on,and consider them to also have constitutions. The rules of the game ofmarkets can be seen as a ‘constitution’, with firms, families, and govern-ments making up the institutions that jointly organize how we interact witheach other in producing and distributing our livelihoods.

In the previous unit, we explained that market failures—large andsmall—are the rule, not the exception, and result in Pareto-inefficient out-comes. So why do we use markets at all?

Firms, governments, and the extent of the marketIn many cases, we do not use markets. The structure of our economy, takenas a whole, shows that markets are not the chosen way to organize manyaspects of the production and distribution of goods and services.

If you think of the economy as a territory, as Herbert Simon’s imaginaryMartians did in Unit 6, then even setting aside families, vast areas are notorganized by markets.

• Firms are centrally planned economies: Firms are organized this waybecause it costs more for privately owned firms to buy some of thecomponents of the product they sell than to make the components in-house. As a result, in-house production is more profitable than acquiringthe same thing by purchase.

Coase explained that, as a result, the boundaries of this divide between thefirm and the market are set by the relative costs of the ‘make it’ and ‘buy it’options. Thus, the extent of the market is determined by the firm’s decisionabout which components of a product to produce and which ones to buy.

His explanation underlines an important fact that is often lost in heateddebates about the merits of decentralized systems of organization-likemarkets, as opposed to more centralized ones like governments. There aresome things that centralized systems (like the firm) are better at, and othersthat are better handled by the market.

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The beauty of this demonstration is that it is not a judgement by some,possibly biased, observer; it is the verdict of the market itself. Competitionamong firms ultimately punishes firms that overdo the ‘make it’ option byoverextending the boundaries of the centralized system through internalexpansion. And market competition equally punishes the firms that fail totake advantage of centralized decision making by overly opting for the‘buy it’ option.

• Governments are top–down organizations: We will see that they organizevery substantial portions of the economic life in most societies today.Given the prevalence of market failures, why is the whole of the eco-nomy not organized by some combination of firms and governments?

The answer is that, just as there are market failures, there are also failures ofcentralized and top–down organization. And there are limits too, to whatfamilies can do. Markets are important parts of all modern economies andhave been important in most economies in human history.

Markets are essential economic institutions, not because they workperfectly (the previous unit shows they do not), but because there are agreat many aspects of production and distribution for which markets dobetter than the alternative institutions—governments, families, and firms.

12.2 MARKETS, SPECIALIZATION, AND THE DIVISIONOF LABOURWhen you hear the word ‘market’ what word do you think of?‘Competition’ probably comes to mind, and you would be right toassociate the two words.

But ‘cooperation’ applies too. Why?Because markets allow each of us, pursuing our private objectives, to

work together, producing and distributing goods and services in a waythat, while far from perfect, is in many cases better than the alternatives.Markets allow us to interact with people (for the most part completestrangers to us) in ways that we can mutually benefit from, specializing inthe things we are relatively good at doing.

This is a more amazing accomplishment than it might at first seem.Look around at the objects in your workspace. Do you know the

people who made them? What about your clothing? Or anything else insight from where you are sitting?

Now imagine that it is 1776, the year that Adam Smith wrote The Wealthof Nations. The same questions, asked anywhere in the world at that date,would have had different answers.

At that time, many families produced a wide array of goods for theirown use, including crops, meat, clothing, even tools. Many of the thingsthat you might have spotted in Adam Smith’s day would have been madeby a member of the family or someone in the village. You would havemade some objects yourself; others would have been made locally andpurchased from the village market.

One of the changes that was underway during Adam Smith’s life, but hasgreatly accelerated since, is specialization in the production of goods andservices. As Smith explained, we become better at producing things whenwe each focus on a limited range of activities. This is true for three reasons:

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economies of scale These occurwhen doubling all of the inputs to aproduction process more thandoubles the output. The shape of afirm’s long-run average cost curvedepends both on returns to scale inproduction and the effect of scaleon the prices it pays for its inputs.Also known as: increasing returnsto scale. See also: diseconomies ofscale.

• Learning by doing: We acquire skills as we produce things.• Some people are better at producing some things than others: This might be

because they have more skill, or because of natural surroundings, such asthe quality of the soil.

• Economies of scale: Producing a large number of units of some good isoften more cost effective than producing a smaller number. (We studiedeconomies of scale in Unit 7.)

These are the advantages of working on a limited number of tasks orproducts. People do not typically produce the full range of goods andservices that they use or consume in their daily lives. Instead, we specialize,some producing one good, others producing other goods, some working aswelders, others as teachers or farmers. This is called the division of labour.

Adam Smith begins The Wealth of Nations with the following sentence:

But people do not specialize unless they have a way to acquire the othergoods they need. For this reason, specialization and the resulting division oflabour pose a problem for society: how are the goods and services to bedistributed from the producer to the final user?

This result—the coordination of the division of labour—is accomplishedin different ways, depending on a society’s institutions. In the course ofhistory, the division of labour has been coordinated by means of direct gov-ernment requisitioning and distribution, as was done in the US and manyeconomies during the Second World War, or by gifts and voluntary sharingas we do in families today; it was even practised among unrelated membersof a community by our hunter-gatherer ancestors. Today, in most countries,markets play an essential role in coordinating the division of labour.

Chapter 3 in Smith’s Wealth of Nations is titled ‘That the Division ofLabour is Limited by the Extent of the Market’, in which he explains:

When the market is very small, no person can have anyencouragement to dedicate himself entirely to one employment, forwant of the power to exchange all that surplus part of the produce ofhis own labour, which is over and above his own consumption, forsuch parts of the produce of other men’s labour as he has occasionfor.

Markets accomplish an extraordinary result: they create unintendedcooperation on a global scale. The people who produced the phone inyour pocket did not know or care about you. They produced it becausethey are better at producing phones than you are, or were willing towork for lower wages than you are. You ended up with the phonebecause you paid the producers, allowing them to buy goods, alsoproduced by total strangers to them.

Adam Smith. (1776) 2003. AnInquiry into the Nature and Causesof the Wealth of Nations. NewYork, NY: Random HousePublishing Group.

The greatest improvement in the productive powers of labour, andthe greater part of the skill, dexterity, and judgment with which it isanywhere directed, or applied, seem to have been the effects of thedivision of labour.

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12.3 PRICES ARE MESSAGES PLUS MOTIVATION: THEMAGIC OF THE MARKETThe key to how this process works can be expressed in a single sentence.When markets work well, prices send messages about the real scarcity ofgoods and services. The messages provide information that motivatespeople to take account of what is scarce and what is abundant, and as aresult to produce, consume, invest, and innovate in ways that make the bestuse of an economy’s productive potential.

Prices coordinate specialization among complete strangersIf drought in the American Great Plains means that there is less wheat onthe world market, the resulting increase in the price of bread sends amessage to the shopper: ‘Consider putting potatoes or rice on the tabletonight instead of bread.’ The shopper may know nothing about weatherconditions in America and need not be the slightest bit concerned aboutconsuming less of a good that has become scarcer. To respond to themessage of the higher price in a way that makes the best use of a society’savailable resources, the shopper needs to be concerned about just one thing:saving money. The shopper not only gets the message, but has a goodreason to act on it.

It is this—the fact that prices combine information and a reason to acton the information—that allows the market system (many marketsinterlinked) to coordinate the division of labour through the exchange ofgoods among entire strangers, without centralized direction. FriedrichHayek, who was part economist and part philosopher, suggested we thinkof the market as a giant information-processing machine that producesprices; the prices provide information that guides the economy, usually indesirable directions. The remarkable thing about this massivecomputational device is that it’s not really a machine at all. Nobodydesigned it, and nobody is at the controls. When it works well, we usephrases like ‘the magic’ of the market.

Are the prices sending the right messages?But for this to be the case, the messages that prices send must convey theright information—how scarce a good really is. Think about what thismeans—the scarcity of a good is measured by its social marginal cost, thatis, the total cost of having one more unit of it, including not only the cost ofthose producing and distributing it, but also the external effects imposed onothers (for example, environmental damages).

You have seen many cases in the previous units in which the price of agood is not equal to its social marginal cost. The price of bananas inMartinique, for example, did not include the loss of life and livelihoodinflicted on the downstream fishing community by the pesticides used onthe plantations.

The price may fail to reflect the social marginal cost due to either:

• A lack of competition: Price is greater than the private marginal cost to theproducer.

• External effects that are costs: For example, the negative environmentaleffects just mentioned.

• External effects that are benefits: For example, the positive external effectfor others if your scientific research created a valuable piece ofknowledge that was a public good.

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Joseph A. Schumpeter. (1943) 2003.Capitalism, Socialism andDemocracy. pp. 167—172.Routledge.

Friedrich A. Hayek. 1944. The Roadto Serfdom. Chicago, Il: Universityof Chicago Press.

Hayek, Friedrich A. 1948. ‘TheMeaning of Competition’, in Indi-vidualism and Economic Order.Chicago, Il: University of ChicagoPress.

When prices send the wrong messages, as you saw in the previous unit, weask whether some modification of how markets work could be introducedby public policies to improve economic outcomes, for example, taxing pro-duction processes that emit greenhouse gases or subsidizing basic research.

We now illustrate how prices can send the right message, and sometimesnot, by two real world cases.

GREAT ECONOMISTS

Friedrich HayekThe Great Depression of the 1930sravaged the capitalist economies ofEurope and North America,throwing a quarter of theworkforce out of work in the US.During the same period, thecentrally planned economy of theSoviet Union continued to growrapidly under a succession of five-year plans. Even the arch-opponent of socialism, JosephSchumpeter, had conceded: ‘Cansocialism work? Of course itcan. … There is nothing wrong with the pure logic of socialism.’

Friedrich Hayek (1899–1992) disagreed. Born in Vienna, he was anAustrian (later British) economist and philosopher who believed that thegovernment should play a minimal role in the running of society. He wasagainst any efforts to redistribute income in the name of social justice.He was also an opponent of the policies advocated by John MaynardKeynes, designed to moderate the instability of the economy and theinsecurity of employment.

Hayek’s book, The Road to Serfdom, was written against the backdrop ofthe Second World War, when economic planning was being used both byGerman and Japanese fascist governments, by the Soviet communistauthorities, and by the British and American governments. He argued thatwell-intentioned planning would inevitably lead to a totalitarian outcome.

His key idea about economics—that prices are messages—revolu-tionized how economists think about markets. Messages conveyvaluable information about how scarce a good is, information that isavailable only if prices are free to be determined by supply and demand,rather than by the decisions of planners. Hayek even wrote a comicbook, which was distributed by General Motors, to explain how thismechanism was superior to planning.

But Hayek did not think much of the theory of competitive equilib-rium, in which all buyers and sellers are price-takers. ‘The moderntheory of competitive equilibrium,’ he wrote, ‘assumes the situation toexist which a true explanation ought to account for as the effect of thecompetitive process.’

In Hayek’s view, assuming a state of equilibrium (as Walras haddone in developing general equilibrium theory) prevents us fromanalysing competition seriously. He defined competition as ‘the action

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Hayek, Friedrich A. 1948. ‘TheMeaning of Competition’, in Indi-vidualism and Economic Order.Chicago, Il: University of ChicagoPress.

Hayek, Friedrich A. 1945. ‘The Useof Knowledge in Society’, reprintedin Friedrich A. Hayek. 1948. Indi-vidualism and Economic Order.Chicago, Il: University of ChicagoPress.

excess demand A situation inwhich the quantity of a gooddemanded is greater than thequantity supplied at the currentprice. See also: excess supply.

12.4 PRICES AS MESSAGESPrices worked as messages on a global scale even before the transatlantictelegraph was introduced. Students of American history learn that thedefeat of the southern Confederate states in the American Civil War endedthe use of slaves in the production of cotton and other crops in that region.There is also an economics lesson in this story.

At the war’s outbreak on 12 April 1861, President Abraham Lincolnordered the US Navy to blockade the ports of the Confederate states. Topreserve the institution of slavery, these states had declared themselvesindependent of the US.

Lincoln’s blockade halts the export of cottonAs a result of the naval blockade, the export of US-grown raw cotton tothe textile mills of Lancashire in England came to a virtual halt,eliminating three-quarters of the supply of this critical raw material.Sailing at night, a few blockade-running ships evaded Lincoln’s patrols,but 1,500 ships were destroyed or captured.

We have seen in Unit 7 that the market price of a good, such as cotton, isdetermined by the interaction of supply and demand. In the case of rawcotton, the tiny quantities reaching England through the blockade were adramatic reduction in supply. There was large excess demand—at theprevailing price, the quantity of raw cotton demanded exceeded the avail-able supply. As a result, some sellers realized they could profit by raising theprice. Eventually, cotton was sold at prices six times higher than before thewar, keeping the lucky blockade runners in business. Consumption ofcotton fell to half the pre-war level, throwing hundreds of thousands ofpeople who worked in cotton mills out of work.

of endeavouring to gain what another endeavours to gain at the sametime.’ Hayek explained:

Now, how many of the devices adopted in ordinary life to that endwould still be open to a seller in a market in which so-called‘perfect competition’ prevails? I believe that the answer is exactlynone. Advertising, undercutting, and improving (‘differentiating’)the goods or services produced are all excluded by definition—’perfect’ competition means indeed the absence of all competitiveactivities.

The advantage of capitalism, to Hayek, is that it provides the rightinformation to the right people. In 1945, he wrote:

Which of these systems [central planning or competition] is likelyto be more efficient depends mainly on the question under whichof them we can expect [to make fuller use] of the existingknowledge. This, in turn, depends on whether we are more likelyto succeed in putting at the disposal of a single central authorityall the knowledge which ought to be used but which is initiallydispersed among many different individuals, or in conveying tothe individuals such additional knowledge as they need in order toenable them to dovetail their plans with those of others.

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British textile mill owners increase demandMill owners responded. For them, the price rise was an increase in theircosts. Some firms failed and left the industry due to the reduction in theirprofits. Mill owners looked to India to find an alternative to US cotton,greatly increasing the demand for cotton there. The excess demand in themarkets for Indian cotton gave some sellers an opportunity to profit byraising prices, resulting in increases in the prices of Indian cotton, whichquickly rose to almost match the price of US cotton.

Farmers in India and Egypt switch to cottonResponding to the higher income now obtainable from growing cotton,Indian farmers abandoned other crops and grew cotton instead. The sameoccurred wherever cotton could be grown, including Brazil. In Egypt, farm-ers who rushed to expand the production of cotton in response to thehigher prices began employing slaves, captured (like the American slavesthat Lincoln was fighting to free) in sub-Saharan Africa.

There was a problem. The only source of cotton that could come close tomaking up the shortfall from the US was in India. But Indian cottondiffered from American cotton and required an entirely different kind ofprocessing. Within months of the shift to Indian cotton, new machinerywas developed to process it.

Mill owners introduce new machineryAs the demand for this new equipment soared, firms that made textilemachinery, like Dobson and Barlow, saw profits take off. We know aboutthis firm, because detailed sales records have survived. Dobson and Barlowresponded by increasing production of these new machines and otherequipment. No mill could afford to be left behind in the rush to retool,because if it didn’t, it could not use the new raw materials. The result was,in the words of Douglas Farnie, a historian who specialized in the history ofcotton production: ‘such an extensive investment of capital that itamounted almost to the creation of a new industry.’

A change in price was the message and the motivationThe lesson for economists—Lincoln ordered the blockade, but in whatfollowed, the farmers and sellers who increased the price of cotton were notresponding to orders. Neither were the mill owners, who cut back theoutput of textiles and laid off the mill workers, nor were the mill ownersdesperately searching for new sources of raw material. By ordering newmachinery, the mill owners set off a boom in investment and new jobs.

All these decisions took place over a matter of months, made by millionsof people, most of whom were total strangers to one another, each seekingto make the best of a totally new economic situation. American cotton wasnow scarcer, and people responded, from the cotton fields of Maharashtrain India, to the Nile delta, to Brazil, to the Lancashire mills.

To understand how the change in the price of cotton transformed theworld cotton and textile production system, think about the prices determinedby markets as messages. The increase in the price of US cotton shouted: ‘Findother sources, and find new technologies appropriate for their use.’ Similarly,when the price of petrol rises, the message to the car driver is: ‘Take the train’,which is passed on to the railway operator: ‘There are profits to be made byrunning more train services.’ When the price of electricity goes up, the firm orthe family is being told: ‘Think about installing photovoltaic cells on the roof.’

Douglas A. Farnie. 1979. TheEnglish Cotton Industry and theWorld Market: 1815-1896. Oxford:Oxford University Press.

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In many cases (like the chain of events that began at Lincoln’s desk on 12April 1861) the messages make sense, not only for individual firms andfamilies, but also for society; if something has become more expensive, thenit is likely that more people are demanding it, or the cost of producing it hasrisen, or both. By finding an alternative, the individual is saving money andconserving society’s resources. This is because, in some conditions, pricesprovide an accurate measure of the scarcity of a good or service.

Centrally planned economies (or firms)In planned economies, which operated in the Soviet Union and othercentral and eastern European countries before the 1990s (discussed in Unit1), messages are sent deliberately by government experts about how thingsare produced. They decide what is produced and at what price it is sold.The same is true, as we saw in Unit 6, in large firms like General Motors,where managers (and not prices) determine who does what.

The amazing thing about prices determined by markets is that indi-viduals do not send the messages, but rather the anonymous interaction ofsometimes millions of people. And when conditions change—a cheaper wayof producing bread, for example—nobody has to change the message (‘putbread instead of potatoes on the table tonight’). A price change results froma change in firms’ costs. The reduced price of bread says it all.

12.5 PUTTING MOTIVATION BEHIND THE MESSAGEFish and fishing are a major part of the life of the people of Kerala in India.Most of them eat fish at least once a day, and more than a million people areinvolved in the fishing industry. But before 1997, prices were high andfishing profits were limited due to a combination of waste and the bargain-ing power of fish merchants, who purchased the fishermen’s catch and soldit to consumers.

The importance of timingWhen returning to port to sell their daily catch of sardines to the fishmerchants, many fishermen found that the merchants already had as muchfish as they needed that day. They refused to buy any more fish at any price.The price was effectively zero! Fishermen at these markets just dumpedtheir worthless catch back into the sea.

A lucky few returned to the right port at the right time when demandexceeded supply, and they were rewarded by extraordinarily high prices.

On 14 January 1997, for example, 11 boatloads of fish were broughtto the market at Badagara, which was found to be oversupplied; the catchwas jettisoned. There was excess supply of 11 boatloads. But at fishmarkets within 15 km of Badagara, there was excess demand—15 buyersleft the Chombala market unable to purchase fish at any price. The luck,or lack of it, of fishermen returning to the ports along the Kerala coast isillustrated in Figure 12.1.

Only seven of the 15 markets did not suffer either from over- or under-supply. In these seven villages (on the vertical line), prices ranged from Rs4per kg in the market at Aarikkadi to more than Rs7 per kg in Kanhangad.

When the fishermen had bargaining power because there was excessdemand, they got much higher prices. In markets with neither excess demandnor excess supply, the average price was Rs5.9 per kg, shown by the hori-zontal dashed line. In markets with excess demand, the average was Rs9.3 perkg. The fishermen fortunate enough to put in at these markets obtained

See Who’s in Charge?, Chapter 1 ofPaul Seabright’s book, for moredetail on how market economiesmanage to organize complextrades among strangers.

Paul Seabright. 2010. The Com-pany of Strangers: A NaturalHistory of Economic Life (RevisedEdition). Princeton, NJ: PrincetonUniversity Press.

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extraordinary profits, if we assume that the price in markets with neitherexcess demand nor supply was high enough to yield economic profits. Ofcourse, on the following day they may have been the unlucky ones who foundno buyers at all and would have to dump their catch into the sea.

Prices contained important messages: ‘Fish are scarce in Chombala, butnot in Badagara’, but the fisherman did not receive them in time to motivatethem to change what they did so as to adjust to surpluses in one market andexcess demand in others.

Cell phones deliver the message on timeThis all changed when the fishermen got cell phones. While still at sea, thereturning fishermen phoned the beach fish markets and pick the one wherethe prices were highest that day. If they returned to a high-priced market,they would earn an economic rent (that is, income in excess of their nextbest alternative—returning to a market with no excess demand or, evenworse, one with excess supply).

By gaining access to real-time market information on relative prices forfish, the fishermen could adjust their pattern of production (fishing) anddistribution (the market they visit) to secure the highest returns.

A study of 15 beach markets along 225 km of the northern Kerala coastfound that, once the fishermen had cell phones, differences in daily pricesamong the beach markets were cut to a quarter of their previous levels. Noboats jettisoned their catches. Reduced waste and the elimination of thedealers’ bargaining power raised the profits of fishermen by 8%, at the sametime as consumer prices fell by 4%.

Cell phones allowed the fishermen to become very effective rentseekers. Their rent-seeking activities changed how Kerala’s fish marketsworked—virtually eliminating the periodic excess demand and supply—tothe benefit of fishermen and consumers, but not of the fish dealers whohad acted as middlemen.

Figure 12.1 Bargaining power and prices in the Kerala wholesale fish market(14 January 1997). (Note: Two markets had the same outcome, with a price of Rs6.2per kg.)

Robert Jensen. 2007. ‘The DigitalProvide: Information (Technology),Market Performance, and Welfare in theSouth Indian Fisheries Sector.’ TheQuarterly Journal of Economics 122 (3)(August): pp. 879–924.

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repugnant market The exchange ofsome thing (such as infants, organsor sex) that many people findmorally offensive.

merit goods Goods and servicesthat should be available toeveryone, independently of theirability to pay.

This happened because the Kerala sardine fishermen could respond toprice messages. The information given by the prices at different beachmarkets came at the right time, so they were motivated to land at themarkets where fish was needed most.

QUESTION 12.1 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)Figure 12.1 shows how bargaining power affected prices in Keralabeach markets on 14 January 1997. Based on this information, whatcan we conclude?

The higher the excess supply, the lower the price of fish.The price of fish in all markets with excess demand is Rs9.3 per kg.In cases of demand being equal to supply, the price that fishermenfaced was the same in all markets.The data demonstrates that buyers have bargaining power whenthere is excess supply.

12.6 THE LIMITS OF MARKETS: REPUGNANT MARKETSAND MERIT GOODSSeeing prices as both message and motivation teaches us the following:markets work well when prices are informative about the real scarcity ofgoods and services, and when people can change their behaviour to takeaccount of change in this information. When this is the case, we have ‘themagic of the market’; when it is not the case, we have market failures.

But even when markets work well in this sense, many (probably most)people think that there are reasons to organize the production and distribu-tion of some particular goods and services by other means.

• Repugnant markets: Marketing some goods and services—vital organs,votes, prizes, or human beings—may violate an ethical norm, orundermines human dignity.

• Merit goods: It is widely held that some goods and services (called meritgoods) should be available to all, independently of a person’s ability orwillingness to pay. Access to personal security, basic and emergencyhealth care, and fair judicial proceedings are examples.

Repugnant marketsIn most countries, there are well-established institutions that allow parentsto voluntarily give up a baby for adoption, but laws typically preventparents from selling their infants. Commercial surrogacy—a coupleproviding a new-born infant to another couple for pay—is held to beimmoral by many and is not legal in most countries (although it legal insome states in the US, India, and Russia).

The research done by Alvin Roth, the economist whose video youwatched when we discussed kidney transplants, has identified many ofthese repugnant markets.

Why do most countries ban the buying and selling of babies? Is it nottrue that a market for infants would provide opportunities for mutual gainsfrom exchange between parents wishing to sell and would-be parentswishing to buy?

Alvin E. Roth. 2007. ‘Repugnance asa Constraint on Markets’. Journalof Economic Perspectives 21 (3):pp. 37–58.

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A common response is that some goods and services are different fromthe shirts, haircuts, and other goods that we routinely buy and sell onmarkets. Virtually all countries ban the sale of human organs for transplant.

Some economists might reason that it is wrong to prevent thesetransactions if both parties engage in them voluntarily—preventing thoseexchanges would be Pareto inefficient. But economic reasoning of this kinddoes not apply to just any transaction, and most economists now recognizethat not everything should be put up for sale.

• The sale may not be truly voluntary: For example, poverty might forcepeople to enter into a transaction that they might later regret, and thebaby put up for sale is surely not doing this voluntarily.

• Can you put a value on dignity? Putting a price on a baby, or a body part,or sex may violate the principle of human dignity.

• It undermines institutions: Putting votes or human beings up for saleundermines the workings of valued social institutions or principles, suchas democracy and freedom of movement.

• It might not be fair: Allocating goods according to the willingness to pay(which depends on an individual’s income), as is done in markets may,seem less fair than other ways of determining who gets what, such as‘first come first served’ or universal access to the good.

• It encourages self-interest: Markets, and the monetary incentives on whichthey are based, may lead people to act in a more self-interested and a lesspublic-spirited way than they would under other institutions.

Regarding the final bullet point, recall (from Unit 3.7) that this seems tohave occurred when parents were fined for coming late to pick up theirchildren at daycare centres in Israel (more parents picked their kids up laterafter the fine was imposed).

Merit goodsEconomists recognize that there are some goods and services that are con-sidered special in that they should be made available to all people, eventhose who lack the ability or willingness to pay for them. These are calledmerit goods; they are provided by governments rather than allocated by amarket governed by the willingness to pay.

In most countries, primary education is provided free to all children andfinanced by taxation. Basic health care—at least emergency care—is alsooften available to all, irrespective of the ability to pay. The same holds forlegal representation at trial in many countries—a person unable to pay for alawyer should be assigned legal representation without charge. Personalsecurity—protection from criminal assault or home fires, for example—istypically ensured in part by publicly provided police protection and fire-fighting services.

Why should merit goods be provided to people free of charge? People oflimited income do not have access to a great many things. They typicallylive in substandard and often unhealthy housing and have very limitedopportunities for recreational travel. Why are basic health care andschooling, legal representation, and police and fire protection different?The answer is that in many countries, these goods and services are con-sidered the right of every citizen.

Michael Walzer and MichaelSandel, two philosophers, havediscussed the moral limits ofmarkets. Some markettransactions conflict with the waywe value humanity, such as buyingand selling people as slaves;others conflict with principles ofdemocracy, such as allowingpeople to sell their votes.

Michael Sandel. 2009. Justice.London: Penguin.

Michael Walzer. 1983. Spheres ofJustice: A Defense of Pluralism andEquality. New York, NY: BasicBooks.

Sandel investigates the morallimits of his audience (studentsaround the world) in a talk called‘Why we shouldn’t trust marketswith our civic life’ (http://tinyco.re/2385666) and in a series of videoscalled ‘What money can’t buy’(http://tinyco.re/7062034).

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EXERCISE 12.1 CAPITALISM AMONG CONSENTING ADULTSShould all voluntary contractual exchanges be allowed among consentingadults?

State what you think about the following (hypothetical) exchanges. Youmay assume in each case that the people involved are sane, rationaladults who have thought about the alternatives and consequences of whatthey are doing. In each case, decide whether you approve, and if you donot approve, whether you think the transaction should be prohibited. Ineach case explain why the transaction described produces mutual benefits(that is, it is a Pareto improvement over not allowing the exchange).

1. A complicated medical procedure has been discovered that cures arare form of cancer in patients who will otherwise certainly die. Staffshortages make it impossible to treat all those who could benefit, andthe hospital has established a policy of first come, first served. Ben, awealthy patient who is at the bottom of the list, offers to pay Aisha, apoor person on the top of the list, $1 million to exchange places. IfAisha dies (which is very likely), then her children will inherit themoney. Aisha agrees.

2. Melissa is 18. She has been admitted to a good university but does nothave any financial aid, and cannot get any. She signs a four-year con-tract to be a stripper on the Internet and will begin work when she is19. The company will pay her tuition fees.

3. You are waiting in line to buy tickets for a movie that is almost sold out.Someone from the back of the line approaches the woman in front ofyou and offers her $25 to exchange positions in the line (he takes herposition in front of you and she takes his at the back of the line).

4. A politically apathetic person, who never votes, agrees to vote in anelection for the candidate who pays him the highest amount.

5. William and Elizabeth are a wealthy couple who give birth to a babywith a minor birth defect. They sell this baby to their (equally wealthy)neighbours and buy a child without any birth defects from a family thatneeds the money.

6. An individual with an adequate income decides that he would like tosell himself to become the slave of another person. He finds a buyerwilling to pay his asking price. The aspiring slave will use the money tofurther his children’s education.

12.7 THE GOVERNMENT AS AN ECONOMIC ACTORThe reasons why institutions other than markets play an important part inproduction and distribution include market failures, the status of somegoods or services as merit goods, and the morally repugnant nature of someexchanges. This helps to explain why governments are major economicactors. Government spending, taxation, laws, wars, and other activities areas much a part of economic life as the working, investment, saving, buying,and selling activities of families and firms.

When we say that governments are economic actors (as we did in callingfirms economic actors), we refer to those making the key decisions—policy-makers, military leaders, and top judicial authorities in a government.

In earlier units, especially the previous one, we identified many cases inwhich government policies could be introduced to address problems of

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either inefficiency or unfairness. But in Unit 3, we also showed how gov-ernments (like firms and individuals) are limited in what they can do, notonly because they have limited resources to accomplish their objectives, butalso because, in most economic matters, even a powerful governmentcannot dictate what citizens do.

The government can require that a minimum wage be paid to allworkers, but it cannot require workers to work hard instead of loafing onthe job. The government can require the owners of a business to pay taxes,but it cannot require them to invest in building new productive capacityinstead of purchasing a second home. In many cases, the most it can do is toalter the circumstances under which people decide what to do. Here wereturn to the question of government policies, stressing not what govern-ments might do to address market failures, unfairness, and other problems,but instead what they actually do and why that sometimes falls short ofwhat we would like.

A government allows people to do things together that they could not doindividually. An example is going to war. Governments also engage inactivities that vastly improve living standards and the quality of life of theircitizens. Examples include:

• Reduced poverty: Fifty years ago, even in rich countries, many retired orelderly people were trapped in poverty. For example, in 1966, 28.5% ofUS citizens aged 65 and over were classed as ‘poor’. Governmenttransfers in many countries have virtually eliminated serious economicdeprivation among the elderly. In 2012, just 9.1% of elderly people in theUS were poor.

• Increased life expectancy and the dramatic reduction in child mortality inmany countries: When these improvements occurred in the latenineteenth and early twentieth century, they were not primarily theresult of advances in medicine, most of which came later. They followedgovernment policies that improved sanitation and water supply.

• Economic security: The increased size of government spending hasreduced economic insecurity by dampening the extent of booms andbusts. This is referred to as reducing the volatility of the business cycle.

Coercion and providing public servicesGovernments are actors on a scale unparalleled by families and most firms.The US government—federal, state and local—employs almost 10 times asmany people as the country’s largest firm, Walmart. However, governmentswere not always economic actors on this large a scale. In Figure 12.2 weshow the total tax revenues collected by the government of the UK as afraction of gross domestic product—a measure of the size of the govern-ment relative to the size of the economy—over more than 500 years. Thefigure rises from about 3% in the period prior to 1650 to 10 times thatamount after the Second World War.

Even when tax revenues were only 3% of gross domestic product, thegovernment of the UK was an immensely important actor. It is not the sizeof governments that make them unique, or uniquely important as actors.

Within a given territory, only a government has the authority to useforce and restraints on an individual’s freedom to achieve its objectives.Because citizens generally see the use of the government’s coercivepowers to maintain order, regulate the economy and deliver services aslegitimate—meaning that they accept the government’s authority—most

More about the economics ofpoverty reduction: Angus Deaton.2013. The Great Escape: health,wealth, and the origins of inequal-ity (http://tinyco.re/8421941).Princeton: Princeton UniversityPress.

Peter Lindert. 2004. GrowingPublic: Social Spending and Eco-nomic Growth since the EighteenthCentury. Cambridge: CambridgeUniversity Press.

Jon Bakija, Lane Kenworthy, PeterLindert, and Jeff Madrick. 2016.How Big Should Our GovernmentBe? Berkeley: University ofCalifornia Press.

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government Within a giventerritory, the only body that candictate what people must do or notdo, and can legitimately use forceand restraints on an individual’sfreedom to achieve that end. Alsoknown as: state.

citizens comply with government-made laws. One application of govern-ment’s coercive power is the collection of taxes, which can be used tofund its operations.

To distinguish governments from private economic actors like firms,families, individuals, trade unions, and professional organizations, wedefine the government as the only body in a geographical territory (thenation) that can legitimately use force and the threat of force to pursue itsends. Governments routinely do things—locking people up, for example—which, if done by a private individual, are considered wrong and illegal.

Beyond its legitimate use of coercive powers, a second feature of thegovernment is that it has obligations to its citizens based on civil andhuman rights; this feature also distinguishes the government from firmsand other private economic entities. To advance and protect these rights,governments use tax funds to provide services such as national defence,police protection, and schooling. These services are often available tocitizens without restrictions to those who use them, and withoutcharging a price.

People differ greatly in their income and wealth and, therefore, in thetaxes they pay; however, as citizens, they are equally entitled to manygovernment provided services. This simple fact is at the root of manydebates about the appropriate ‘size’ of the government; people with lessincome and wealth benefit from many government services, but peoplewith more wealth and income pay more (in absolute terms) of the taxesthat finance these services. The tax, transfer, and expenditure systems ofdemocratic governments typically redistribute income from those withhigher incomes to those with lower incomes (See Figures 5.20 (page 235)and 5.21 (page 236) in Unit 5).

Figure 12.2 The growth of government in the UK (1500–2015).

UK Public Revenue; Patrick K. O’Brienand Philip A. Hunt. 1993. ‘The rise of afiscal state in England, 1485–1815’.Historical Research 66 (160):pp.129–176. Note: Pax Britannica refersto the century between the end of theNapoleonic Wars and the beginning ofthe First World War, in which (comparedto earlier or subsequent periods) Europeand most of the world was relativelypeaceful, with the UK the militarilydominant nation. The Glorious Revolu-tion deposed King James II in 1688 andincreased the independent power ofparliament.

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Part of the solutionGovernments may adopt the twin objectives that we have used in thiscourse:

• Maximizing the surplus: They may try to ensure that the mutual gainspossible through our economic interactions are as large as possible andare fully realized.

• Ensuring fairness: They can influence how that these gains are shared.

Examples of policies commonly adopted by governments to address marketfailures and unfairness include:

• Competition policies: To reduce the price-setting powers of monopolies.• Environmental policies: To reduce emissions of pollutants.• Subsidies: For Research and Development (R&D).• Policies that establish the expectation that the economy is relatively stable: So

that firms invest.• Public provision of health care or compulsory insurance.• Providing information: To allow people to make better decisions, such as

the risks associated with financial products, children’s toys, and foods.• Central bank policies: That require commercial banks to minimize their

risk exposure by restricting the leverage of their balance sheets.• Minimum wage laws: That prohibit contracts that pay below a stated

minimum.

Governments pursue these objectives by some combination of four means:

• Incentives: Taxes, subsidies, and other expenditures alter the costs andbenefits of activities that have external effects that would lead to marketfailures or unfair outcomes if left unaccounted for.

• Regulation: Direct regulation of economic activities, such as the degree ofcompetition, including mandatory universal participation in social andmedical insurance, and regulation of aggregate demand.

• Persuasion or information: Altering available information and people’sexpectations about what others will do (for example, their belief thattheir property is secure or that other firms will invest) so as to allowpeople to coordinate their actions in a desirable way.

• Public provision: In-kind provision or through monetary transfers,including merit goods such as basic education, legal representation incourt proceedings, and income transfers to alter the distribution ofliving standards.

Part of the problemTo accomplish these valuable objectives, governments must haveextraordinary powers to acquire information and to compel compliance.This creates a dilemma. For the government to be a successful problemsolver, it must also be powerful enough to potentially be a problem itself.Examples from history, and today’s news, show governments using theirmonopoly on the use of force to silence opposition and to acquire hugepersonal wealth for their officials and leaders.

• Ivory Coast: As president from 1960 to 1993, Felix Houphouet Boignyaccumulated a fortune estimated to be between $7 billion and $11

Jean Tirole, an economist whospecializes in the role ofintervention and regulation,describes the way that govern-ments can intervene in his Nobelprize lecture (http://tinyco.re/4684631).

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billion, much of it held in Swiss bank accounts. He once asked, ‘Is thereany serious man on earth not stocking parts of his fortune inSwitzerland?’

• Romania: Nicolae Ceausescu, the head of state under Communist Partyrule for over two decades, amassed extraordinary wealth, the mostvisible parts of which were more than a dozen palaces that hadbathrooms with gold-tiled baths and solid-gold toilet paper holders.

• Russia: Personal connections with President Vladimir Putin haveallowed a class of business people called oligarchs to obtain hundreds ofmillions of roubles’ worth of assets.

Before the French Revolution, Louis XIV of France constructed a luxuriouspalace and grounds for himself at the Palace of Versailles, which is now oneof the top tourist attractions in the world. He was called the Sun King by hissubjects and claimed, ‘L’etat, c’est moi’ (‘I am the state’). The word ‘state’ issometimes used—as the Sun King did here—to mean ‘government ingeneral’, distinguishing it from any particular body, such as the governmentof France. In neighbouring Britain, at almost the same time, William Pitthad a different view of his King, declaring that ‘The poorest man may in hiscottage bid defiance to all the forces of the Crown,’ as we saw in Unit 1(Exercise 1.5 (page 33)).

Well-governed societies have devised ways to limit the damage that theuse of government powers can inflict, without undermining the govern-ment’s capacity to solve society’s problems. These have generally included acombination of:

• Democratic elections: To allow citizens to dismiss a government that isusing its powers for its own benefit or for the interests of some othersmall group.

• Institutional checks and balances and constitutional restrictions on what thegovernment can do: These entirely prohibit some actions by a govern-ment, such as imposing a particular religion on a population.

The second point is why Pitt could observe that, while the farmer may havedifficulty keeping rain out of his cottage, he could confidently exclude theKing of England.

In a capitalist economy, aside from the obligation to pay taxes and inexceptional circumstances, the government cannot seize what you own; thislimits the government’s capacity to enrich itself at your expense. This is anessential limit on arbitrary government powers.

An example of an exceptional case would be if you owned a piece ofland that was the only possible site for a bridge needed to solve a trafficproblem. Most governments have the right to acquire the land at what isindependently judged to be a fair price, even if you are unwilling to sell.This power to take private property for public use has many names. Forexample, it is known as the ‘right of eminent domain’ in the US or a‘compulsory purchase order’ in the UK. Even with well-designed limitson government powers and provision for exceptions allowing govern-ments to better serve the public, we will see that governments, likemarkets, sometimes fail.

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natural monopoly A productionprocess in which the long-runaverage cost curve is sufficientlydownward-sloping to make itimpossible to sustain competitionamong firms in this market.

government failure A failure of political accountability. (Thisterm is widely used in a variety of ways, none of them strictlyanalogous to market failure, for which the criterion is simplyPareto inefficiency).

economic accountability Accountability achieved by economicprocesses, notably competition among firms or other entities inwhich failure to take account of those affected will result inlosses in profits or in business failure. See also: accountability,political accountability.

political accountability Accountability achieved by politicalprocesses such as elections, oversight by an elected govern-ment, or consultation with affected citizens. See also:accountability, economic accountability.

QUESTION 12.2 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)Which of the following statements are correct?

A government should not be able to seize private property.A government should not be the monopoly supplier of a service.A government should not be allowed to use force against its cit-izens.A government should not collect information about its citizens.

Government failureTo understand why neither markets nor governments may provide idealsolutions to economic problems (http://tinyco.re/8993136), think about thecase of a natural monopoly. An example would be the provision of tapwater in a city, or electricity transmission over a national network. In thesecases, as a result of economies of scale, the most efficient solution is to havea single entity provide the service. This could be a private firm, an eco-nomic monopoly, or the government, which is a political monopoly.

If the firm were privately owned as a monopoly, we know from Unit 7that it would face a downward-sloping demand curve, which would limitthe price at which it could sell its goods. In order to maximize the profits ofthe firm, and hence the value of the owners’ assets, the monopoly firmwould both seek to reduce costs and restrict output so that it could charge ahigher price. The result would be a price above the marginal cost of pro-duction, which would mean that some consumers who value the service atmore than its marginal cost would not consume it. Private ownership of themonopoly would result in a market failure.

Would the government do a better job?Ideally, a government-owned natural

monopoly would set the price equal to the mar-ginal cost and finance the fixed costs throughtaxation. But the government may have littleincentive to reduce costs. The publicly ownedwater- or electricity-supply company may beunder pressure to overstaff the company withwell-paying jobs for politically connected indi-viduals. As a result, the costs may be higher.Wealthy individuals or firms may lobby the gov-ernment-owned monopoly to provide its serviceson favourable terms to special-interest groups.These outcomes of public ownership would be agovernment failure.

This case illustrates both the similarities anddifferences between the economicaccountability provided by the market and thepolitical accountability provided by ademocratic form of government. Both the ownersof the monopoly firm and the governmentdecision makers may act to further their own interests at the expense of theconsumer or citizen, but they would both operate within constraints. Themonopoly firm would not be free to charge whatever price it wished; itsprofits are limited by the demand curve. The government would not be

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market failure When marketsallocate resources in a Pareto-inefficient way.

entirely free to inflate the costs of provision by hiring or catering only to‘friends of the government’, because it may suffer an election defeat.

These two cases—private or government ownership of a naturalmonopoly—illustrate the problem of market failure (the monopolycharging more than the marginal cost) and what is sometimes called gov-ernment failure (the failure to minimize the cost of providing the service),and the problem of adopting policies in a real world in which neither issuecan be avoided entirely.

Which works better? There is no general answer to this question. Andthere are many choices besides private ownership or governmentownership, including private ownership under public regulation, or publicownership with competition among private firms for the time-limited rightto produce and price the service.

Viewing the government as an economic actor that pursues its objectivesbut is constrained by what is feasible, helps us clarify which factors caninfluence a government to be more of a problem solver, and less of aproblem.

EXERCISE 12.2 BUILDING SELF-CONTROL INTO GOVERNMENTJames Madison, a leading figure in the debates about the US Constitutionafter the formerly British colonies in the United States of America won itswar of independence, wrote in 1788:

‘In framing a government which is to be administered by men over men,the great difficulty lies in this: you must first enable the government tocontrol the governed; and in the next place oblige it to control itself.’

How does democracy (including the rule of law) address Madison’sconcerns to oblige the government to ‘control itself’?

EXERCISE 12.3 THE RELATIONSHIP BETWEEN ECONOMIC DEVELOPMENTAND SIZE OF GOVERNMENTUse Figure 12.2 (page 530) to help you answer the following questions:

1. Why was Pax Britannica a period of smaller government?2. Compare Figure 12.2 (page 530) with Figure 1.4 (page 9). Why do you

think the growth of the size of government coincides with both theemergence of capitalism as an economic system in the seventeenthand eighteenth centuries, and the increase in output per capita?

3. Compare two ‘peacetime’ periods—Pax Britannica and the period sincethe end of the Second World War. Why do you think the size of govern-ment was so much larger in the second period?

Andrei Shleifer. 1998. ‘State versusprivate ownership’(http://tinyco.re/4317440). Journalof Economic Perspectives 12 (4):pp. 133–150.

Alexander Hamilton, JamesMadison, and John Jay (1961). TheFederalist. Middletown, Ct.,Wesleyan University Press.

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political rent A payment or otherbenefit in excess of the individual’snext best alternative (reservationposition) that exists as a result ofthe individual’s political position.The reservation position in thiscase refers to the individual’s situ-ation were he or she to lack aprivileged political position. Seealso: economic rent.

QUESTION 12.3 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)In order to be able to deal effectively with cases of market failure,unfairness, and to discharge its other obligations, the state needs to besufficiently large and powerful. This means that the problem solver isalso big enough to be a potential problem. How is this paradox usuallyresolved?

the rule of lawconstitutional restrictionsinternational pressuredemocratic elections that give citizens the power to dismiss thegovernment

12.8 POLITICAL RENTS AND DEMOCRATIC POLITICALCOMPETITIONJust as competition disciplines firms in the economy by limiting the profitsthey can get by producing less and setting a price greater than marginalcost, competition to win elections is the way that a democracy disciplinesits politicians to provide the services desired by the public at a reasonablecost (in terms of taxes it raises to pay form them). In the ‘How economistslearn from data’ box below, we use evidence from the US to answer thequestion: ‘Does electoral competition affect policy?’ (page 537). There isalso evidence from other countries that the prospect of being removedfrom office affects what politicians do. The introduction of village-levelelections in China led to increased provision of local public services such ashealth services and schooling, and arguably a reduction in corruption.

Political rentsOur analogy between firms and governments suggests a similarity betweena dictator and a monopolist—neither faces much competition. But there areother similarities. Think about what a dictator can do. The examples abovefrom Russia, Ivory Coast, France and Romania show that the lack of com-petition allows the ruler to gain substantial income that would not bepossible were it not for his political position.

This income is called a political rent. It is political because it isassociated with a political position or connections. It is a rent in thesense already used many times in this course—a payment above andbeyond what the actor can get from his or her next best alternative. Thisis similar, for example, to the employment rents received by an employedworker. In the case of the worker, the next best alternative is consideredto be unemployment; for a member of the political elite, the next bestalternative is what the person would receive without a political positionor connections. In the case of the Russian oligarchs mentioned above,their political rents are the income they have received above and beyondwhat they would have had in the absence of any privileged connection tothe Russian government. In Figure 12.3 (page 536) we illustrate politicalrents by contrasting the effects of competition and the lack of competi-tion in the economy and in government.

Monica Martinez-Bravo, Gerard P.I. Miquel, Nancy Qian, and YangYao. 2014. ‘Political reform inChina: The effect of local elections’(http://tinyco.re/4667186). NBERworking paper, 18101.

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QUESTION 12.4 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)Why is the term ‘political rent’ used to describe the increases inpersonal wealth often enjoyed by dictators?

The income is derived from hiring out public property to privateindividuals.These are ‘excessive’ earnings resulting from the dictator’s politicalposition.Political rent is income that dictators earn from confiscating privateproperty and letting it to friends at preferable rates.‘Rent’ is a term used to describe any excessive level of income.

QUESTION 12.5 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)The magnificent chateaux in France’s Loire Valley, built between 1550and 1780, are a major tourist attraction. Many of them werecommissioned and built by finance ministers serving French kings ofthe period. How might this be explained in the context of this unit?

There was a lack of accountability.The king’s ministers were drawn from aristocratic French familieswho were generally very wealthy.Building a magnificent chateau was a way of confirming one’sstatus.The Loire valley was well provided with the essential materials forbuilding.

Varieties of politicaland economiccompetition

Source of rents or reasons for their absence Controls on politicalelites and firmowners

Power of the non-elite (citizens andconsumers)

Profits/rents

The extreme case oflimited politicalcompetition (adictator)

The dictator uses tax and other governmentrevenues as a source of personal income abovewhat he would receive as an ordinary citizen.

Limited threat ofremoval from office,e.g. revolutionaryoverthrow

Little Politicalrents > 0

The extreme case oflimited economiccompetition (amonopolist)

The monopolist restricts sales, charges pricesabove the average cost of production andreceives a profit greater than the opportunitycost of capital.

Limited threat ofmarket entry bycompeting firms

Little Economicprofits >0

‘Ideal democracy’ Rents are eliminated by competition amongpolitical parties and other freedoms such as afree press

Electoral loss iscertain if significantpolitical rents areextracted.

Exercised mainlythrough‘Voice’–vote forsomeone else

Politicalrents = 0

‘Perfect competition’among firms

Rents are eliminated by competition amongfirms

Zero sales (and firmfailure) if sets a pricehigher than averagecost.

Exercised mainlythrough ‘Exit’—buy fromsomeone else

Economicprofits =0

Figure 12.3 Political and economic rents under competition and monopoly.

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Timothy Besley and Anne Case.2014. Does ElectoralAccountability Affect EconomicPolicy Choices? Evidence fromGubernatorial Term Limits.Quarterly Journal of Economics110: pp. 769–798.

QUESTION 12.6 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)The role of the dictator can perhaps be compared to that of themonopolist, in that both earn rents that they try to protect, either byspending on police and security services (dictator) or by creatingbarriers to entry (monopolist). In what important respects do these rentseekers differ?

The dictator is looking to maximize benefits for himself, andpossibly for his family and various interest groups.The monopolist is a private firm and subject to governmentregulation, whereas the dictator is the government. The state isalways more powerful than an individual firm.Unlike the monopolist, the dictator seeks to maximize long-runrents by staying in office for as long as possible.Some of the barriers to entry used to protect monopoly rents (forexample, economies of scale, innovation) yield some economicbenefits. This not true for the dictatorship.

HOW ECONOMISTS LEARN FROM DATA

Does electoral competition affect policy?Think of a politician as wanting to stay in office and knowing that shemust satisfy a majority of voters when seeking re-election. But she alsohas her own objectives: to advance a particular project that she favours,or to maintain good relations with wealthy individuals who will supporther political campaigns or employ her when her political career is over.Does the threat of ‘give the voters what they want or get thrown out’lead her to emphasize the public’s interests, instead of her own?

Just comparing the policies adopted by politicians in districts thatare non-competitive (for example, there is no other candidate for theseat) with those who face electoral competition does not answer thequestion. The reason is that competitive and non-competitive polit-ical districts, and the politicians who represent them, are different inso many ways that the comparison would mix the effects of politicalcompetition with the effects of these other differences.

Tim Besley and Anne Case, two economists, devised an ingeniousway to answer the question. Some state governors in the US arelimited to two four-year terms of office. This means that, at the end oftheir first term, they face electoral competition when they ask votersto re-elect them. During their second term, the prospect of politicalcompetition does not affect them, because they are not allowed tostand for re-election.

Considered as an experiment, the ‘treatment’ is the prospect ofelectoral competition, the governors in their first terms are the‘treatment group’ and the same governors in their second terms arethe ‘control group’. As in any good experiment, other importantinfluences are held constant. We are measuring the same individuals,in the same districts, under a treatment and a control condition.

Besley and Case found that, during the governors’ first terms (thetreatment period), Republican and Democratic governorsimplemented virtually identical levels of total taxation per capita. But

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political institution The rules of thegame that determine who haspower and how it is exercised in asociety.

Democratic political competitionIn Unit 6 we explained that the firm is not only an actor, it is also a stage onwhich the various groups making up the firm also act, sometimes inconflict, sometimes in cooperation. The same can be said of governments.On the stage of government, politicians, political parties, soldiers, citizens,and bureaucrats interact according to the informal and formal rules thatconstitute political institutions.

The political institutions of a country are the rules of the game thatdetermine who has power and how it is exercised in a society. Democracy isa political institution, which means it is a set of rules that determine

• who makes up the government• the powers they can use when governing.

Political institutions differ from country to country and over time.Major categories of political institutions include democracy anddictatorship.

The key value motivating democracy is political equality. Citizensshould have substantially equal opportunities to be able to express theirviews in ways that can shape the policies and other activities of the gov-ernment. Recall that in Unit 1 we explained that we use the term‘democracy’ to refer to a form of government characterized by the rule oflaw, civil liberties, and inclusive, fair, and decisive election. Inclusivemeans that no major group—for example, women, ethnic minorities,those without property—can be excluded from the right to vote.

Democracy is sometimes advocated as a means to ‘let the people rule’,or in Abraham Lincoln’s words, a ‘government of the people, by thepeople and for the people.’ But who ‘the people’ are and what ‘the people’want is difficult to determine. Kenneth Arrow is the economist whocontributed most to our understanding of the problems that electionssometimes encounter in selecting between different courses of action.

during their second terms (the control period), Democratic Partygovernors, who tend to favour more public expenditure and taxation,implemented much higher levels of taxation than did the Republicans.Republican governors, when not facing political competition,implemented much lower levels of the state minimum wage.

Whether Democrat or Republican, governors faced with electoralcompetition in their first term implemented very similar policies tothose favoured by the ‘swing’ voters ,who tend to change who theyvote for, and so tend to decide many elections—lower taxes andhigher minimum wages. But the governors diverged according totheir own political preferences or economic interests when electoralcompetition was removed.

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Kenneth J. Arrow. 1978. ‘A cautiouscase for socialism’. Dissent 25 (4):pp. 472–480.

Steven Durlauf. 2017. ‘KennethArrow and the golden age of eco-nomic theory’. VoxEU.org. Updated8 April 2017.

There is by now a long and … imposing line of economists fromAdam Smith to the present who have sought to show that adecentralized economy motivated by self-interest and guided byprice signals would be compatible with a coherent disposition ofeconomic resources that could be regarded … as superior to alarge class of possible alternative dispositions. … It is important toknow not only whether it is true but whether it could be true.(original emphasis) (General Competitive Analysis, 1971)

No existing government fulfils the democratic ideal of political equality,with each citizen having equal influence over an outcome. Similarly, nogovernment today can be said to perfectly match the three political institu-tions that define democracy.

Think about inclusive elections. Some population groups—for example,those convicted of major crimes—are excluded from voting in many coun-tries, but we still consider the country’s political system as democratic.However, exclusion of a major population group—women, for example, aswas common in recent history—is a sufficiently serious violation of the‘inclusive elections’ criterion to disqualify a country from the club ofdemocratic nations.

GREAT ECONOMISTS

Kenneth ArrowKenneth Arrow (1921–2017) wasborn in New York City toRomanian American parents. Hisessay, ‘A cautious case forsocialism’, explains how the GreatDepression and the Second WorldWar influenced his ideas,especially those of ‘freedom andavoidance of war’.

Steven Durlauf’s essay,‘Kenneth Arrow and the goldenage of economic theory’, provides agood summary of KennethArrow’s explanation of the problems of using voting to determine whichaction is preferred, and his broader contributions to economics andsocial science.

In addition to his work on voting systems, Arrow was among the firstto demonstrate that there were conditions under which something likeAdam Smith’s ‘invisible hand’ would work. Characteristically scholarlyand detached from ideological rhetoric, he later wrote:

Arrow was a pioneer in the study of many of the themes in Economy,Society, and Public Policy, including asymmetric information and the eco-nomics of knowledge. He helped broaden the scope of economics toinclude insights from other disciplines.

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Albert O. Hirschman. 1970. Exit,Voice and Loyalty: Responses toDecline in Firms, Organizations andStates. Cambridge, MA: HarvardUniversity Press.

Some examples include:

• The US: The Voting Rights Act of 1965 secured the vote for largenumbers of effectively disenfranchised African American citizens. Theresult was a substantial shift in educational spending in districts withlarge numbers of previously excluded black voters.

• Brazil: In Brazil, before the mid-1990s, casting a valid ballot required thatvoters could read and write reasonably well (which perhaps a quarter ofthe population could not). Around 11% of ballots cast were declaredinvalid due to communication barriers, most of them cast by poor voters.New electronic voting introduced in 1996 used pictures of candidates, aninterface similar to phone keypads or ATM screens, and prompted thevoter through the process step by step. The effect was to increase thenumber of valid votes made by the poor. The resulting change in thenature of the electorate led elected political leaders to prioritize the kindsof spending predominantly benefiting the less well off. Expenditure onpublic health, for example, increased by more than a third.

Albert O. Hirschman, an unconventional economist, helped define how theperformance of entities such as firms and governments could be improvedby his concepts of ‘exit’ and ‘voice’, which we mentioned briefly in Figure12.3.

Thomas Fujiwara. 2015. ‘Votingtechnology, politicalresponsiveness and infant health:Evidence from Brazil’.Econometrica 83 (2): pp. 423–464.

GREAT ECONOMISTS

Albert O. HirschmanAlbert Hirschman (1915–2012)lived an extraordinary life. Born inBerlin in 1915, he fled to Paris in1933 after Adolf Hitler won powerin Germany and joined the FrenchResistance in 1939, helping manyartists and intellectuals to escapefrom the Nazis. He emigrated tothe US in 1941.

Given this history, it’s hardlysurprising that Hirschman’s careeras an economist did not follow aconventional path. He crosseddisciplinary boundaries with ease, grappled with questions that lay welloutside the professional mainstream, and developed ideas that wereimaginative, profound, and enduring.

Among Hirschman’s many influential contributions, he is best knownfor the thesis laid out in his 1970 book, Exit, Voice and Loyalty. He wasconcerned with how the performance of entities such as firms and gov-ernments could be improved.

He identified two forces—exit and voice—that could serve to alert anorganization that it was facing decline and provide incentives forrecovery. ‘Exit’ refers to the departure of a firm’s customers to acompetitor. And ‘voice’ refers to protest, the tendency of disappointedcustomers to ‘kick up a fuss’. When a company performs poorly or

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For further reading on AlbertHirschman, see this blog: RajivSethi. 2010. ‘The Astonishing Voiceof Albert Hirschman’(http://tinyco.re/2899363).Updated April 7 2010.

12.9 GOVERNMENT SPENDING PRIORITIES OF ANATIONJoseph Schumpeter (page 36) once wrote that the public budget is the‘skeleton of the state stripped of all misleading ideologies’. He argued thatthe way in which a government spends its money reveals its true priorities,much in the way that an individual’s spending pattern is a lens throughwhich to study his or her preferences.

As we have seen, before the twentieth century a major activity of gov-ernments was defence (in some cases, predation on other nations), andraising the taxation to support it. But well before that time, some rulinginstitutions came to understand that they would benefit from providingconditions for the growth of the economy—building canals, roads andschools in the nineteenth century, for example. Economic developmentcould be an asset by creating a larger tax base, educating a morescientifically oriented cadre of citizens, or by building financial institutionsthat could loan money to the government.

During the twentieth century, large-scale production in firms was easyfor the government to see and it happened in one place. This made taxationand regulation of firms easier, and governments could also use theaccounting books and payroll records of firms to find out who was paidwhat. This meant that taxing individuals became easier, too. Governmentsin many countries deducted tax directly from the pay of their citizens, andmany workers were taxed explicitly for ‘social security’, that is, to fundpensions and sometimes health care.

unethically, shareholders can sell their shares (exit) or campaign for achange of management (voice).

Hirschman observed that economists had traditionally extolled thevirtues of exit (competition), while neglecting the operation of voice.They favoured exit-based policies, for example, those that made it easierfor parents to choose which school their children attended so thatschools would have to compete to enrol students.

He considered this an omission, because voice could allow a lapse tobe reversed at little cost (in this example, parents who exercise theirvoice in meetings could usefully seek changes in school policies), whileexit might waste physical capital and human capabilities. Also, exit is notan option in some case—for example, tax administration—so the freeexercise of voice is critical to good performance.

The interplay between exit and voice works through a third factor,which Hirschman called loyalty. Attachment to an organization is apsychological barrier to desertion. By slowing exit, loyalty can createthe space needed for voice to do its work. But loyalty can hinderperformance if it becomes blind allegiance, because that stifles bothexit and voice. Organizations may promote loyalty for precisely thisreason. But if they were too effective at repressing exit and voice, theywould ‘deprive themselves of both recuperation mechanisms’.

Joseph Schumpeter. 1918. ‘Thecrisis of the tax state.’ Reproducedin Swedberg R. (ed.) 1991. JosephA. Schumpeter, The Economics andSociology of Capitalism. PrincetonUniversity Press.

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Figure 12.4 Patterns of public expenditure in Finland, the US, and South Korea(2013) measured as a percentage of total spending by government.

OECD. 2015. ‘Government at a Glance’(http://tinyco.re/2331814). This datasettakes data from OECD NationalAccounts Statistics (http://tinyco.re/9200122) and from Eurostat governmentfinance statistics (http://tinyco.re/4616738).

social insurance Expenditure bythe government, financed bytaxation, which provides protectionagainst various economic risks (forexample, loss of income due tosickness, or unemployment) andenables people to smooth incomesthroughout their lifetime. See also:co-insurance.

Changes in the structure of the economy also made it easier for govern-ments to levy taxes, not on a specific good—such as salt or imports—but alsoon consumption in general and ultimately on value added in production.These broad-based taxes play an important role in the public finances ofadvanced economies. With the extension of voting rights to virtually all adults,governments became accountable to their citizens for delivering services.

The historical processes of transition from political monopoly to polit-ical competition have produced most of the modern governments in theworld, with their distinctive patterns of spending.

Figure 12.4 shows how the democratic governments of the US, SouthKorea, and Finland spend their money.

The size of the government spending in Finland is 57.5% of its GDP, whichis the largest of the three countries. For the US, it is 38.8%. Note: this doesnot mean that the US spends less than Finland in absolute terms, just thatgovernment expenditure is a smaller fraction of the country’s GDP.Expenditure by South Korea’s government is 31.8% of its GDP.

This is what the categories mean:

• Public services: These include funds for running parliament, congress,local councils, also foreign aid and public debt transactions.

• Military: As previously stated, one of the motivations for governmenthas been for protection or to wage war.

• Economic affairs: This includes expenditures on infrastructure such asroads, bridges, and the Internet.

• Public order and safety: This includes police, fire, prison services, and lawcourts.

• Social protection: Social insurance spending that a government mightmake, such as unemployment benefits and pensions is labelled ‘Socialprotection’ in the figure.

Many governments are currentlyinvestigating whether theirsystems of taxation are efficientand fair. An example is the 2010Mirrlees Review (http://tinyco.re/6726989), which offered proposalsfor a comprehensive reform of theUK’s tax and transfer system,establishing the scope for betteraddressing market failures andunfairness.

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• Schooling: All governments are responsible for at least some educationprovision.

• Health: This includes medical equipment, hospital and outpatientservices, and public health.

There are many reasons why governments differ in their spending patterns.One reason is that political institutions differ, even among democracies.

EXERCISE 12.4 PAST INFLUENCES ON CURRENT GOVERNMENTSPENDING PATTERNS1. How would you characterize the two biggest differences in the spend-

ing patterns among the three pairs of countries (the US vs South Korea,the US vs Finland, and Finland vs South Korea)?

2. Can you think of factors in the countries and their histories that mightaccount for these differences? You need to do some research tosupport your claims.

EXERCISE 12.5 USING EXCEL: COMPARING GOVERNMENTEXPENDITURESGo to the source of Figure 12.4, OECD statistics (http://tinyco.re/2331814),and see if you can find different countries for each of the criteria below(for the year 2015, or the most recent year available). For each of yourchosen countries, plot a stacked column chart similar to Figure 12.4.

• General government expenditure (as a percentage of GDP) is greaterthan South Korea’s, but less than Finland’s.

• Government expenditure on health (as a percentage of GDP) is greaterthan the US’s.

• Government expenditure on social protection (as a percentage of GDP)is greater than Finland’s.

• Government expenditure on defence (as a percentage of GDP) isgreater than South Korea’s.

A puzzle: Persistence of unfairness and market failuresIt is clear that even governments considered to be ‘small’ in spending relativeto their economy—South Korea and the US in the above figure—control vasteconomic resources that could be used in pursuit of both efficiency andfairness. But previous units have revealed many cases in which economic out-comes are Pareto inefficient, so potential mutual gains remain unrealized.These seem like potentially ‘win–win’ situations that those engaged in polit-ical competition—aspiring electoral candidates or political parties, forexample—would energetically exploit. Yet the problems persist.

We know that citizens in many countries think the distribution ofwealth or income is unfair. In 2005 in the US, for example, bothRepublicans and Democrats, both rich and poor, when asked said that thepoorest 80% of the wealth distribution should receive at least three timesthe wealth that they then had received (https://tinyco.re/5232349). Morerecently, changes in US tax policy have favoured the wealthy, not thebottom 80%.

This is a puzzle.

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economically feasible Policies forwhich the desired outcomes are aNash equilibrium, so that onceimplemented private economicactors will not undo the desiredeffects.

administratively feasible Policiesfor which the government hassufficient information and staff forimplementation.

politically feasible Capable ofbeing implemented given theexisting political institutions.

12.10 ECONOMIC FEASIBILITYTo make sense of this puzzle, we must think about the feasibility of the poli-cies that a government might adopt. Fixing some problem of Paretoinefficiency or perceived unfairness will happen only if:

• It is economically feasible: The policy to fix the problem, if implemented,must work.

• It is administratively feasible: The government must have the capacityto implement the policy.

• It is politically feasible: Those who determine which policies areimplemented—both officials and private interests—must want to see thepolicy implemented and, if they do implement the policies, they orothers supporting the policy must remain in office.

We take up these three problems in turn, starting with economicfeasibility.

Given people’s preferences and the information available to private eco-nomic actors, there may not be a feasible set of policies that would sustainan efficient and fair outcome. For a policy to have economic feasibility, itmust be a Nash equilibrium, which means no actor can improve its positionby changing its behaviour.

In Section 3.8 (page 140) we showed that a government’s policy to raisethe tax rate for the rich to be able better to provide needed services to low-income families might be less effective than expected if the high tax ratesmake it cost effective for the wealthy to engage in tax evasion.

To take another example, a government that tries to enforce perfectcompetition in every industry will fail. Since firms are free to advertise, andto differentiate their products, it is impossible for the policymaker tolegislate that demand curves be horizontal.

We have also seen that no macroeconomic policy can entirely eliminateunemployment, given that the threat of unemployment motivates people towork hard and well.

Economic feasibility: An example from ChileThe model of tax evasion in Unit 3 is a simplification, but it helps us under-stand real economic forces operating in the world. The experience of Chileprovides such an example.

In 1970, the socialist Salvador Allende was elected president of Chile ina surprise victory, on a platform promising greater public services andnationalization of many of the privately held firms in the country.

To interpret the data in Figure 12.5, notice the vertical line that marksthe day before the election. The series for share prices dropped dramaticallythe next day. The fall in share prices indicates a major sell-off of shares inChilean companies as soon as the news arrived. This tells us that the victoryof Allende was a surprise. Had his victory been anticipated, the stockmarket would have fallen before the election.

A stock (or share) is a share in the ownership of a company; its pricemeasures how much it is worth to own part of that company and as a resultreceive a share of its profits, and benefit in the future from selling it toanother person.

Share prices rise when, taking everything into account, owners orpotential buyers of shares think that the company will be more profitable in

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the future. When a socialist president was elected in Chile, wealthy peoplewere worried about:

• higher taxes• policies favouring employees that would mean paying them higher

wages• and the possibility that the government or even workers might

expropriate (take over the ownership of) the assets of private firms.

In turn, these worries created a limit to the policies that would prove eco-nomically feasible for the Allende government. If the wealthy thought thatthe firms they owned would be less profitable in the future, they wouldhave no incentive to invest in increasing the assets of the firm. Rather thaninvest in these firms, these people might instead invest in another country(known as capital flight), in housing, or in other Chilean assets more likelyto be valuable in the future.

The result was poor economic performance of the Chilean economy. Wewill return to the Chile story a bit later, when we will see that politicalinterests, as well as economic infeasibility, can limit what a democraticallyelected government can do.

QUESTION 12.7 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)What is meant by economic feasibility?

Policies that solve the problem must be possibleto implement in practice.For a policy to have economic feasibility, it mustproduce a Nash equilibrium and sustain a fair andefficient outcome.

Policies that would solve the problem and arepolitically acceptable.Must be able to make someone better off withoutmaking anyone else worse off.

Figure 12.5 Stock market prices in Chile: The election of a socialist president, 1970.

Proprietary data from the Santiago stockmarket. Time zero is the first trading dayon the Santiago stock market followingthe election. Daniele Girardi and SamuelBowles. 2017. ‘Institutional Shocks andEconomic Outcomes: Allende’s Election,Pinochet’s Coup and the Santiago StockMarket’. Journal of Development Eco-nomics.

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fiscal capacity The ability of a gov-ernment to impose and collectsubstantial taxes from a populationat low administrative and othercosts. One measure of this is theamount collected divided by thecost of administering the taxsystem.

12.11 ADMINISTRATIVE FEASIBILITY: INFORMATIONAND CAPACITIESEven if there exists an economically feasible set of policies that wouldaddress market failures, in order to design and implement these policies,the government needs:

• information about the nature of the uncompensated external effects thataccount for the market failure

• the administrative and fiscal capacity to design and implementeffective policies.

As we have seen, the magic of the market means that, as long as pricesreflect social marginal costs, the information required to direct resourcesto more highly valued rather than less highly valued uses arises as a by-product of people’s everyday transactions.

Contrast this with the case of a citizen attempting to get a remedythrough the courts for an environmental market failure. If the citizensuffering from a respiratory illness could bring a lawsuit against thepolluting firm that caused it, and secure compensation for the costs ofhis illness, then this might ‘internalize’ the external costs of the polluter’sactions, leading to more effective abatement efforts. But in most cases,this cannot be done because the citizen does not have the necessaryinformation about who is polluting, or cannot afford the legal and othercosts of pursuing the case.

Governments have limited informationMarket failures arise because essential information is not available tobuyers, sellers, and other private economic actors. But this informationis not likely to be available to the government either, limiting its abilityto design policies that address environmental market failures. Govern-ments often do not know how much citizens value environmentalquality, or how effective environmental policies will be in ensuring asustainable environment. If prices are sending the wrong messages, andif the government is to correct them through the implementation oftaxes, subsidies, or regulation, it must find ways of collecting thenecessary information to design those interventions.

Limited information is not the only factor limiting theadministrative feasibility of policies to remedy market failures.

Limited fiscal capacitiesTo levy taxes effectively and collect the revenue, governments needrevenue officers who are competent, not corrupt, with sufficientresources to find and punish tax evaders, and with enough legitimacy toensure that most people pay their taxes.

Administrative capacity is required for many different kinds of taxes,from trade tariffs enforced at the border, to payroll taxes levied onwages, and to corporate income taxes charged on legally incorporatedeconomic entities. The use of accounting books in large firms makes iteasier to audit firms and accurately assess their tax bill. But this alsodepends on the technology and institutions available. International flowsof difficult-to-track financial obligations make illegal tax evasion, andlegal tax avoidance (for example, by moving profits to international tax

Timothy Besley and TorstenPersson. 2014.‘Why do developingcountries tax so little?’. TheJournal of EconomicPerspectives 28 (4): pp. 99–120.

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Imran Rasul and Daniel Rogger.2016. ‘Management of bureaucratsand public service delivery:Evidence from the Nigerian civilservice.’ The Economic Journal.

havens), a problem for governments who want to collect tax. This lowerstheir fiscal capacity.

Lack of administrative capacity affects all aspects of government, notjust taxes. An educational reform, for example, requiring teachers toabandon rote-learning methods and engage in more active student-centred learning may simply be impossible to implement, given the skillsof the current teaching force.

HOW ECONOMISTS LEARN FROM DATA

Administrative infeasibility: An application from NigeriaA lack of information about the progress of infrastructure projectsfunded by the government, and a poorly functioning and corruptadministration, resulted in poor outcomes in Nigeria.

In 2006–2007, the public sector was given funding and maderesponsible for implementing 4,700 small-scale infrastructureprojects like installing water wells, constructing dams, and buildinghealth centres. Just 31% of the projects were completed and 38% werenot even started. For example, the funding was paid for 1,348 waterwells, but 846 were never completed, leaving hundreds of thousandsof people without improved access to water.

Economists Imran Rasul and Daniel Rogger wanted to find outwhy some organizations succeeded in completing projects onschedule and budget, while others did not. They could do theirresearch because the Nigerian government had collected informationfrom independent teams of engineers about the quantity and qualityof completed projects. Accurate information of this kind fromindependent observers on the quantity and quality of public servicesis very rare for a low-income country.

Rasul and Rogger found that ‘getting things done’ by public sectororganizations is affected by how the organizations are managed. Theywere surprised to discover that using performance incentives, withwhich managers were rewarded for good performance as measured bythe organization (not by independent assessors), was correlated withlower completion rates. In organizations where officials had greaterautonomy in making decisions—not in response to performanceincentives—outcomes were better.

While financial incentives can play a positive role in motivatinggovernment officials, the Nigerian case shows that, if it is difficult tocollect and verify information, trying to attach simple performanceincentives to complex tasks may backfire. If there is poor informa-tion, then it may be better to give organizations greater autonomy. Inthis case, officials given autonomy observed social norms ofresponsibility, and completion rates were higher.

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principal–agent relationship This isan asymmetrical relationship inwhich one party (the principal)benefits from some action orattribute of the other party (theagent) about which the principal’sinformation is not sufficient toenforce in a complete contract. Seealso: incomplete contract. Alsoknown as: principal–agent problem.

12.12 POLITICAL FEASIBILITYIn a democracy, it is often said that ideally the government is the servant ofthe people. In economic terms, government officials are the agents and thecitizens are the principals. But this immediately raises two questions:

• Why would the agent (the elected official) do what the principals (the citizens)desire? As in any principal–agent relationship, the agent has his or herown objectives, and they differ from the principal’s objectives. We sawthat, although political competition can help, the problem does notdisappear in a democracy.

• Who are ‘the people’? In economic terms, who is (or are) the principal(s)?Until now the principal has been the lender or the employer, which wecould simplify by representing as a single individual. But there are manycitizen-principals and they have differing priorities for what the govern-ment should do, for example, abatement of pollution, schoolimprovement, policies to boost innovation, tax-funded transfers to thepoor, and so on.

Think about the first problem—motivating the elected official to do whatthe citizens prefer—as a principal–agent problem, like the employer tryingto motivate a worker to contribute to the profits of the firm. What are thepossible solutions when the manager tries to motivate workers? Themanager could:

• Pay the agent an economic rent: She will fear losing it if she does anunsatisfactory job.

• Monitor the work activity of the employee: To detect signs of inadequatework.

• Replace the worker with another worker: If the work is found to beunsatisfactory.

In a democracy, elected officials are held accountable to the electorate by asimilar set of strategies:

• Give the official a sufficient salary, prestige, and other amenities of office: Theofficial would then like to keep the job.

• Monitor the activities of the government: Determine the quality of the gov-ernment’s performance using legal principles of transparency andjudicial review, along with a free press and free speech.

• Hold periodic elections: A government that has not performed well in thecitizens’ eyes is replaced by a different set of political leaders.

But these methods—while essential components of a democratic society—sometimes work imperfectly, if at all. There are many reasons. But one isthat citizens or groups that can amass substantial wealth for the purposes ofinfluencing the government have extraordinary political influence even in ademocracy.

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Joshua L. Kalla and David E.Broockman. (2015). ‘Campaigncontributions facilitate access tocongressional officials: Arandomized fieldexperiment’. American Journal ofPolitical Science 60 (3): pp. 1–14.

It seems that democracy alonecannot reverse rising inequality:Adam Bonica, Nolan McCarty,Keith T. Poole, and HowardRosenthal. 2013. ‘Why hasn’tdemocracy slowed rising inequal-ity?’ (http://tinyco.re/7031342) TheJournal of Economic Perspectives27 (3): pp. 103–123.

Elites and organized groups seemto have much more influence onpolicy than average citizens:Martin Gilens and Benjamin I.Page. 2014. ‘Testing theories ofAmerican politics: Elites, interestgroups, and average citizens’(http://tinyco.re/7911085). Perspectives on politics12 (03): pp. 564–581.

HOW ECONOMISTS (AND POLITICAL SCIENTISTS) LEARN FROMDATA

Does money talk?In the US, people often say ‘money talks’. Many are concerned that ittalks particularly loudly when it comes to politics.

To some, it is obvious that, when a candidate for political officereceives a large contribution for his electoral campaign from a businessor a trade union, the candidate is more likely to use political power toinfluence policy in favour of the contributor.

Research by Joshua Kalla and David Broockman, two politicalscientists, shows that election campaigns for the US congress in 2012spent on average $8.5 million per congressional seat. But did thewinners provide favours for the donors that would not have occurredwithout the donors’ contributions? We might ask if the members ofcongress who received contributions from those with investments inthe oil industry tended to favour the interests of those firmsafterwards. Or did those receiving funds from trade union memberssupport an agenda that favoured the union’s interests? The answer inboth cases would be that they did.

But this does not demonstrate that donor contributions purchasedinfluence over the legislator. Remember, causation can work both ways;those with oil wealth are likely to donate to candidates who alreadyfavour that industry’s interests; trade union members will donate moneyto those who already support the interests of trade unions. Simplyshowing a correlation between the source of the funding and the policiessupported by the legislator does not show that the contributions causedthe legislator to act differently.

Kalla and Brockman designed a clever experiment to see if thedonation caused the congress member to behave in the donor’sinterest. They reasoned that citizens could influence legislators bymeeting with them and expressing their views. Members of congressare busy people, so gaining access to them for a meeting is somethingthat groups compete for.

Kalla and Brockman wanted to find out if those who gave moneyto a congress member were more likely to be granted a meeting.With the cooperation of a (real) interest group Credo Action(http://tinyco.re/3459944), they contacted 191 members ofcongress to ask for a meeting. All the constituents making thisrequest had contributed some funds to the member’s campaign. Thecontrol group, randomly chosen, and half of the total sample, saidonly that they were residents of the member’s district. Thetreatment group also identified themselves as donors. All callers inboth groups read from a script, so the requests for a meeting wereotherwise identical.

Among those not identified as donors, 2.4% gained a meeting witheither the congress member or the chief of staff. For those identified asdonors, 12.5% got a meeting.

The authors concluded “The vast majority of Americans whocannot afford to contribute to campaigns in meaningful amounts are ata disadvantage when attempting to express their concerns to policymakers.”

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Political feasibility: The story of Chile continuedWhat happened after the election of Allende in Chile in 1970 tells a storynot only of economic limits to feasible policies, but also of political limits.

Amid faltering economic performance, due in part to potential investorsholding back on investment in Chile, opposition to President Allende’s gov-ernment mounted, some of it supported in secret by the US government. In1973, the Chilean armed forces attacked the presidential palace, defeatingtroops loyal to Allende. They took over the government, ending democracyand replacing Allende with General Augusto Pinochet, who ruled as adictator—without the democratic constraints of elections and individualpolitical rights—for the next 17 years.

The wealthy anticipated that Pinochet would introduce pro-businesspolicies, so stock prices rose again (Figure 12.6). The Pinochet dictatorshipwould remain until a constitutional referendum in 1988 demanded a returnto democracy, which the armed forces respected.

Allende’s economic program was infeasible for two reasons:

• It was economically infeasible: He could not force private firms to invest inChile, and without their investment the economy would stagnate oreven shrink.

• It was politically infeasible: Though democratically elected, he did notcontrol the Chilean armed forces that, with the support of businessesand the US Central Intelligence Agency, turned against him.

Figure 12.6 Stock market prices in Chile: The military overthrow of the socialistgovernment, 1973. (Note: Time zero is the first trading day on the Santiago stockmarket following the military takeover.)

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12.13 POLICY MATTERS AND ECONOMICS WORKSIn this unit, you have learned that Adam Smith’s reasoning about the menon the chessboard can now be expressed in economic terms by saying that,for a policy to improve an outcome, it must change the current Nash equi-librium to a different and preferable one (economic feasibility). And it alsomust be favoured by a governing elite with the authority and capacity toimplement it (political and administrative feasibility).

The limits posed by special interests, as well as economic andadministrative feasibility, explain why governments often do notsuccessfully address the problems of market failure and unfairness that wehave encountered throughout this course. Looking at the different eco-nomies of the world, however, you see substantial differences in the extentto which these problems are effectively addressed. As a result, the limitsposed by economic, political, and administrative feasibility differsubstantially among countries.

Policies differ across countriesTo see this, we return to the problem of climate change introduced in Section2.10. In Figure 12.7 we can see that Sweden, Australia and the US have roughlythe same per capita income. If they all faced similar constraints of economic,administrative, and political feasibility in adopting policies to limit greenhousegas impacts on climate, then we might expect to see their similarity in incomematched by similarity in CO₂ emissions per capita.

But this is not at all what we see in the figure. The US and Australia emitabout three times as much per capita as Sweden. It seems likely that what iseconomically feasible may not differ very much in these three countries, asall share the same knowledge about technologies, and their citizens arelikely to respond in similar ways to incentives to adopt cleaner energysources. The government information and capacities in the three countriesare also similar—all have well-informed and capable governments.

Figure 12.7 Carbon dioxide emissions are greater in richer countries, but countriesof the same level of income differ greatly in how much they emit.

The World Bank. 2015. ‘WorldDevelopment Indicators.’ Note: Threesmall very high-income countries(Kuwait, Luxembourg, and Qatar) are notshown.

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Although carbon dioxide emissions are affected by industrial structureand trade specialization, they are also affected by what is desired by theelites, who have political influence. Policies to address climate change aremore likely to have political support in Sweden than in Australia and theUS. One reason for this difference is the importance in US and Australianpolitics of lobbies representing the natural resource industries, includingthe gas, oil, and coal producers.

A similar contrast appears when we look at inequality, shown in Figure12.8. Germany and the US have both experienced about the same rate ofgrowth in GDP per capita over the past four decades, but they differmarkedly in inequality of living standards, as can be seen by the muchhigher Gini coefficient for disposable income in the US. The comparisonfor the measure of intergenerational inequality is similar. Denmark,Sweden, and Finland are more equal by this measure than even Germany.

Many things could account for these differences. They are, at least inpart, due to the greater political influence in Germany than in the US, ofthose who value sustaining a higher living standard for the least well off.

What can we learn from the comparisons in Figure 12.8 showing thathigh income countries with a similar growth in GDP per capita do notnecessarily have similar levels of inequality.

Lessons from the experiences of different countriesOne lesson, if we wish to address problems like climate change and unfairinequalities in living standards, is that for most countries it is possible to doa lot more than is currently being done. The fundamental forcescontributing to inequality in the high-income countries—new technologiesand growing imports (from China, for example) that make the skills of low-paid workers redundant—do not differ much among the high-incomecountries in Figure 12.8. The differences appear to be a matter of choicesamong the similar set of policies that are economically and administrativelyfeasible, some countries opting for policies that sustain high levels ofinequality, and others pursuing the goal of greater equality.

Figure 12.8 Greater equality in disposable income is not associated with slowergrowth in average income.

Chen Wang and Koen Caminada.2011. ‘Leiden Budget Incidence FiscalRedistribution Dataset’. Version 1.Leiden Department of EconomicsResearch.

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In our ‘Economist in action’ video,James Heckman, a Nobel-prize-winning economist from theUniversity of Chicago and a leaderin this research, explores thequestion of how schooling andpreschool experience affectsinequality. http://tinyco.re/3964341

We also have a lot to learn from the top performers in these and similarfigures, by studying the policies and institutions that appear to account fortheir success in addressing market failures and unfairness.

Not all policies and institutions that are effective in one country can betransferred to another. For example, a comparison between the innovationsystems in Silicon Valley and in Germany in Section 21.2 (https://tinyco.re/2640737) of The Economy shows how different combinations of innovatingfirms, government policies, financial institutions, and social norms in thesetwo regions produce effective solutions to the market failures associated withknowledge production. Neither would be easily adopted in the other country.

Schooling and inequalitySome countries have school systems that teach much more effectively thanothers. Because educational policies differ greatly among countries, we canget some idea of the importance of good policy by looking at differencesamong nations in performance on a mathematics test administered to15-year-old students around the world.

Using the OECD data, let’s compare two countries that are ethnicallydiverse and have about the same per capita income: the US and Singapore.The average maths score in Singapore was 20% higher than in the US. Evenmore striking, the student whose score placed him or her in the middle ofthe US students (the student with the median score) would have been in thebottom quarter of Singapore’s students. A similar comparison would placethe median American student in the bottom quarter of Japanese students,and just above the bottom quarter of Finland’s students.

Economic research has explored the question of how schooling andpreschool experience affects inequality. In our ‘Economist in action’ video,James Heckman shows how economists can learn from experiments andother data about how to level the playing field for children growing uppoor. You may also want to read his book Giving kids a fair chance.

His book begins by noting that: ‘The accident of birth is a principalsource of inequality in America today. American society is dividing intoskilled and unskilled … birth is becoming fate.’

Heckman’s ‘strategy that works’ to address this problem is based on thefollowing logic. ‘Both cognitive and socio-emotional skills develop in earlychildhood and their development depends on family environment.’Growing up poor deprives children of opportunities to develop these skills,and ‘family environments in the US have deteriorated’.

In response, Heckman advocates ‘early interventions’, such as enrichedpreschool environments and home visits by professionals to assist parents,which his research shows can ‘produce positive and lasting effects onchildren in disadvantaged families.’

Policies of the kind advocated by Heckman are being implemented inseveral countries, including Colombia, Jamaica, Chile, and in the state ofOrissa in India. Teams of economists and experts in child development arerigorously evaluating them (http://tinyco.re/2744426) for their longer-term effects and to assess the feasibility of scaling them up from small pilotinterventions.

We know that the kids of poor parents often grow up to be poor. Wenow also know that this has little to do with genetics, and more to do withthe socio-emotional behaviour associated with growing up poor. We nowknow of, and governments can implement, effective policy remedies tobreak this cycle of poverty.

You can access the data from atest at the OECD’s Programme forInternational Student Assessment(http://tinyco.re/1018246).

James J. Heckman. 2013. GivingKids a Fair Chance. Cambridge, MA:MIT Press.

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QUESTION 12.8 CHOOSE THE CORRECT ANSWER(S)CHOOSE THE CORRECT ANSWER(S)Watch the ‘Economist in action’ video (http://tinyco.re/3964341) ofJames Heckman. According to Heckman, which of the following indi-vidual attributes are NOT among the reasons for persistent poverty ina family from generation to generation?

inherited IQlimited schoolingracesocial behaviour

Politics matters and economics worksHarold Lasswell, a prominent mid-twentieth-century American politicalscientist, is best known for his book, Politics: Who gets what, when and how(http://tinyco.re/2227728). The title captures a basic point of this unit.Politics is all about:

• Who gets what.• Who gets to be what.• Who gets to do what.

The reason is that political processes determine the rules of the game—thebasic institutions that govern how we interact in the economy and otherarenas of our society.

But politics is not simply about dividing up a pie, with the powerfulgetting the larger slice and the struggle for power sometimes resulting in asmaller pie. Well-designed government policies are also able to increase thesize of the pie, improving living standards for the vast majority of people.Examples that you have already seen include the economic policies of thegovernment of China, which since the 1980s resulted in the most rapideradication of large-scale poverty ever witnessed in human history.Another example was the clean water and sanitation policies that werebehind the global reduction in child mortality.

12.14 CONCLUSIONGovernments and markets are two major economic institutions today, andthey exist because they can better organize some economic activitiescompared to other major institutions (firms and families).

Markets can allow large numbers of people to interact in mutuallybeneficial trades, relying on prices to convey information rather thancentralized planning or coordination. However, markets are not ideal in thecases of repugnant markets or merit goods, and even for goods wheremarkets are acceptable, market failures are common. Therefore, we needgovernments to produce and distribute some types of goods and to helpaddress unfairness or inefficiencies resulting from market failure.

A government is distinct from other economic actors because it has theauthority to act on behalf of all people within a given territory and torequire citizens to abide by its decisions. These powers allow the govern-ment to be a successful problem solver, but also to become a problem itself.There are many examples in which governments were more concernedwith earning political rents than serving the interests of their citizens.

Harold D. Lasswell. 1936. Politics;who gets what, when and how.New York: Whittlesey House.

‘Sound economic policy should bebased on a careful analysis ofpolitical economy’: DaronAcemoglu and James A. Robinson.2013. ‘Economics versus politics:Pitfalls of policy advice’(http://tinyco.re/5915146). TheJournal of EconomicPerspectives 27 (2): pp. 173–192.

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In well-governed societies, democracy is a political institution thatgives citizens the power to dismiss the government. This politicalaccountability constrains what governments can do to further theirprivate interests. Still, the principal–agent relationship between gov-ernment officials and the citizens that exists because of differences inobjectives means that some policies are not politically feasible.

Besides political feasibility, governments may fail to adopt policiesthat solve society’s problems for two reasons. First, the policy may not beeconomically feasible, meaning that an efficient and fair outcome isnot a Nash equilibrium. Second, the policy may not be administrativelyfeasible, meaning that it is impossible for the government to implementit in practice, given the information available and its fiscal capacity.The extent to which governments can address problems of unfairnessand inefficiency depends on the limits posed by economic, political, andadministrative feasibility.

repugnant market The exchange of some thing (such asinfants, organs or sex) that many people find morallyoffensive.merit goods Goods and services that should be available toeveryone, independently of their ability to pay.market failure When markets allocate resources in a Pareto-inefficient way.government Within a given territory, the only body that candictate what people must do or not do, and can legitimatelyuse force and restraints on an individual’s freedom to achievethat end. Also known as: state.political rent A payment or other benefit in excess of theindividual’s next best alternative (reservation position) thatexists as a result of the individual’s political position. Thereservation position in this case refers to the individual’s situ-ation were he or she to lack a privileged political position.See also: economic rent.political institution The rules of the game that determinewho has power and how it is exercised in a society.political accountability Accountability achieved by politicalprocesses such as elections, oversight by an elected govern-

ment, or consultation with affected citizens. See also:accountability, economic accountability.principal–agent relationship This is an asymmetrical rela-tionship in which one party (the principal) benefits from someaction or attribute of the other party (the agent) about whichthe principal’s information is not sufficient to enforce in acomplete contract. See also: incomplete contract. Also knownas: principal–agent problem.politically feasible Capable of being implemented given theexisting political institutions.economically feasible Policies for which the desired out-comes are a Nash equilibrium, so that once implementedprivate economic actors will not undo the desired effects.administratively feasible Policies for which the governmenthas sufficient information and staff for implementation.fiscal capacity The ability of a government to impose andcollect substantial taxes from a population at lowadministrative and other costs. One measure of this is theamount collected divided by the cost of administering the taxsystem.

12.15 DOING ECONOMICS: GOVERNMENT POLICIESAND POPULARITY: HONG KONG CASH HANDOUTIn Sections 12.9–12.13, we looked at government spending priorities in dif-ferent countries, and discussed how economic, administrative, and politicalfeasibility influence government policy decisions.

An important role of the government is to use tax funds to provide goodsand services for its citizens. When governments have a budget surplus (taxesexceed government spending), they may choose to increase spending on publicprograms or improve the goods and services provided to their citizens.

In Doing Economics Empirical Project 12, we will look at an unconventionalpolicy adopted by the Hong Kong Government in 2011, which was to simplygive a lump sum to every citizen aged 18 or above. We will assess the effectsthat this policy could have on inequality, and discuss some reasons why gov-ernments may choose this policy over other redistributive policies.

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Go to Doing Economics Empirical Project 12 (https://tinyco.re/7482053)to work on this project.

Learning objectivesIn this project you will:

• draw Lorenz curves• assess the effect of a policy on income inequality• convert cells from text to number format• convert nominal values to real values (extension).

12.16 REFERENCESArrow, Kenneth J. 1978. ‘A cautious case for socialism’ (http://tinyco.re/

3618241). Dissent 25 (4): pp. 472–480.Bakija, Jon, Lane Kenworthy, Peter Lindert, and Jeff Madrick. 2016. How Big

Should Our Government Be? Berkeley: University of California Press.Besley, Timothy, and Anne Case. 1995. ‘Does electoral accountability affect

economic policy choices? Evidence from gubernatorial term limits’.The Quarterly Journal of Economics 110 (3): pp. 769–798.

Besley, Timothy, and Torsten Persson. 2014. ‘Why do developing countriestax so little?’ (http://tinyco.re/3513621). The Journal of EconomicPerspectives 28 (4): pp. 99–120.

Durlauf, Stephen. 2017. ‘Kenneth Arrow and the golden age of economictheory’ (http://tinyco.re/9029504). VoxEU.org. Updated 8 April 2017.

Farnie, Douglas A. 1979. The English Cotton Industry and the World Market1815-1896. Oxford: Clarendon Press.

Fujiwara, Thomas. 2015. ‘Voting technology, political responsiveness andinfant health: Evidence from Brazil’ (http://tinyco.re/3783631).Econometrica 83 (2): pp. 423–464.

Hamilton, Alexander, James Madison, and John Jay. 1961. The Federalist.Middletown, Ct. Wesleyan University Press.

Hayek, Friedrich A. 1948. Individualism and Economic Order(http://tinyco.re/3958172). University of Chicago Press.

Hayek, Friedrich A. 1994. The Road to Serfdom (http://tinyco.re/0683881).Chicago, Il: University of Chicago Press.

Heckman, James. 2013. Giving Kids a Fair Chance: A Strategy That Works.Cambridge, MA: MIT Press.

Hirschman, Albert O. 1970. Exit, voice, and loyalty: Responses to decline infirms, organizations, and states. Cambridge, Mass: Harvard UniversityPress.

Kalla, Joshua L., and David E. Broockman. 2015. ‘Campaign contributionsfacilitate access to congressional officials: A randomized fieldexperiment’ (http://tinyco.re/5765353). American Journal of PoliticalScience 60 (3): pp. 1–14.

Lasswell, Harold D. 1936. Politics; who gets what, when and how(http://tinyco.re/2227728). New York: Whittlesey House.

Lindert, Peter. 2004. Growing Public: Social Spending and Economic Growthsince the 18th Century. Cambridge: Cambridge University Press.

Rasul, Imran, and Daniel Rogger. 2016. ‘Management of bureaucrats andpublic service delivery: Evidence from the Nigerian civil service’(http://tinyco.re/1535739). The Economic Journal.

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Roth, Alvin E. 2007. ‘Repugnance as a Constraint on Markets’(http://tinyco.re/2118641). Journal of Economic Perspectives 21 (3):pp. 37–58.

Schumpeter, Joseph. 1918. ‘The crisis of the tax state’. Reproduced inSwedberg R. (ed.) 1991. Joseph A. Schumpeter, The Economics andSociology of Capitalism. Princeton University Press.

Schumpeter, Joseph. (1943) 2003. Capitalism, Socialism and Democracy(https://tinyco.re/4075703). pp. 167—172. Routledge.

Smith, Adam. (1776) 2003. An Inquiry into the Nature and Causes of theWealth of Nations. New York, NY: Random House Publishing Group.

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