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.