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UNIT 12 GOVERNMENTS AND MARKETS IN A DEMOCRATIC SOCIETY INTRODUCTION • Governments and markets, along with firms and families, are the major economic institutions today; how they are organized and how they interact affect the extent to which economic outcomes are efficient and fair. • Some economic activities are better organized primarily by markets, others by firms, families, and governments. • Market competition allows large numbers of people to interact in mutually beneficial ways because prices convey important economic information that would be difficult, if not impossible, for a government to obtain and use in their absence. • A government is distinct from other actors in society not because public officials are less self-interested than private economic actors, but because it has the capacity to act on behalf of all the people and require citizens to abide by its decisions, using force if necessary (for example, police powers). • Governments also use tax funds to provide goods and services (such as the courts or schooling and, in some countries, health care), that are usually free of charge. • Ideally, democracy empowers citizens by extending voting rights in competitive elections to everyone, and limits what governments and other powerful bodies can do by ensuring individual rights of speech and association. • Even in cases in which public policies to address unfairness or market failures are economically feasible, they may still not be carried out because powerful groups, including the wealthy or government elites, pursue other objectives, or because governments do not have the capacity to implement them. 513 UNIT 12 GOVERNMENTS AND MARKETS IN A DEMOCRATIC SOCIETY The Social Science 125 course at Harvard University was oversubscribed; more students had signed up for it than could be enrolled, given the 95-student limit placed on class size. Students who crowded into the lecture hall on the first day of the semester were surprised when the professor announced that admission to the course would go to the 95 high- est bidders. The sums collected, he explained, would help to pay for the cost of extra materials to be circulated to students. He then asked students to write down their student ID numbers and the amount of US dollars they were willing to pay for admission to the course. Who was this professor? Samuel ‘Why should I pay to get into a class?’ one of the students asked politely. Bowles, one of our authors. The professor replied that limiting the class size was regrettable but necessary. In the circumstances, he said, the best way to allocate the scarce places was to identify the students most willing to pay for a place. What other methods could he have considered? • Randomly selecting students to be admitted by lot: This would mean that some students who really wanted to take the class would be excluded, while others who were barely interested would be enrolled. • Asking students how interested they were: This would not work, he explained to his students, because there would be no reason to tell the truth if it meant you might not win a place. Each student would have an incentive to exaggerate. As an economist, the professor proposed to allocate places in the class in a similar manner to the way in which access to most goods and services is allocated in a capitalist economy, that is, by means of a market. Students could bid for their places. Imagine that you had been there, hoping to enrol in the class that day. Would you have accepted his logic? Most of the students did not. And when he tried the same thing in another class, some students shouted insults at him and walked out! The professor wasn’t really going to auction places in his class to the highest bidders; his experiment was simply a first lesson in economics for the students. Nevertheless, every day school administrators, healthcare providers, managers of food banks, and many others face the problem of allocating scarce resources among individuals with differing needs. Their decisions are real. Here is one of those real-life dilemmas. You must decide who will receive an organ transplant, say, a kidney: • Buying and selling kidneys is illegal in most places: An illegal (black) market exists, in which the huge differences between the price received by organ donors (many of them very poor) and price paid by organ recipients (mostly rich) deliver profits to the criminals who organize the transactions. • Some generous people choose to donate a kidney: This is legal, and they are allocated according to medical professionals’ determination of medical need; possible beneficiaries are under the care of well-connected physicians. Kidneys can be allocated using a combination of medical need and generosity. We know that many people waiting for kidney transplants die every day, because there are too few donors to save everyone who needs a 514 INTRODUCTION transplant. So, might it be feasible to let people buy a kidney instead? If so, we can add a third option: • Create a legal market for kidneys: Some people would prefer to be able to buy and sell kidneys, if there were strict regulations to ensure the safety of donor and recipient. But letting kidneys be allocated by markets like any other good that is sold—like clothes or cars—has been criticized on the grounds that, under this arrangement, only rich people would get transplants. You might object to this system, reasoning: ‘The difference between the people who get replacement kidneys and the people who don’t, is not that one group values life more than the other; it is that only one group can afford it.’ In this case, ‘willingness to pay’ is simply ‘ability to pay’. There is yet another way to improve the way in which kidney transplants can be organized: • Create a matching platform for kidneys: This would use a digital techno- logy like Airbnb or Uber. The platform would connect potential donors and recipients, but with a twist. Suppose your brother needed a replacement kidney, and you were willing to donate one of yours. But you are very unlikely to be able to donate your kidney to your brother because matching between donors and recipients is complicated (blood and tissue type must match). So, under this proposal, you would contribute your kidney to the overall supply of available kidneys, and in return be entitled to a properly matched kidney for your brother. A network of exactly this kind is providing replacement kidneys in the US under the New England Program for Kidney Exchange (NEPKE), which you can hear more about in our ‘Economist in action’ video featuring Alvin Roth, a Nobel Laureate in economics and former president of the American Economic Association. NEPKE is like a market in that it allows exchanges to take place among total strangers who are matched by what they need or can provide. But unlike a market, who gets what is not based on the willingness to pay. The key to getting a replacement kidney is not being wealthy enough to afford one, but instead having some friend or family member (or even a stranger) who is willing to contribute a kidney to the pool so that the person needing the replacement gets a kidney matching his type. Markets sometimes seem to be everywhere in the economy, but this is not so. • Firms are not markets: Recall Herbert Simon’s image (page 250) from Unit 6 of a Martian viewing the economy. The Martian mainly sees green fields, which are firms. They are connected by red lines representing buying and selling in markets, but many resource allocation decisions are made within the firms. Alvin Roth explains how matching • Families are not markets: They do not allocate resources between parents markets work. http://tinyco.re/ and children by buying and selling. 8435358 • Governments are not markets: They use the political process rather than market competition to determine where, and by whom, schools are built and roads maintained. 515 UNIT 12 GOVERNMENTS AND MARKETS IN A DEMOCRATIC SOCIETY Why are some goods and services allocated in markets, while firms, families, and governments allocate others? This is an old question, and one that is hotly debated. But the main reason is that some kinds of activities are better organized if they are regulated by the rules of the game that characterize families, or governments, or firms, instead of by markets. It is hard to see, for example, how conceiving and raising children could be effectively carried out by firms or markets. A combination of families and governments (schooling) does the job in most societies. People disagree about the appropriate extent of the market. Some think that things that are now to some extent for sale—like sex, or influence over political decisions—should be allocated by other means. Others think that markets should take a larger role in the economy. These disagreements are about matters of fact (for example, do public schools or home schooling do a better job?) and matters of value (is the sale of sexual services or bodily organs immoral, even if these transactions are well regulated?). In this unit, we consider why some economic activities are organized primarily by markets and some are organized in other ways, by firms, families and governments. Family is the main institution that organizes how we give birth to infants and raise them in their first few years of life. In the rules of the game characteristic of families, parents teach and set limits for children, and these rules differ from the way markets determine out- comes. Similarly, as you learned in Unit 6, firms organize the process of production through a top–down structure of command, from owners to managers at various levels, down to production workers.

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