Chapter 2 WELFARE ECONOMICS AND PUBLIC FINANCE Russell S. Sobel West Virginia University [email protected] Abstract This contribution deals firstly with the differences between market ac- tion and government action, and then explores the justification for gov- ernment intervention based on concepts of economic efficiency and eq- uity. The chapter then proceeds to discuss individual cases in which un- regulated private market outcomes are generally considered to violate this criterion. Keywords: Equity, economic efficiency, economic stabilization, market failure, monetary stability, welfare economics JEL classification: D60, H11 1. INTRODUCTION In a market economy, it is commonly accepted that the role of government should be limited. This philosophical approach not only dominates economic thinking back to the time of Adam Smith’s Wealth of Nations in 1776, but can also be clearly seen in eighteenth-century political philosophy in the writings of Locke, Jefferson, and Madison, among others. It is a philosophical approach that is plainly expressed in the U.S. Constitution adopted in 1789.1 The mod- ern interpretation of the principle of limited government within the field of economics envisions a more active role for government than the founding fa- thers would have held. It is, however, still based in the idea that public sector intervention should be limited. In particular, government intervention should be limited to cases in which the outcome of the private unregulated market is somehow judged to be undesirable. That is, in each case, the market outcome is compared to some ideal and only when it fails to meet that ideal is there a role for government intervention. 20 RUSSELL S. SOBEL In modern economic analysis, the two criteria generally used to judge a market outcome are efficiency and equity. Efficiency is defined as economic (or Pareto) efficiency, while equity deals with the more ambiguous issue of fairness. These two criteria differ substantially as the first (efficiency) is a pos- itive, objective criterion, while the other (equity) is a normative, subjective criterion. Because of this difference, arguments for government intervention in cases when markets fail to achieve efficiency are somewhat less contro- versial than are arguments for government intervention based on equity con- siderations. It is worth explicitly noting that the commonly used term “market failure” corresponds only to cases in which the private unregulated market out- come fails to meet the conditions for economic efficiency and is not generally used for judgments on equity grounds.2 Economic thinking about the role of government in the economy has under- gone a drastic change over the past three decades due primarily to the insights provided by public choice analysis. It was once thought that any case in which a market failed to meet the conditions for economic efficiency necessarily im- plied that the government should intervene and move the market toward the efficient outcome. Recent economic thinking incorporates the idea that public sector institutions are also imperfect, that there is a cost of using them, and thus there is no a priori reason to believe that government intervention into an imperfect market will necessarily lead to a more efficient outcome. This is perhaps best illustrated in the following quote from George Stigler: A famous theorem in economics states that a competitive enterprise economy will pro- duce the largest possible income from a given stock of resources. No real economy meets the exact conditions of the theorem, and all real economies will fall short of the ideal economy— a difference called “market failure.” In my view, however, the degree of “market failure” for the American economy is much smaller than the “political failure” arising from the imper- fections of economic policies found in real political systems. The merits of laissez-faire rest less upon its famous theoretical foundations than upon its advantages over the actual perfor- mance of rival forms of economic organization.3 Indeed, it is now accepted that in some cases an unregulated “bad” mar- ket outcome may still be preferable to the one achieved with government intervention.4 The burden has shifted from one in which government involve- ment was justified in all cases of imperfect market outcomes to one in which government involvement is justified only in cases where the potentially im- perfect outcome with government involvement is likely to be better than the imperfect outcome with an unregulated private market. Thus, modern public sector economists tend to be in favor of an even more limited role of govern- ment than were public sector economists of the past. This chapter proceeds by first discussing the differences between market action and government action, and then exploring the justification for govern- ment intervention based on concepts of economic efficiency and equity. The WELFARE ECONOMICS AND PUBLIC FINANCE 21 chapter then proceeds to discuss individual cases in which unregulated private market outcomes are generally considered to violate these criterion. 2. THE DIFFERENCE BETWEEN MARKET ACTION AND GOVERNMENT ACTION The private sector (markets) and the public sector (government) may simply be thought of as two alternative institutions that can be used to allocate scarce resources in an economy. In a market economy, characterized by private own- ership, it is important to remember that these resources are not owned collec- tively by society, but rather are owned privately by individuals. The market process that allocates these resources works through the voluntary, uncoerced specialization and exchange undertaken by individual owners. In contrast, col- lective action undertaken through the public sector uses the coercive powers of government to alter the choices of individual owners. This is the first of two fundamental differences between market action and government action—the reliance on voluntary choice versus coercion to allocate resources. When mar- ket exchange occurs it is clear that both parties have been made better off (or were both expecting to be made better off), while with government action it is frequently the case that some parties have been made better off while others have been made worse off.5 The second fundamental difference between market action and government action rests in the nature of planning and choice. In the public sector plan- ning is done centrally, while in private markets planning is done individually. Government intervention can thus be thought of as replacing individual plan- ning with central planning. In markets, individuals are left to make choices based on the personal costs and benefits they face according to their individual preferences. When action is done through the public sector, the choices and decisions must be made collectively. Collective choice is a much more diffi- cult process than individual choice as it requires a mechanism for aggregating the preferences of many diverse individuals. To make good collective choices requires registering or knowing a vast amount of information about individual preferences. The fact that no single central planner could possibly know all the information necessary to make these good choices was a key element of F.A. Hayek’s (1945) defense of capitalism over socialism. In modern market based economies, democratic voting procedures, rather than the selection of a knowledgeable central planner, is generally used as the process to make col- lective choices. These voting rules, however, inherently have problems with registering the intensity of preferences, getting individuals to truthfully reveal their preferences, and providing enough incentive for voters to become well informed about the choices they must make.6 22 RUSSELL S. SOBEL Models of public sector intervention in cases of market failure have histori- cally modeled government as being represented by a socially benevolent dicta- tor who had all the information necessary to make changes that would improve the efficiency of resource allocation. Modern day economic analysis, how- ever, generally models the process of collective choice as one dominated by rationally ignorant voters, powerful special interest groups, vote-maximizing elected officials, and budget-maximizing bureaucrats. It should be apparent that this has important implications for government intervention, both to cor- rect market failure and to achieve normative equity goals. Interest groups and bureaucrats will tend to cloak their self-interested demands for transfers, bud- gets, and legislation as policies to address market failures or equity goals, even when that is not the true intention of the policy. For this reason, stringent con- straints on government intervention and regulation appear necessary. 3. THE CONCEPT OF ECONOMIC EFFICIENCY Within the neoclassical economic paradigm, economic efficiency is the benchmark by which both market outcomes and government intervention are judged. Economic efficiency requires two conditions be met: (1) all actions generating more social benefits than costs should be under- taken, and (2) no actions generating more social costs than benefits should be under- taken. If both of these conditions are met, a Pareto Optimal allocation will be attained—that is, one in which it is impossible to reallocate resources in such a way to make at least one person better off without harming another person.7 When market exchange occurs it is clear that both parties have been made better off, while when government