4 Market Failure and Government Failure

At the close of chapter 3, we saw that Adam Smith envisaged the task of government as highly limited and beneficent only
in three areas: national defense, the administration of justice, and in certain large-scale infrastructural investments that
private industry would not, or could not, assume. However, a glance at any modern market economy reveals that
government activity is not confined to these areas but extends into production, regulation, and redistribution. In the wealthy
countries of the Organization for Economic Cooperation and Development (OECD) governments take in and spend an
average of about 40 percent of gross domestic product (GDP).1 Despite the common political rhetoric of the 1980s and
1990s on the need to downsize government, the trend, measured in terms of governments’ share of GDP, seems to be
inexorably upward.2 How is such widespread interference in the market economy explained? There are two main answers:
the correction of “market failure” and redistribution of the social product toward disadvantaged, primarily economically
inactive, groups.

MARKET FAILURE
One general justification for government intervention in the operation of free enterprise economy is market failure. While
many modern economies are characterized by highly competitive markets for some products and factors of production, the
conditions necessary to establish perfect competition in all markets are seldom encountered. Four phenomena considered to
lead to serious inefficiencies are briefly listed here:
1. Market power. The possession of substantial market power by a single or small group of market participants creates
conditions under which prices deviate from marginal costs, an allocatively inefficient outcome. Similarly we might
encounter market power in the supply of labor through unionization, implying that the price of labor will differ from
the value of its marginal product.
2. Lack of information. Any inability of relevant market participants to access relevant information at reasonable cost
prevents them from acting in an economically rational fashion.
3. Public goods. Goods that are nonrival in consumption and for which the marginal cost of supply is zero will not be
produced in efficient quantities by a private market.
4. Externalities. Outcomes based on private costs and private benefits are inefficient when social costs and social
benefits are economically significant.
Government intervention has frequently been seen as a corrective to these problems, but there is a growing criticism that
such action is often more harmful than the market imperfections that occasioned it. In this chapter we will first examine the
rationale for such intervention and then we will assess to what degree government action is likely to benefit, rather than
harm, the general welfare.

SOURCES OF MARKET FAILURE: MARKET POWER

Markets function efficiently only when no participant has substantial market power. Such power may be found on either
side of the market. However, it is power on the supply side, monopoly (a single seller) and oligopoly (a few sellers), that
has been seen as the most injurious to economic welfare and has been the target of most governmental legislative, judicial,
and regulatory activity. Market power on the buying side (monopsony) is considered less harmful to public welfare and is
rarely a target of regulatory activity.3

The Problem of Monopoly

When markets are perfectly competitive, firms are price takers, facing a horizontal, or infinitely elastic, demand curve.
Any deviation of price from that dictated by the market will result either in a lower than normal profit rate, untenable in the
long run, or a total loss of sales to lower priced producers. Competitive pressures ensure that the market price is equal to
the marginal cost of production. Whenever markets are not perfectly competitive, a firm’s demand curve is not horizontal
but slopes downward; the firm becomes a price setter, having some control over the prices that it charges.
Confronted by downward sloping demand curves, profit-maximizing firms restrict production, raise prices, and,
therefore, generate economic profits, returns above the normal rate for all industries. The existence of barriers to entry
prevents these super-normal profits from serving their usual function, which should be to attract new entrants and capital
into the industry that would, over time, return the profit rate to normal. Importantly, monopoly drives a wedge between the
price that the buyer must pay and the marginal cost of production. Consumption is reduced and consumers’ surplus is lost
creating economic inefficiency. This is illustrated in Figure 4.1. The monopolist maximizes profit by setting output at the
point where marginal cost is equal to marginal revenue. This results in a lower output than might be the case under
competition QM as opposed to Qc, and a higher price, PM as opposed to Pc. The loss of welfare is denoted by the triangle
labeled deadweight loss in consumption.
Monopoly also results in a transfer of welfare from consumers to the monopolist. This is shown in the diagram by the
rectangle labeled monopoly profit. Such a transfer is not a loss to society, since both consumer and monopolist are
members, but it is often seen as inequitable and it can be at least as important as the deadweight loss in motivating
government action. Correction of this form of market failure, in order to promote efficiency and protect consumers, is
considered in many countries a reason for government action.

NATURAL MONOPOLY.   Economists have traditionally distinguished between two forms of monopoly. One, usually termed
natural monopoly, occurs because of high fixed costs and declining or constant marginal costs, which cause the long-run
average cost curve to be falling across the relevant output quantities. If competition can be created, it is only at the cost of
the expensive and wasteful replication of facilities. In such cases monopoly is generally tolerated, but it is modified by
government action, generally through the control of prices by a public agency.
Natural monopoly is common in industries that require very high fixed costs due to extensive initial capital investment.
Electricity supply, telephone networks, and TV cable distribution are frequently cited as typical examples of natural
monopoly. The existence of natural monopoly in fact involves a dual problem. As shown in Figure 4.2, in the absence of
price regulation, a profit-maximizing monopoly would fix output at Q M and price at PM, thus earning profits in excess of
the normal rate of return. This provides a rationale for government intervention to fix the price, usually through the activity
of a public utility commission.
However, once the decision to regulate has been made, the appropriate price remains a subject of contention. From an
efficiency point of view there is a case for regulators to fix the price at marginal cost. In Figure 4.2, we can see that in
declining average cost industries marginal cost lies below average cost for all relevant output levels. Marginal cost pricing
would give a price of PE, and would require an output of QE. However, at such a price revenues would fail to cover the
total costs of the enterprise. Such policy would require the granting to the utility of a subsidy (ideally in the form of a block
grant) from the government to cover fixed costs. Subsidies of this kind are often politically unattractive, and a common
“compromise” solution is for regulatory commissions to fix the price at average total cost, as shown in the diagram as P R.
This price is above the marginal cost and allows the utility to cover all fixed and variable costs including a “normal” rate of
return on capital. This solution avoids the “gouging” potentiality of an unregulated monopoly, but it does dilute incentives
to strive for optimal efficiency. It also presents the possibility of capture of the regulatory agency by the regulatee, a topic
we will return to as an example of “government failure.”
Natural monopolies do not represent a fixed and unchanging set of industries but are a function of the state of
technology. They are a much less significant phenomenon in the long run than in the short run, and economists now regard
them as a less of an impediment to efficiently functioning markets than in the past. Changes in technology are capable of
bringing about the emergence of competitors that may obviate the need for regulation, and sometimes regulation is a
barrier to their emergence.
 Consider, for example, long-distance telephone services. When all phone traffic had to be carried on fixed cables, the
construction of the network was very expensive. There was an opportunity to earn monopoly profits because the high cost
of establishing the network made the entry of a second or third supplier unlikely. Furthermore, in most people’s minds it
would be socially wasteful to replicate the network. The emergence of satellite technology to replace cables has had a
profound effect on competitive structure and eased entry, obviating the need for regulation. However, it took regulatory
changes (in the United States there was the breaking up of ATT, the telephone monopoly, and in much of Europe there was
the end of state-provided phone service) to allow the wind of competition to blow through the communications
marketplace. In electricity supply, a similar change has occurred, due to the realization that, although the grid of cables
itself is a natural monopoly, there can be vigorous competition among the suppliers who serve users connected to the grid.
Thus, rather than regulating the delivered price of electricity, most of the benefits of competition might be grasped through
regulating the price of conveyance on the grid and allowing electricity suppliers to compete on a price basis.
In some cases, government’s willingness to intervene in the market can lessen competition and act against the
consumers’ interest. For example, all transportation modes are gross substitutes and are to some degree in competition with
each other. In a market context they can act as a limit on the price behavior of each other. Regulating transportation on a
mode-by-mode basis, with mode-specific agencies, can tend to reduce competition in the broader industry and be
counterproductive to consumer welfare.

ANTITRUST POLICY.   The other form of monopoly (which can be termed unnatural or artificial) is created by the gathering
of market share by a dominant enterprise, which then erects barriers to entry to forestall competition. This behavior is
countered by what in the United States is termed antitrust policy, regulatory and legal action designed to promote freedom
of entry and to prohibit the merger (or collusion) of competitive firms that would result in harm to consumers.
All developed nations have a government agency nominally charged with the maintenance of competition, although in
some countries it is more vigilant than in others. In the United States the relevant agency is the Federal Trade Commission,
an arm of the Department of Justice, empowered to investigate and bring suit in defense of trade. In the United Kingdom it
is the Competition Commission, formerly known as the Mergers and Monopoly Commission. Such agencies are charged
with reviewing competitiveness on an industry basis, assessing the impact of mergers on competition, and, in cases where
the evidence merits, taking legal action because the public interest has been or might be harmed.
In doing so, such agencies are looking for accretion of economic power and its impact on economic welfare. In the past
much attention tended to be focused on the existence of power as measured by “concentration ratios,” defined as the share
of domestic market consumption represented by a given number of firms. The logic behind this is that the greater the
domination of the market by a small number of firms, the less likely is competition to be intense. The most usual index is
the four firm concentration ratio—that is, the amount of total sales accounted for by the largest four firms. In the United
States, using this basis, the most concentrated industries reported in the Census of Manufacturing were chewing gum and
cigarettes (96 and 92, respectively). Another measure is the so-called Herfindahl Hirschman index (HHI, named for its
originators, O. C. Herfindahl and A. O. Hirschman),4 which takes account of the market composition among the four
largest firms.
However, recent developments have led to a change of thought about how we should measure economic power or loss
of welfare. First, there is skepticism of the view that either market share or concentration ratios are useful indices. Many
economists today are of the view that what matters to keep a market functional, even if not perfect, is not how static
market shares add up but the degree to which the market is contestable.5 The threat of a competitor may be as effective as
the existence of one in moderating excesses in pricing behavior. If there are few firms in the market and high barriers to
entry, potential competition is certainly choked. However, even a total monopolist may be subject to restraint, and behave
therefore more like a competitor, if entry into the market is easy. The issue therefore becomes not one of the size of market
share at any moment in time but rather the height of the barriers to entry that determine the level of contestability.
Consider the position of Microsoft, Inc. In many areas of personal computer software, the company has a near total
monopoly. However, historically, entry into the industry has been relatively easy, and high product prices would serve to
lure competitors into the industry. Consequently it is the threat, rather than the actuality, of competition that moderates
Microsoft’s pricing behavior. If, as has been alleged in the current antitrust suit, Microsoft can use its market power to
restrict entry, the market is no longer contestable and loss of welfare can result.
 The decline in reliance on domestic concentration ratios as indices of market power has been accelerated by the growing
integration of the world economy and generally falling barriers to international trade.6 In the past, domestic markets
tended to be relatively closed to each other compared to the situation today. Tariff barriers were higher and frictional
impediments to trade more significant because of high communications and transportation costs. Trade to GDP ratios
were generally lower than they are today. Because of the relatively closed nature of national economies, power in the
domestic market represented a definite threat to the welfare of domestic consumers. Now in general there is a greater
volume of trade, lower average tariff levels, and an increasing number of regional free trade blocs, all of which make the
structure of domestic concentration increasingly irrelevant. In such circumstances, domestic markets, although perhaps
highly concentrated, may be highly contestable because of growing competition from abroad and relatively low barriers to
entry to foreign firms. For example, the four firm concentration ratio for the U.S. automobile market in the late 1960s was
very high, and one firm, General Motors (GM), represented over half the market. Conventionally measured market power
was high, but the surge of imports in the 1970s showed how easily contestable the market was. The Federal Trade
Commission closed its ongoing investigation of GM in the mid-1970s.
In some cases the existence of this high degree of contestability of domestic markets due to potential entry of foreign
firms has led to the virtual abandonment of traditional antitrust policy. Many governments tolerate, encourage, or even help
to create through merger national champions to monopolize the domestic market and control the resources to compete
with foreign firms.7 This policy is justified generally by the belief in substantial economies of scale in production or, more
relevant recently, in research and development.

Labor Unions
So far we have discussed only monopoly in the supply of goods and services. Labor organizations represent the
monopolization of a factor of production with a view to restrict supply and raise its price. The consequence in general
terms is higher wages and better benefits for workers, and a higher level of unemployment than would exist otherwise.
Governmental policy toward labor unions varies widely from country to country and has changed a good deal over time.
For example, in the first capitalist industrial society, 19th-century Britain, the government, elected by and largely beholden
to property owners, took a dim view of the union movement because it sought to shift income from capital to labor. It was,
therefore, criminalized through the Combination Acts,8 and union organizers were arrested, imprisoned, and on occasion
deported. After the extension of the electoral franchise to nonproperty owners in the 1880s, labor won the right to organize
and formed its own political party to protect such gains. Other industrialized nations also saw violence and political
upheaval in the birth of the movement.
Today most industrialized countries not only recognize unions, but also make organized labor part of the process of
economic management. In Europe especially, organized labor has a prominent role in both politics and economic
management as we will discuss more fully in the chapters on Sweden, France, and Germany. However, it should be noted
that the decline of heavy industry and the growing surplus of labor in these economies, as indicated by secularly high rates
of unemployment, has weakened the power of the union movement. Union power in the European economies is greatest
now in the public sector, where it is resistant to market forces because of a clear link to electoral politics.
Later industrializing countries are still passing through the stage of union establishment. The Japanese miracles of the
1960s through 1980s were assisted by the repression of the labor movement in the late 1950s. After decades of opposition
by employers and government, Korean unions are now emerging. In countries more remote in development terms, like
Indonesia, independent unions are still banned.

LACK OF INFORMATION
Market systems can work well only if consumers have access to reliable information about the product that they are
buying. In the case of simple commodities, reliance on the old maxim caveat emptor (“let the buyer beware”) is probably
adequate; information is relatively cheaply available and reputation is an important asset when repeat purchasers are
frequent. However, in the case of more complex goods or goods that are purchased infrequently, information might be
difficult, impossible, or expensive to obtain.
In such cases, governments frequently step in to “protect” the consumer. In some cases this is done by prescribing
specific behavior for those who make and sell products to the public or by dictating specific product standards. Rules or
laws specify what information a seller must offer to the buyer and what recourse the buyer has in the case of
disappointment. In other industries or professions, the government may create barriers to entry by limiting access to the
industry to those who have “appropriate qualifications,” preventing the unqualified from offering such goods or services.
Such licensing is common in a wide variety of professions from lawyers to morticians.
 This may provide an effective way of minimizing the consumers’ need for expensive information. Consider, for
example, a potential patient choosing a surgeon. In most countries only people who have attended medical school, served
an internship, and passed examinations can hang up a shingle and offer surgical services. Performing surgery without such
qualifications is forbidden. In contrast, there are few restrictions on who can offer to shave people or cut hair. In more
remote times, such licensing was not considered essential for surgeons, and indeed barbers doubled surgery with their
shaving duties.
Why is government intervention merited in one case and not the other? The answer lies in the availability of
information and the consequences of not being able to get it. When it comes to hairdressing, we feel we can rely on
reputation to weed out poor performers. One bad haircut does not kill and serves in itself to tell others about performance.
One poor surgery can kill, and licensing, while not eliminating the problem entirely, does, it is argued, reduce the risk to
the public.
The goal of protecting of the public has spawned a large regulatory industry. In the United States, the government hires
inspectors to tell consumers what meat is “choice,” requires product information on labels, looks for “misleading”
advertising, requires approval of drugs, and so forth. Few people would argue that all of it is necessary, especially in view
of the fact that there are market remedies in many cases. Frequently such licensing is the result of rent-seeking behavior, a
phenomenon which we will discuss in greater detail later in this chapter.

PUBLIC GOODS
The third major class of market failure is due to the existence of “public goods.” The qualities of public goods may best be
understood by looking first at those of private goods. Private goods and services, whose supply is left to individual rather
than collective action, have two important qualities: excludability and diminishability. Excludability enables producers or
sellers to charge a price for private goods and services because they can deny access to those who fail to pay the price.
Diminishability implies that one person’s consumption of a good or service reduces the supply available to others. This is
really another way of saying that the marginal cost of consumption is greater than zero. Efficiency, therefore, requires that
private goods should have a price that is greater than zero as well. Excludability establishes there is a feasible mechanism
to impose a charge.
In contrast, pure public goods are neither diminishable nor excludable. The marginal cost of additional unit of
consumption is zero, and therefore efficiency requires a zero price. Anyway, there is no cost-effective way of charging for
the service. The absence of excludability leads to the free rider problem, in which people are able to enjoy the service
without payment and therefore make no financial contribution to their “fair” share of costs. Consequently, private
institutions will fail to supply, or will chronically undersupply, such goods, and only the government, with its ability to
coerce payment through taxation, has the potential to supply the goods at the optimal level.
Although pure public goods are theoretically important, in reality they represent a relatively small class. National
defense, the system of administration of justice, and public health measures are salient examples. In none of these cases
can an individual be excluded from benefit without fundamentally altering the nature of the good. In virtually all countries,
these goods are provided by the government and are financed out of taxation. Moreover, such goods are probably essential
for the existence of the modern state, and it is hard to imagine in these cases how a private substitute could be created.
The provision of lighthouses is a much-used example of public goods in the economic textbooks. Its frequency stems
more from its tractability than its economic significance. Lighthouses are not as fundamental to an economy as defense or
the law, but they obviously do have economic benefits. Use of the services of lighthouses is susceptible to free ridership,
and they would therefore be undersupplied by private institutions,9 who would have to rely on donations from shippers,
sailors, and the general public to finance them. It requires a considerable step to assume that the government would get the
level of provision right. To supply even pure public goods at an optimal level, the government must have some means of
accurately estimating benefits or inducing consumers (in this case the shippers and sailors) to reveal their demand. It is
quite conceivable that the government would err just as much as a private system based on subscription or contribution. In
fact, the nature of politics and lobbying would probably lead to oversupply, for reasons which will be discussed later in the
chapter.
In general, socially provided goods are not “public” in the rigorous sense. In most cases they are excludable, as we can
see by looking at the examples of education, health services, highways, recreation facilities, and so forth, all of which have
counterparts in the private sector. In most countries, services that are clearly diminishable (for example, postal services or
garbage disposal) are provided by the government as well as the private sector. To justify government supply of such
potentially private goods and services, market failure is not sufficient. The actual motivations might include distributive
concerns, a need to establish equitable standards, or a conviction that government is superior in efficiency terms to private
enterprise in some tasks. In recent years economists have focused considerable attention on public goods supply and have
frequently arrived at the conclusion that it is determined at least as much by the lobbying activity of interested parties as by
a concern for correcting market failure.
EXTERNALITIES
The final class of market failure to be introduced here consists of imperfections created by the presence of externalities,
external economies and diseconomies (which are sometimes called spillovers). These are consequences to third parties (or
bystanders) of the economic activities of others. Such consequences may be either positive, contributing to the welfare of
the third party, or negative. Because externalities are unrequited (we do not receive compensation for negative effects, nor
do we pay for the positive ones), they do not enter into the decision process of the individuals initiating the activity.
Decisions by consumers and producers are made by considering private benefits and private costs. From a societal point of
view, the appropriate considerations should be social benefit and social cost. This is illustrated in Figure 4.3.
In this diagram, the existence of a substantial externality (perhaps the ability of producers to emit smoke into the
atmosphere without paying any pollution fee or compensation to those affected) causes a divergence between the private
marginal cost and the social marginal cost. The consumer is confronted by prices based on the private, not the social
marginal cost. Correspondingly, the market system with the imperfection of uncompensated externalities tends to
overproduce the good, to the point QP in Figure 4.3, rather than the socially optimal position of Q S.
One of the most obvious and pressing examples of externalities lies in the analysis of environmental issues. Consider a
factory that emits air pollution as a byproduct of manufacturing a good. In the absence of any control, the manufacturer
considers only private benefit and treats the environment as a free resource, despoiling the air and reducing the welfare of
others in the process.
Government regulatory activity to counter pollution can be of several kinds:
 It can ban the polluting process entirely.

 It can establish minimum compliance standards for the manufacturer to meet.

 It can offer subsidies to the manufacturer to reduce pollution.

 It can charge the manufacturer a fee per unit of pollution emitted.

The first two remedies are generally held by economists to be allocatively inefficient. In the first case, banning the
production totally will generally result in an undersupply of the polluting good; the loss of consumer welfare from the
absolute nonavailability of the product may outweigh the gains of completely clean air or water. In the second case,
establishing minimum standards for pollution leaves no incentive for manufacturers to press for a further reduction below
the standard, even though an additional cut might be socially beneficial. The third and fourth courses of action can both
lead to an economically efficient outcome. A subsidy to reduce pollution can have the same effect as a pollution fee since
either can be designed to reflect the marginal cost of the polluting activity. What is obviously very different is the
distributional impact of the two approaches. Policy 3 grants the right to pollute to manufacturers and bribes them to stop.
Policy 4 gives the manufacturers no rights but forces them to purchase the ability to pollute from the state.
Some economists have argued that the problem of externalities is solely the
result of the inadequate specification of property rights. Private individuals who have clear rights of ownership, and who
live in countries where the legal system functions well, have recourse against the despoliation of their property or loss of
health through a civil suit. The threat of litigation results in negotiation and in many cases a contract that will result in a
mutually acceptable, and therefore efficient, solution to “externality problems.” Consider, for example, a case in which my
neighbor was about to reduce my welfare by building a skyscraper that would block the sun. If my right to access to light
were clear and legally guaranteed, then he could only proceed if we were able to arrive at a contract whereby my
permission to build was granted on the basis of some form of compensation. Alternatively, if he clearly has the right to use
his site in any way he chooses, irrespective of third-party consequences, I might dissuade him from construction through a
contract that appropriately compensated him for his lost opportunity and revenue. Either solution would be efficient
although the distributional effects (who gained and who lost welfare) would be markedly different according to how the
property rights were determined.
 This approach to the problem of externalities is exemplified by the work of Ronald Coase.10 His work suggests that the
externality problem might be solved through the complete definition of property rights. Fully comprehensive and well-
specified property rights would result in the “internalization” of externalities, and the optimal solution would be arrived at
through negotiation and contract. This happy result of the Coase theorem is, however, subject to some limitations.
“Internalization” leading to mutually agreeable contracts, and therefore efficiency, might be the outcome in cases where
the number of participants is small, but as soon as we get to a case where either the affecting or the affected party is
numerous the costs of negotiating the appropriate contract may become prohibitively high. In such cases government
intervention may achieve close to equivalent results at the cost of fewer resources. Most of the discussion about
externalities relates to negative effects; this is partly because issues like pollution, global warming, and traffic congestion
are very important issues and play a very prominent role in our lives. However, we should not discount the responsibility of
governments to correct the market failure of the under-provision of positive externalities. Indeed, it can be argued that
much of the benefit of public education lies in the production of external benefits stemming from educated and productive
citizenry.

GOVERNMENT FAILURE
Each of the four phenomena previously discussed is real and each can cause markets to fail, leading to an outcome that is
less efficient than would be the case if markets were perfect. Thus there is an initial rationale to consider the use of
government action to address market failure. However, it would be imprudent to conclude that government intervention in
such cases will always increase welfare. That would unwisely compare imperfect markets to a perfect government. In
recent years, economists have taken a more skeptical view of the capabilities of government, recognizing that there are
many sources of government failure, which can themselves be at least as damaging as the market failure that they seek to
correct.
We cannot assume that governments will always be, in Anne Krueger’s phrase, “benevolent, costless social
guardians.”11 It is problematic even to consider a homogenous “public” interest, because only rarely will all members of
the public be affected in a symmetrical fashion; there will always be those who gain more than others from any action.
Government, even if it is motivated to increase aggregate welfare, will inevitably have problems in determining the
preferences of citizens in the absence of markets and meaningful prices. Furthermore, like the rest of us, bureaucrats and
politicians are subject to complex incentives. They will, in most cases, pursue their own interest, as do employers, workers,
and households. Of course, this is nothing new. We are led back once more to Smith, who had a poor opinion of
government, just as he had a poor opinion of manufacturers. He wrote in The Wealth of Nations:
Great nations are never impoverished by private, though they sometimes are by public, prodigality and misconduct. The whole, or
almost the whole, public revenue is in most countries employed in maintaining unproductive hands. Such are the people who
compose a numerous and splendid court, a great ecclesiastical establishment, great fleets and armies, who in time of peace produce
nothing, and in time of war acquire nothing which can compensate the expense of maintaining them, even while the war lasts. Such
people, as they themselves produce nothing, are all maintained by the produce of other men’s labor.

Sources of Government Failure

We turn now to look at some of the specific sources of government failure.

AVAILABILITY OF INFORMATION.   One of the beauties of the market system lies in its economy of information, since it
operates in a decentralized way, with no participant needing to see “the whole picture.” Government action, on the other
hand, requires all relevant information to be centralized. Even if we make the contentious assumption that the objective of
bureaucrats and politicians is to maximize public welfare, rational choices about what public goods to supply and in what
quantity require an accurate picture of the total costs and benefits of that activity. Later in this book we will discuss the
socialist planned economy more fully and examine in some detail the problems and the resource costs of maintaining a
reliable flow of information from periphery to center. However, the problem of gathering accurate information is not
unique to centrally planned economies. In a mixed market economy it is in the interest of groups that benefit from the
provision of a publicly supplied good to overstate their demand by strategically misleading behavior. Government will only
outperform even an imperfect market if it has access to all appropriate information, but this is at best expensive and at
worst impossible when participants have an incentive to provide misleading information.
THE CAPTURE OF REGULATORS.   We know that the presence of monopoly power can reduce social welfare and for this
reason public policy to regulate monopolies is a staple of government activity. The main device for the control of
monopoly power lies with regulatory agencies established to supervise pricing and output. However, there is a large body
of literature suggesting that over time a regulated industry “captures” the regulatory body set to oversee it. Such bodies
tend to identify more with those of the industry that they in theory control than with the public at large. In part this is due
to a “revolving door” of personnel between the agency and the industry, in part it is due to a understandable absence of
adversarial behavior between the regulator and the regulated.
Regulation may also impair dynamic performance. A regulated industry generally enjoys guaranteed profit margins set
by the agency. Given this guarantee, firms tend to grow cautious about innovation and often pay too little attention to cost
control. The industry actually comes to enjoy the protection of the agency that was set to constrain it. A comfortable
symbiosis develops, characterized by high costs, excess capacity, and a lack of enterprise. Prices to the consumer, which
are set to cover average costs, trend upward as increasing inefficiency and waste are accommodated. A soft budget
constraint is established whereby the cost structure of the industry is legitimized by the action of the regulators at the
expense of consumers. Anne Krueger points out “that the real truth of the capture theory is frequently revealed when
deregulation is proposed: it is more often than not, those in the regulated industry themselves who are the loudest in protest
against deregulation!”

COLLECTIVE ACTION.   In his important book The Logic of Collective Action,12 Mancur Olsen argues that small interest
groups can organize much more easily and forcefully than large ones. Small groups with intense preferences will lobby
hard for some types of expenditure, even if total costs well exceed benefits, precisely because the costs will be spread
among large numbers, while the benefits are more compactly distributed. Members of beneficiary groups try to “free-ride”
on the broader tax-paying population, and the consequence is that some public goods will be oversupplied. Moreover, in a
process known as “log rolling” pressure groups band together to form coalitions and are thus able to receive the support of
other small groups for their cause in return for reciprocal support of the other groups’ schemes. The result of this process is
a general oversupply of public goods.
The same lobbying phenomena have implications elsewhere in the sphere of government action. Consider, for example,
the issue of trade protection. An industry and its workers may have very strong preferences concerning the imposition of a
protective tariff and may lobby hard for it. They will frequently prevail although the impact on overall consumer welfare
might be strongly negative, purely because they are easily organized and highly focused, while the “losers” are dispersed
and disorganized. A good example of this is the U.S. motor industry in the 1980s, which was adversely affected by foreign
(primarily Japanese) competition and a surging import market share. Extensive lobbying in Washington produced
government sympathy, which in turn led to pressure on the Japanese to impose “voluntary export restraints,” which
curtailed the number of vehicles shipped into the United States (though not their value). It has been estimated that this
action led to an increase of $960 in the price of each new automobile sold in the United States and a cost in extra burden
on consumers of $160,000 per job saved.13 Automobile company profits rose sharply, and motor executives earned record
salaries, not for their leadership in production but for their persuasive lobbying. In short, the total costs of government
action certainly exceeded the benefits, but a compact lobbying group for control overwhelmed a dispersed opposition and
earned monopoly rents.

RENT-SEEKING BEHAVIOR.   This example from the U.S. motor industry introduces us to rent-seeking behavior defined as
the expenditure of real resources in the attempt to appropriate a surplus in the form of rent. Company executives employ
lobbyists (real resources) who convince the government to restrict competition (the “voluntary” export restraints), reducing
supply and creating monopoly rents, which accrue to management, capital, and labor in the motor industry.14
A common form of government intervention, ostensibly motivated by a desire to protect the consumer, is to deny access
to specific industries or professions to those who are not appropriately qualified. This reduces the supply in such activities
and enables the successful entrants to earn a monopoly rent. The possibility of this reward encourages rent-seeking
behavior, which can be defined as the expenditure of real resources in an attempt to secure a monopoly rent. Rent seeking
has been frequently analyzed and discussed in the context of less developed countries where it appears in many forms,
from the ability of customs clerks to generate bribes to the allocation of large-scale import licenses.

PORK BARRELING.   Politicians, whether democratically elected or not, are prone to use government expenditures to bolster
their own position. James Buchanan was awarded the Nobel Prize in economics for work in political economy based on the
premise that politicians in a democracy act to maximize the probability of their reelection.15 Representatives of a
particular district will lobby hard for specific expenditures that will benefit their own electorate. These may take the form
of public expenditure on infrastructure or government facilities that benefit the locality but the cost of which is spread over
the tax-paying population of the entire economy. We can also note that while they are less sensitive to the vagaries of
public opinion, dictators or other authoritarian regimes are also likely to use the public exchequer to build coalitions of
supporters.
 We can find examples of politicians opportunistically using expenditures to enhance their future in many contexts. For
example, in the runup to the Russian presidential elections in 1994, Boris Yeltsin acted to relax the relatively tight
monetary policy of the central bank. This ensured that joblessness and the failure of enterprises to pay wages to their
workers would have a minimal impact on electoral preference. U.S. presidential candidates may support higher levels of
defense expenditure to capture votes in politically marginal areas where the local economy is highly defense dependent.
This “pork barrel” analysis has three general implications for government activity. First, voters, or groups of voters, that
care a great deal about a specific issue are likely to be rewarded for their concern. This is especially true of “single issue”
voters. For example, in the United States it would be difficult to reduce health care expenditure for the elderly largely
because this is a decisive issue for a large group of voters. Second, in countries where politicians rely on contributions to
finance their election campaigns, the concerns of the check-writing rich are, ceteris paribus, likely to receive greater
attention than those of the poor. Finally, because of log rolling, the creation of coalitions will result in a general oversupply
of quasi-public goods.

AGENCY INERTIA.   Once created, bureaucracies tend to have a life of their own, and they will seek to perpetuate their
existence by finding work to do. In 1935 the Roosevelt administration founded the Rural Electrification Authority to
facilitate the provision of electricity to rural farms and households. Since practically all households now have power, and
those who don’t have a lifestyle so remote that they can be presumed to be avoiding it, its task is now finished. However, it
stays in business, albeit under the new name of the Rural Utilities Service, by providing subsidized funds to ski areas and
golf courses. This is not a unique oddity, but results when bureaucrats have little interest in cutting their own jobs and in
some cases have a choke-hold on the information about their own activities.

DEADWEIGHT LOSS AND TAXES.   The case for “correcting” market failure rests on imperfect markets causing a deadweight
loss, a fall in economic welfare that accrues to no one. However, government action is not costless and requires finance in
one of three ways: taxation, borrowing, or the printing of money, any of which inevitably has an adverse effect on the
operation of the market and therefore its own deadweight loss.
With the exception of lump-sum taxes (those levied on a base that is totally inelastic such as a poll tax, whose base is
population),16 all taxes influence economic choices by changing relative prices. They thereby impose an excess burden
and reduce economic welfare. Taxes on income, for example, drive a “wedge” that distorts the household’s choice between
labor and leisure. Consumption, value-added, and excise taxes also change relative prices, distorting choice and creating
deadweight losses.
Sometimes a particular tax results in a large excess burden while generating little revenue. In the late 18th century, for
example, Britain imposed a revenue-raising tax on the improbable tax base of number of windows. The rationale behind
this was that the number of windows in a dwelling was a rough approximation of the wealth of the occupant. It also had the
advantage of being a highly visible tax handle. However, in order to avoid the tax, many occupants simply bricked up
windows, hence, reducing the tax base. Any change in behavior occasioned solely by the imposition of a tax is an example
of deadweight loss.
While less visible than taxes, the other means of finance for government also imply deadweight losses. An increase in
government borrowing will tend to raise interest rates, thereby distorting the choice between saving and consumption, and
will lead, it is frequently argued, to a crowding out of private-sector investment. Printing money has inflationary
consequences that, even if anticipated, distort the choice between present and future consumption and if unforeseen by
some will have profound distributional consequences. It is therefore important to recognize that any government
expenditure must be financed by means that impose welfare losses. Any efficiency gains that can be anticipated by the
establishment of regulatory agencies or the provision of public goods must be weighed against the efficiency losses that are
occasioned by raising the revenue to finance them.

GOVERNMENT AND REDISTRIBUTION

Government action is not limited to regulation nor is government expenditure limited to the provision of goods and
services. A large part of government spending, particularly in industrialized countries, consists of redistributive
expenditures. This is the part of the government budget that has grown most rapidly in recent years and that will, for the
reasons of interest group politics outlined earlier, be difficult to contain or curtail in the years ahead.
 Redistributive expenditures can take two forms. They may be direct transfer payments of cash (such as old age
pensions, unemployment compensation, and cash welfare benefits). Alternatively, redistribution may take an in-kind form
such as the provision of subsidized housing, free education, free medicine, and so on. These are all goods and services that
may be provided by the market but to which the less well off have limited access since they are constrained by limited
budgets. These redistributional expenditures have come to dominate the public finances
of most of the developed market economies. In the cross-section of countries of Western Europe and the United States,
subsidized housing and social security payments taken together represent between 38 percent and 60 percent of total
government expenditure. However, statistics like this tend to overstate the redistributive stance of most government policy
toward lower income groups. While many program expenditures are targeted toward the poor, these are by and large offset
by tax expenditures that favor the better off. Such tax expenditures take the form of tax relief for inter alia pension
contributions, insurance premia, mortgage payments, and property tax payments, all of which are expenditures that rise
more than proportionally with income.
The justification of a role for government in reshaping the distribution of income that results from market interaction
must be different from that which legitimizes the “correction” of market imperfections that reduce allocative efficiency.
Although the income and wealth distributions that result from a market economy are frequently seen as one of its
“failures,” it is not apparent that a fall in efficiency results. A somewhat tenuous case can been made that a more even
income distribution can enhance social cohesion, and thus “social productivity,” but it is by no means universally
accepted.17
The “justness” of the distribution of income that results in a market system depends on the idea that material reward
should be directly related to contribution.18 Given the appropriate assumptions, each factor of production in a market
economy may be thought of as being appropriately rewarded when it receives its marginal value product; that is, each
factor is paid what it contributes at the margin. An individual’s, or a family’s, income is therefore the sum of the
contributions of the factors of production that it owns or controls. These factors derive from six sources:
1. Natural talent and ability. Ability is not equally distributed at birth. Some people have characteristics (intelligence,
strength, stature) that are going to be more productive and therefore more rewarded than others.
2. Acquired skills. The earning power of congenital characteristics is qualified by the skills and experience acquired
during education and working life. Economists generally regard this as the accumulation of human capital
(investment in oneself) made by education and foregone earnings.
3. Effort. Inasmuch as effort is a determinant of productivity it should have an effect on earnings. Employers should
hire the hard worker and pay him or her more than a time server. The ability to do this is conditioned on the ability
of employers to pay different rates for the same job description, which is often organizationally difficult or in some
cases legally prohibited.
4. Inherited wealth. In almost all of the countries for which we have good statistics, wealth is distributed less equally
than income. Much of this is due to inheritance whereby blocs of wealth, represented by productive physical and
financial assets, are passed from generation to generation. It is also important to note that human capital and
inherited wealth are highly correlated. More affluent parents are more able to invest in the human capital of their
offspring.
5. Accumulated savings. Not all physical and financial assets are inherited. One’s stock of productive assets is also a
function of savings and consumption decisions made over a lifetime. The more one foregoes in one time period, the
greater will be the capital to be consumed in a later one.
6. Related supply and demand considerations. Finally, income has a lot to do with circumstances over which we have
little control. The value of a worker’s marginal product, for example, is a function of the supply and demand, and
therefore the price, of the product that he makes. Consider a coal miner. His income would rise should the world oil
supply be restricted, but it might fall were a technology for cheap solar energy devised.
Given these complex considerations (which are compounded by the many imperfections of both product and factor
markets), it becomes difficult to sustain a belief in the unique justice of market-based distribution. Most people would
accept the premise that the amount of effort one puts into one’s work, as well as the amount of saving and investment in
one’s own human capital, should be rewarded. These represent sacrifices that should be compensated, and be seen to be
compensated, because of favorable incentive effects.
There is still strong disagreement on the ethics of inheritance. In the immediate  post–World War II period, especially in
the European social democracies, egalitarian sentiment supported the enactment of almost confiscatory estate taxation
designed to break up inherited wealth and level the playing field for a new generation. However, loopholes enabled those
who availed themselves of forward thinking estate planning to avoid the tax, and the incidence fell only on the unwary.
Today, tax planners refer to the estate tax in the United States as “the voluntary tax.”
 Governments not only affect the income distribution by tax and transfer, but they may also attempt to influence the
structure of wages. One frequently used policy is the institution of a minimum wage. The original justification was that all
jobs should pay at least “a living wage.” Within the United States at least this has clearly not been achieved, and many
critics claim that the imposition of a nonmarket clearing wage has resulted in high levels of unemployment, especially
among young people. Currently in the United States and in some nations of Europe, there is pressure on the government to
influence the labor market through the imposition of a wage structure based on “comparable worth.” In simple terms, this
theory suggests that two jobs that require roughly similar effort, education, and qualifications should be paid similarly. It
has been used to justify setting public-sector pay scales in line with private ones and was a part of the Swedish system of
wage settlement. It has also been used as an argument to raise the rates of pay in typically “female” occupations to
eliminate the gap between male and female average wages.

Justifications for Redistributive Policy

What then are the cases that might be made for government intervention to amend or correct the income distribution
determined by the market? Some of the most familiar are discussed next.

UTILITARIANISM.   If we start from a generally held position in economics, that the more one has of a good the less it is
valued at the margin, it can be argued that the intrinsic value of one dollar is greater to a poor person than a rich one.
Consequently, taking a dollar from a rich person and giving it to a poor one would increase social well-being. This
utilitarian (or “greatest happiness of the greatest number”) principle makes a case for the maximization of social well-
being through redistribution. It follows that an enlightened Benthamite social guardian might pursue redistribution on these
grounds, subject always to the caveat that the disincentive effects on total output are less than the welfare gain. However,
in reality such a picture of government is at variance with the views that we laid out earlier.

ALTRUISM.   The development of extensive social welfare programs has been seen as an outgrowth of collective altruism.
In such a view the welfare-promoting aspects are even greater than the utilitarian rationale. Under altruistic motivation,
giving, like Portia’s “quality of mercy,” would be twice blessed, enhancing the welfare of both givers and receivers. Again,
however, there seems little support for this as an explanation for the growth of major social programs.

SOCIAL CONTRACT.   A more contemporary view of redistribution is that it is motivated by quasi-contractual relationships.
In this conception citizenship, or residence, endows everyone with rights to a minimum standard of living. Thus it is the
right of the old, the young, the halt, the lame, and the unemployed or others who have little to sell in the market system to
be supported to some minimum level. A key question is where that minimum level should be located.
In early capitalist economies, the right was to subsistence alone, and no more. Support above that level was denied
because it would reward indigence and, according to vacuum theory of population, attributed to Malthus, it would
increase the number of paupers. Consequently, support for the poor whether “indoor” (that is in poorhouses) or “outdoor”
using cash grants and in-kind support was minimal. The rise of the liberal welfare states and the extension of the voting
franchise changed that. In contemporary European social democracies, the level of support is relatively high, and the
income distribution that results is quite egalitarian. The income share of the richest 20 percent in Europe is generally
around five times that of the poorest 20 percent, as opposed to about 8:1 in the United States. Such redistribution is
criticized by “supply-side” economists because it reduces the incentive to find work and contributes to the high level of
unemployment. On the other side of the coin, financing redistributive policies requires high rates of taxation, which lower
the incentives to work and to save. Thus egalitarianism is seen as a root cause of economic stagnation. When transfers are
regarded as rights or entitlements, demographics play a powerful role in determining the structure of expenditures. Low
birthrates and a sharp increase in life expectancy have caused a pronounced aging of the population in industrial societies
and require ever higher levels of transfer.

THE INCREASE OF SOCIAL PRODUCTIVITY.   Redistribution has been justified as having a positive impact on social
productivity. This might be achieved in two ways. By elevating social cohesion it might solidify institutions that are
beneficial to growth. Moreover, redistribution can lower social problems, leading to savings on expenditures (like crime or
remedial education).
SOCIAL CONTROL.   A fifth view sees redistribution in contemporary market economies as a tool in a struggle to maintain
social peace and stability. Potential disruptive elements of society are bought off by providing access to quite generous
pensions and goods. This strategy certainly has a history. Imperial Rome secured the quiescence of the Roman unemployed
through the provision of free “bread and circuses.” The response to contemporary urban disturbances in industrialized
countries has frequently been to increase the number and funding of social programs oriented toward the disaffected group.
Redistribution can be regarded as a substitute for expenditure on more conventional aspects of law enforcement. The level
of distribution is not determined by concern for, or by rights of, groups disadvantaged by the market process but rather by
the potential power of disaffected groups to create problems.

SHARED GROWTH.   Economists are not unanimous about the relationship between income distribution and economic
growth. Some see in egalitarianism a lowering of incentives and a consequent slower growth path. Others are adamant that
sharing of the proceeds of growth is essential to maintain a growth trajectory; growth that benefits only a few is likely to be
unstable because it leads to a loss of social unity. Each group has some merit; both extreme egalitarianism and extreme
reliance on material incentives (which leads to an unequal distribution of income) are likely to present problems. Some
commentators on the strong growth performance of East Asian economies have noted the sharing of growth as an
important factor in sustaining economic expansion.

THE DEMOCRATIC PROCESS.   In modern democracies the key to the increased share of redistributional expenditure is likely
to be found in the ballot box. Earlier we discussed how politicians act so as to ensure their subsequent reelection, and
providing access to redistribution is one way of influencing voter behavior. This is an especially potent explanation when
the potential group is unified and “single-issue oriented.” This basic thought underlies much of the work of James
Buchanan, Nobel laureate in economics.

DEMAND STABILIZATION.   Capitalist economies are subject to variations in the level of macroeconomic activity, and at
times this has been ascribed to a systemic tendency toward underconsumption. Inasmuch as the less well off have a higher
marginal propensity to consume than the better off, redistribution from rich to poor lowers the societal marginal propensity
to save and reduces the chance of an “underconsumptionist trap.” From the English liberal economist John Hobson
onward,19 some economists have advocated domestic redistribution as an antidote to recession. While it is hard to see such
a clear espousal of a particular macroeconomic theory by the politicians who ultimately determine redistributive policy, it
is a fact that developed nations have managed to steer clear of major recessions since the inception of mass redistribution
programs.

CONCLUSION
Where does this leave us in evaluating the role of government in correcting the inefficient or unacceptable features of
market logic? In the light of this discussion, few would assert that each and every market imperfection is a case for
government intervention. The particular failures of the market must be evaluated against cost and potential failures of
government intervention before any action is initiated.
Even in those cases where market failure is so pronounced that some government intervention is merited, economists
would be best employed in considering solutions that are designed to reduce the risk of government failure, rather than
assuming that regulation along the old lines was necessarily beneficial. The new view of government suggests that policies
that provide individuals with incentives and freedom to correct market failure might be best. At present we have few
examples of these kinds of policies, which might be described as incentive-compatible or market augmenting policies.
Promising approaches seem to lie in the use of quasi-markets to assist in the provision of services currently supplied
largely by the government. This would allow the simultaneous addressing of the equity and the efficiency issue. Such a
device would be the use of vouchers provided gratis by the government to eligible families with children, but which could
then be used to pay for educational services. Market augmenting approaches have also been used in Asian countries as a
means of determining which firms should receive government support, and these will be looked at again when Japan and
Korea are presented in chapters 10 and 11 of this book.
It is sufficient at this point to suggest that the direction of future research should be to identify the areas of comparative
advantage for government and to examine how the logic of the market and appropriately designed incentives may be used
to better the performance of government.

KEY TERMS AND CONCEPTS

agency inertia lack of information
altruism market-augmenting policy
 antitrust policy market failure
barriers to entry market power
capture of regulators national champions
caveat emptor natural monopoly
collective action poll tax
contestable markets pork barreling
deadweight loss price setter
diminishability price takers
excludability private marginal cost
externalities public goods
four firm concentration ratio quasi-markets
free rider problem rent-seeking behavior
government failure social contract
Herfindahl-Hirschman index social marginal cost
incentive-compatible policy tax expenditures
trade to GDP ratio utilitarianism
transfer payments vacuum theory of population

QUESTIONS FOR DISCUSSION

1. Evaluate the arguments for and against the use of government power to curb monopolies.
2. How has the need to regulate “natural monopolies” changed in recent years?
3. Why are concentration ratios not thought of as good indices of the level of industry-wide competition? What may be
a better approach?
4. How does lack of information impede the operation of a market system? How can a government act to correct this?
5. Define public goods. Are pure public goods an important category? Give some examples. Is information a pure
public good?
6. Why may government action be required to correct externality problems like pollution? Which type of system,
planned or market, would you expect to lead to most pollution?
7. Why is the government not a “benevolent, costless social guardian”?
8. Give some reasons why redistribution via both cash and in-kind payments is the fastest growing governmental
activity.

RESOURCES

Web Sites
U.S. Federal Trade Commission www.ftc.gov/
This site has useful information and downloadable papers on specific industries.
U.K. Office of Fair Trading www.oft.gov.uk/
This site gives the background, philosophy, and structure of U.K. policy against monopoly.

Books and Articles

Baumol, William J., John C. Panzar, and Robert Willig. Contestable Markets and the Theory of Industry Structure. New York :
Harcourt Brace Jovanovich, 1982.
Brock, Gerald W. Telecommunication Policy for the Information Age : From Monopoly to Competition. Cambridge: Harvard University
Press, 1998.
Buchanan, James M., and Richard A. Musgrave. Public Finance and Public Choice : Two Constrasting Visions of the State. Cambridge:
MIT Press, 1999.
Buchanan, James M., and Gordon Tullock. The Calculus of Consent. Ann Arbor: University of Michigan, 1962.
Coase, Ronald. “The Problem of Social Cost.” Journal of Law and Economics 3 (October 1960): 1–44.
Crandall, Robert. “Import Quotas and the Automobile Industry.” Brookings Review, summer 1984, 8–16.
Krueger, Anne. “Economists’ Changing Perceptions of Government.” Weltwirtschaftliches Archiv 126, no. 3 (1990): 419.
Musgrave, Richard A. Public Finance in a Democratic Society: The Foundations of Taxation and Expenditure. White Plains: Edward
Elgar, 2000.
Okun, Arthur. Equity and Efficiency: The Big Trade-off. Washington, D.C.: Brookings, 1975.
Olsen, Mancur. The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge: Harvard University Press, 1971.
Train, Kenneth E. Optimal Regulation : The Economic Theory of Natural Monopoly. Cambridge: MIT Press, 1991.
Viscusi, W. Kip, John Vernon, and Joseph Harrington. Economics of Regulation and Anti Trust, 2d ed. Cambridge: MIT Press, 1995.

1Average general government receipts comprised 38.2 percent of GDP in the OECD nations in 1996. Disbursements averaged 41
percent, creating an average general government deficit of 2.8 percent of GDP.
2This apparently universal and irresistible trend has been dignified with the label Wagner’s law, after the work of the 19th-century
German political economist Adolph Wagner.
3In fact monopsony is most likely to lie with the government, which is often the sole purchaser of defense output and which in the
welfare states of many European countries is the sole purchaser of health-related goods. There is little harm to the general welfare in
this form of monopsony, which is frequently seen as a “countervailing power” to monopoly power.
4A good discussion of these measures as well as issues of entry can be found in W. Kip Viscusi, John Vernon, and Joseph Harrington,
Economics of Regulation and Anti Trust, 2d ed. (Cambridge: MIT, 1995).
5The original discussion on this topic can be read in William J. Baumol, John C. Panzar, and Robert Willig in Contestable Markets and
the Theory of Industry Structure (New York: Harcourt Brace Jovanovich, 1982).
6On balance, trade barriers have been falling across the world due to unilateral tariff cutting and the action of the successive rounds of
trade negotiations under the General Agreement on Tariffs and Trade (GATT) and now the World Trade Organization (WTO). One
counter to this trend has been the increase in nontariff barriers to trade (NTBs) in recent years.
7French policy has often leaned in this direction, especially in the 1970s and 1980s when a policy of creating publicly owned national
champions in key industries was espoused.
8The Combination Acts were legislated in 1800 and repealed in 1825; although unions were legal, leaders were still frequently
prosecuted for specific job actions, such as strikes. See Rondo Cameron, A Concise Economic History of the World (New York: Oxford
University Press, 1989), 218.
9In fact, despite the clear public good qualities of lighthouses, in the 19th century they were provided largely by private charities.
10Ronald Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (October 1960): 1–44.
11Anne Krueger, “Economists’ Changing Perceptions of Government,” Weltwirtschaftliches Archiv 126, no. 3 (1990): 419.
12See Mancur Olsen, The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge: Harvard University Press,
1971).
13Robert Crandall, “Import Quotas and the Automobile Industry: the Costs of Protection,” Brookings Review, summer 1984, 8–16.
14Note that the Japanese motor industry shares in these rents that are extracted from the U.S. consumer. Also bear in mind that the
government action produces a deadweight loss (due to reduced consumption) as well as the redistribution from consumers to the
industry, which is due to increased prices.
15James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1989).
16In fact, even a poll tax can have an effect on the choice of family size and so will have a deadweight loss in the long run.
17The “Swedish model,” which we review in chapter 7, lays stress on social cohesion and egalitarianism.
18For an interesting discussion of the justice of rewards in a market economy, see Arthur Okun, Equity and Efficiency: The Big Trade-
off (Washington, D.C.: Brookings, 1975), 40–50. Reprinted in part as “Rewards in a Market Economy” in Bornstein Comparative
Economic Systems: Models and Cases.
19Hobson anticipated many of Keynes’s views on the dangers of underconsumption, although his main agenda was to restrain overseas
imperialism, which in its relentlessness to attach for foreign markets by force was an alternative remedy to redistribution for domestic
stagnation.

 FIGURE 4.1

Monopoly SOURCES OF MARKET FAILURE: MARKET POWER

 FIGURE 4.2


 FIGURE 4.3


Private and Social Marginal Costs and Benefits