What is the role for government?

There are some fundamental misunderstandings about what the role of government is and why government does some of the things it does.  For example, some folks think that the government is supposed to be “fair.”  Fair has nothing to do with it. Not that the government is actively trying to be anti-fair (unless you’re a conspiracy theorist)… It’s just that fair would be incredibly expensive and would result in crazy tax rates and all sorts of negative unintended consequences from messing with the free market.

Roles for government are:

1. Fixing adverse selection problems. This is when there’s imperfect information and one side has information and the other side doesn’t. This causes things like insurance companies not wanting to sell insurance because only sick people will be willing to buy it. But if everybody were forced to have insurance, then the cost of insurance would go down and both insurance companies and people are better off on average. Mandated workers compensation is an example of this– companies and workers are happier that everyone has it, and workers in risky occupations are willing to pay for it in terms of lower wages. (We discussed this concept in terms of the used car market in this post.)

2. Fixing moral hazard problems. Sometimes when something is offered, it causes negative behavior from people trying to legally game the system. Bank regulation might be an example of fixing this problem. Sadly, sometimes fixing an adverse selection problem causes a moral hazard problem! People may be less careful about workplace accidents if they know they have worker’s comp (though because of regulation, companies have gotten empirically MORE careful about safety in the workplace).

3. Discouraging negative externalities and encouraging positive externalities.  Externalities are negative or positive indirect effects.  The canonical example of a negative externality is pollution; pollution hurts more than just the polluter.  The government can regulate pollution in many ways, but even the most market-based solution requires the government to set property rights. Property rights have many other positive externalities as well, as they enable the market to do business, encourage research in the form of patents and so on.

4. Preventing monopoly. If you’ve ever taken an econ 101 class, you probably covered this and vaguely remember something about a big deadweight loss.  Some monopolies aren’t natural monopolies, but businesses with market power use shady tactics to drive other companies out of business (ex.  box store lowers prices far below what they’re paying for things until all the other stores in town go out of business, then raises prices sky high).  In some cases there is a natural monopoly, where it makes sense for there to be only one provider.  This is why utilities in small towns are government provided, but in cities utilities are often private.

5. Public Goods provision.  These are things that you can’t keep people from using and can’t be used up.  That means if anybody buys it, everybody will use it.  So nobody wants to buy it– they’re hoping someone else will.  That leads to free-riding and under-provision.  Some folks believe, but don’t realize that’s what they believe, that the only role for government is public goods provision. They think that the government should provide national defense, jails, police, possibly roads.  Really national defense is the only pure public good, but many things that government provides are public goods but not completely non-rival and non-excludable.  (e.g. Roads can get full, people could put toll gates on them etc.)

These all come under the heading: Market failure. The role of government is to prevent market failure, or to step in when markets fail. When the government fixes a market failure, everybody is better off. The degree to which any tradeoffs are made with the above five points is a point of disagreement, but those are legitimate roles for government. When the free market breaks down, there is a role for government to step in.

Some people also believe that there’s a role for paternalism (providing basic minimum needs is an example of that, though you could argue that corpses rotting in the streets is a negative externality) or redistribution, since a dollar is worth more to me than to Bill Gates, overall utility is maximized if he gets to keep a smaller percent of his dollars than I do of mine, assuming our utility functions are of equal weight.  But that may or may not be a role for government based on morals and ethics.

Even the most liberal sounding thing can have conservative reasons for government intervention. This point is most obvious when we’re talking about kids (the future of our country). Sure, bleeding heart liberals think we should feed and educate kids because they’re cute and fuzzy… they’re all paternalistic that way. BUT, feeding and educating kids has additional positive externalities as well… a kid who is fed and educated today is less likely to get a mental disability, is less likely to have a teen pregnancy, is less likely to drop out of school, is less likely to start a life of crime. They’re more likely to be productive members of society. This means they are more likely to contribute to the economy, not destroy property in the future, and be less likely to wind up in jail at tax-payer expense. You don’t have to like kids to think they need to be fed. Additionally, with kids the moral hazard is lower, because kids don’t make decisions– their parents do… and sometimes without these government programs the parents are not going to give up whatever they’re spending money on instead of food so they can feed their kids. Feeding the kids doesn’t cause the same kind of bad incentives that say, Disability (SSDI), does.

If you want to know more about the role for government, I strongly recommend Public Finance and Public Policy by Jon Gruber.

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26 Responses to “What is the role for government?”

  1. William Says:

    You know nicoleandmaggie, I actually wrote about this earlier today on my site. This post has really provided me with some food for thought, I think that you have made many really important points. I really wish I had seen it prior to posting my own blog post! Regards,

    cars2scrap

  2. Comrade PhysioProf Says:

    Discouraging negative externalities and encouraging positive externalities.

    My understanding is that the idea isn’t to discourage (or encourage) externalities, but to ensure that their costs (or benefits) are borne by (or inure to) the appropriate economic actors.

    And BTW, economic theory aside, all this “free-market” and “private-sector” verbiage that is constantly spewed by the supposedly conservative political right (and, sadly, the left as well) is a big fat pack of motherf***en lies. What it’s really *all* about is allowing insane uncontrollable greedy motherf***ers to continue to be able to rampantly socialize negative externalities and private detriments and to privatize positive externalities and public goods.

    • nicoleandmaggie Says:

      Forcing the appropriate actors to internalize externalities (bear their own costs) would be ideal and efficient. I think of that more as a solution rather than as motivation. If the externalities are borne by the actors, then they’re not externalities anymore.

  3. Everyday Tips Says:

    What about monopsonies? :) (I always loved the word monopsony from the moment I learned it.)

    I can’t pretend that I know all about the reasons for government existence and purpose. All I know is there are a lot of people in power that probably don’t know the purpose either, and instead push their own personal agendas.

    • nicoleandmaggie Says:

      Monopsony is a type of monopoly power (so goes under the broad heading of “monopoly power” along with oligopolies etc., even though the math is a bit different). (For those who don’t know) Monopsonies are when one company is the sole employer rather than the sole seller. That’s one reason we have the minimum wage.

      But after reading this post you know all about the reasons for government intervention! And yes, politicians should have to take public finance economics (and in some cases, basic math). But alas.

  4. First Gen American Says:

    Thank you for categorizing it out. I think many people (myself included), think about government as only playing a role in only a few of these buckets where it is a whole lot more complex.

    Just out of curiosity, where would things like equal rights, anti discrimination laws, etc, fall in these categories. When the government abolished slavery which category does that fall under?

    • nicoleandmaggie Says:

      These are all complex (and there’s a book written on slavery called Time on the Cross, though I understand our academic historian readers dislike it for reasons I’m not yet clear on)… I’ll get back to answering these after work.

      • nicoleandmaggie Says:

        1. Equal rights and anti-discrimination. There’s multiple lines of thoughts about this one. The first is that markets are efficient and that discrimination cannot exist (this is the Becker school). This school views anti-discrimination laws as unnecessary and harmful. They believe these laws are not a role for government.

        So let’s go through the roles for gov’t and see how they apply.

        Adverse selection: I don’t really see this as an issue. High quality discriminated against candidates would love to share their private information but have no way of doing so. The gov’t doesn’t want to force companies to hire bad quality workers, just to use indicators other than race, gender, age etc. to make their cuts.

        Moral Hazard: No, I don’t really see an argument for this either. We probably don’t care if people try to make themselves look younger etc. because it isn’t all that harmful.

        Externalities: This could be a problem. When they judge a single person by a group’s characteristics or by inaccurate stereotypes, then that has negative externalities on all members of the group who are above average. That’s a problem. Additionally, there’s a subset who believes that firms are actually hurting their companies and thus the economy through taste-based discrimination (that’s when you irrationally dislike a certain group). This type of discrimination may be more true for some groups than others. (People don’t tend to dislike old folks, for example.)

        Monopoly: doesn’t apply (Though the Becker argument only holds in perfect competition)

        Public good provision: Not really, unless you think of an equal landscape as a public good.

        Paternalism: Yes, if you think employers are making mistakes. Yes, if you care about the discriminated against group.

        Redistribution: True to the extent that women, minorities etc. tend to be paid less than vigorous white men. Not so true for age (older folks tend to be better off).

        2. Slavery. Without a government, slavery would be difficult because there would be no property rights or a way to enforce property rights… so, uh, there was a role for government in slavery itself. That kind of sucks.

        Slavery had a ton of problems… Negative externalities on slaves. Negative externalities on the development of the South (if you believe Time on the Cross). Moral hazard problems with the way they were able to do things only because they had slaves. Slave owners were monopsonies. Paternalism and redistribution are both pretty obvious. Especially if you believe that morally slave owners needed to be saved from themselves.

  5. Trish Says:

    I am going to assume you intend this to be a learning opportunity, and as I don’t fully understand, I would like to ask some followup questions. When you say ‘the role of government’ do you mean as set forth by the constitution? it seems that the role of gov’t is arbitrary, whatever the governed decides it should be. and can’t it evolve over time?

    • nicoleandmaggie Says:

      No, this is a general “role for government” that defines why government structures exist in the first place, from the first tribal governments. It’s bigger than the US or the 18th century or even democracy. (Yes, there’s some “might makes right” throughout history, but there wouldn’t be a need for government at all if it weren’t for these issues.)

  6. Linda Says:

    I love to learn something new. Thanks! I often feel so ignorant of what I should be asking of government. And the comments are worth checking this again later today.

  7. bogart Says:

    (Much of) this should perhaps go as a reply to your reply to Trish, but as I started mulling it over before she posted …

    1. OK. But really, what you are writing about is what reasoned people would think the role of government would be or should be if we started from the supposition that we have, or want, a free market system and yet recognize the existence of market failures.

    2. In reality, every government that’s ever been created has been set up by folks with extant resources, interests, etc. The results (governments) reflect that. I don’t think what you’ve written helps us understand the decisions to structure (or maintain) U.S. governments (sic) in a federal model, for example, but absent that understanding it’s impossible to understand why some people might think it is OK for Massachusetts to pass health reform, but not the U.S. national government.

    3. The free market is itself not ubiquitous and alternate systems exist and function — to the benefit of some and the detriment of others. Some government functions — regulation of contracts — are probably essential to the existence of functioning free markets even in contexts where they work well, and others (currency) may facilitate their existence and operation, also.

    (4. The benefits of a clean environment probably also constitute a pure public good, and are interesting to the discussion in that they aren’t confined by national boundaries.)

    (5. To the extent that I have reasoned debates with people over what role(s) government should play, they do often center on an inherent disagreement between me and the other side about whether government can or cannot do a better job than the free market. That is, both sides know about market failures, but disagree as to whether government action can improve things or not.)

    • nicoleandmaggie Says:

      1. Free market systems will start up regardless. Even in communism there’s black markets. Even in tribal societies with fewer property rights there’s gift-giving etc. Trading will happen. These aren’t assuming a free market structure is wanted– a free market structure will happen unless government shuts it down, and even then government will never be entirely successful. All government structures are trying to deal with these market failures whether they’re communism/socialism (which put a higher emphasis on redistribution and paternalism), familial structures, capitalism or so on.

      2. I don’t understand point #2. Could you clarify?

      3. See #1, I think.

      4. Sure.

      5. Yes, there are a lot of trade-offs. Generally there’s no perfect solution. The above don’t mean that the government has to intervene, but there may be a role for intervention that should be considered. Sometimes the cure is more dangerous than the market failure. It’s an iron law.

      • bogart Says:

        1. OK, although for free markets to function optimally (properly? at all?) certain conditions must be met. Multiple buyers & sellers and free entry and exit are two that I’d think neither black markets nor the gift-giving you mention achieve; absent those, free markets won’t “be all that they can be,” to borrow a phrase from a different institution’s advertising.

        2.a. Your post is entitled, “What is the role for government.” I think it should probably be “What the role for government should be” or perhaps “The legitimate role for government” or something along those lines. I’d argue that you’re not (as you claim in your reply to Trish’s comment) actually describing “why government structures exist in the first place.” Historically (and contemporarily), my sense is that a lot of government structures have existed and do exist because one group was able to develop them as a mechanism that allowed it to extract benefits from another group or groups and was (or is) able to maintain them.

        2.b. But even governments that capture some of what you’re getting at (i.e. that seek to coexist with/facilitate/support/deploy free markets) have histories that affect what their roles are and how they function, independent of the basic principles/goals you outline. For example, the U.S. is a federal system the national legislature of which has a structure that reflects a number of compromises reached in the founding of the nation and that still matter today — ditto the executive branch (2000 election, anyone?). To the extent that you are writing about, or interested in, what governments in fact do, as opposed to what they should do, this matters a lot. What interests will get heard, what the strength of their voices will be, and what recourses they will have will all be shaped by institutional design (and practice) — and particularly (though not exclusively) if you’re writing about democratic governments, that stuff matters. The US government in general has had a tremendous bias in favor of maintaining the status quo that is written into its structure (supermajority requirements for various sorts of decisions, etc.).

        3. See my #1 (& 2) in this comment, but also, I hadn’t carefully read your post when I responded and you had addressed this more fully than I thought. So, my bad.

        5. Absolutely

      • nicoleandmaggie Says:

        1. I think you’re thinking of perfect competition, not markets. Markets can exist without perfect competition. A potential role for government is to make it easier to have perfect competition but that’s only the monopoly power role. Not all governments choose to enforce that role. In fact, not all governments choose to enforce (or are able to enforce) many subsets of these roles, but they are still roles for government. And government never functions optimally in practice– there isn’t really any definition of “optimal” for government anyway except in terms of efficiency because we can’t compare different people’s utility functions.

        2a. Sure, there’s some might makes right in governments, but there wouldn’t be any way for government to exist without a reason for it. Really warlords happen and dictators happen because there’s a need for government, and there’s an imperfect person filling that need, or sometimes it’s the best that can be done because the infrastructure isn’t developed yet. There’s a line of research on institutions that explores these issues, and another line describing the natural progression of governments from dictator to monarchy to democracy (though obviously there are many governments that don’t follow that trend).

        2b. That’s way too detailed and specific. These roles for government have nothing to do with federalism or democracy etc. Those are nitty gritty details that talk about how to make a government, not about why there’s a need for government. That’s the kind of thing political scientists talk about.

      • bogart Says:

        OK …

        1. OK, but as I understand it, what makes markets efficient is (a) the absence of a need for a middle man or coordinator (people act on their own to achieve their own interests) and (b) that simply by definition any market transaction meets the Pareto criterion (makes at least one person better off and no one worse off) (I’m not assuming you need these parentheticals but to the extent this is a public discussion don’t want to be exclusive of those unfamiliar with these terms). I’d say it is at best a stretch to claim that gift giving in at least those tribal societies of which I am a part achieves (b), so to the extent that (b) is the reason why we like free markets, I do think it’s plausible to claim (as I have) that they are not universally in place, or close to it (especially across historical time).

        2.a. I don’t really think we need a hugely vaster reason (in the short term) than “My thugs are stronger, craftier, and/or more numerous than your thugs” (where “I” am the dictator), but sure, if you want to make a general claim about likely longer-term stability, etc., then the other factors start to matter. Anecdotal information aside, I’m not familiar enough with the history or the literature to discuss the progressions so won’t try to.

        2.b. Well, again, I do think it matters whether you want to discuss what the role of government “is” (in which case I think who’s in charge and/or what institutions are in place matter vastly), or what the role of government “should be,” in which case, sure. But also, I think we’re talking past each other, largely, and it’s your blog, so I’ll yield to, you’ve posted a great description of what government may be able to offer that free markets cannot, agreeing (as I think is implicit in your original post though not explicit — maybe it’s just too obvious to need stating) that free markets do seem to be the best option for what they do well and that it is useful to think of government stepping in where they fail and not otherwise interfering with them.

      • nicoleandmaggie Says:

        1. No… those are all things that we like, but they’re not really definitions of what makes a market efficient. They’re good things. They help. But sometimes there will be a need for a middle-man and that’s the most efficient solution. Very little in life is pareto optimal to change… sometimes solving an adverse selection problem is pareto optimal, but most of the time we have to make trade-offs whether there’s government or not. We like to think we’re already at the PPF if that’s what you’re talking about.

        2. Organizing thugs is a form of government. The thugs are being governed too. Thugs won’t stay with an overlord unless they’re getting benefits. An overlord cannot provide benefits (food, shelter, money, jails etc.) without some form of government and will not last long if the thugs aren’t getting something they want in return. Even if all they are getting is the public good of protection/defense.

  8. Rumpus Says:

    I know someone who is something of a proponent of anarchy. That fact seems odd to me. I’m not trying to imply that everyone must choose between red and blue or whatever, but this person would prefer to have no government. I don’t really understand the position, except for the underlying belief that institutions focus the worst in a group of people, but as an engineer I believe pretty strongly in order.

    In fact, I would say that my belief in order is a core belief that is integral to who I am. We join together because we are more capable together, and the internet and mobile phones are just an extension of that community structure. The “achievements” unlocking phenomenon in online video games (or equivalently Facebook’s social gaming farmville announcements) leverages this need we have for social interaction, and hopefully will be further explored by Khan’s Academy (for example) and the similar rewards provided therein for learning math, etc. Hm, Khan’s Academy should be a Facebook app people can play on their cell phones.

    I’m a professed ignoramus regarding government, but I’ve never wondered whether it had roles or was good…I always wondered why we weren’t tweaking it more, and having more interaction with it. Anyone else read Earthweb by Stiegler?…I bet we could defeat alien races by internet forums/gambling. USA is a republic, (and I’m not against that, as I shudder when I think about some of the things that have happened in California), but we have all this innovation in technology and all this continuing research (psychology, economics, etc) and yet people appear primarily unhappy with the government (poll briefly mentioned on tv news today said only 30-35% of people are happy with either Republican or Democrat parties). As an engineer, I just want someone to fix it…if only we had a sentient supercomputer to take over….they can win at checkers and chess but I guess Go is still beyond them. Hm, in fact they seem to have problems just guessing what I’ll rate a black and white romantic comedy starring Clark Gable.

  9. Jennifer Says:

    You have forgotten a very important caveat. Yes, government intervention is justified in the presence of market failure. But, government should only intervene if (market failure) > (government failure). Public choice theory goes into depth on that account as well. I always thought it was unfortunate that Econ 101 teaches about market failure but you don’t learn about government failure unless you take a Public Choice upper-division elective.

    • nicoleandmaggie Says:

      I’m not saying that the government should always intervene, but that these are roles in which government could consider intervention. Government failure isn’t really well-defined, but almost any government intervention will have unintended distortionary effects. It is difficult to weigh distortions against each other because it is difficult to determine which priorities are more important. Economists put prices on things and let politicians and philosophers decide if the price is worth it.

      Around here market failure is not taught in Econ 101 (or 102) except for monopoly and perfect public goods. Occasionally adverse selection and moral hazard are covered. And then only briefly. The government is not mentioned in Econ 101 except in its role at the Fed and as a distortionary actor setting prices (wage floors, rent ceilings) and inducing dead-weight loss.

  10. Carnival of Personal Finance | Funny about Money Says:

    [...] my attention when it first appeared, so I’m happy to see it at the Carnival: Nicole’s reflections on the role of government, at Grumpy Rumblings of the [...]

  11. Bret @ Hope to Prosper Says:

    I believe the role of government is pretty clear, despite their penchant for overstepping their bounds. What is unclear for me is how we have allowed our government to become so unresponsive to the wishes of the people. It’s obvious special interests have more influence than voters, as witnessed by the bailouts and healthcare bill. Many politicians were recently voted out of office for supporting these unpopular actions, but I still feel voters are summarily ignored.

    • nicoleandmaggie Says:

      Riiiiiight. You keep watching that Fox News and listening to Rush. Government is definitely all about feelings and beliefs. Thinking is really difficult, so just keep repeating what they say.


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