Governement and the Economy

Although the market system in the United States relies on private ownership and decentralized decision-making by households and privately owned businesses, the government does perform important economic functions. The government passes and enforces laws that protect the property rights of individuals and businesses. It restricts economic activities that are considered unfair or socially unacceptable.

In addition, government programs regulate safety in products and in the workplace, provide national defense, and provide public assistance to some members of society coping with economic hardship. There are some products that must be provided to households and firms by the government because they cannot be produced profitably by private firms. For example, the government funds the construction of interstate highways, and operates vaccination programs to maintain public health. Local governments operate public elementary and secondary schools to ensure that as many children as possible will receive an education, even when their parents are unable to afford private schools.

Other kinds of goods and services (such as health care and higher education) are produced and consumed in private markets, but the government attempts to increase the amount of these products available in the economy. For yet other goods and services, the government acts to decrease the amount produced and consumed; these include alcohol, tobacco, and products that create high levels of pollution. These special cases where markets fail to produce the right amount of certain goods and services mean that the government has a large and important role to play in adjusting some production patterns in the U.S. economy. But economists and other analysts have also found special reasons why government policies and programs often fail, too.

At the most basic level, the government makes it possible for markets to function more efficiently by clearly defining and enforcing people’s property or ownership rights to resources and by providing a stable currency and a central banking system (the Federal Reserve System in the U.S. economy). Even these basic functions require a wide range of government programs and employees. For example, the government maintains offices for recording deeds to property, courts to interpret contracts and resolve disputes over property rights, and police and other law enforcement agencies to prevent or punish theft and fraud. The Treasury Department issues currency and coins and handles the government’s revenues and expenditures. And as we have seen, the Federal Reserve System controls the nation’s supply of money and availability of credit. To perform these basic functions, the government must be able to shift resources from private to public uses. It does this mainly through taxes, but also with user fees for some services (such as admission fees to national parks), and by borrowing money when it issues government bonds.

In the U.S. economy, private markets are generally used to allocate basic products such as food, housing, and clothing. Most economists—and most Americans—widely accept that competitive markets perform these functions most efficiently. One role of government is to maintain competition in these markets so that they will continue to operate efficiently. In other areas, however, markets are not allowed to operate because other considerations have been deemed more important than economic efficiency. In these cases, the government has declared certain practices illegal. For example, in the United States people are not free to buy and sell votes in political elections. Instead, the political system is based on the democratic rule of “one person, one vote.” It is also illegal to buy and sell many kinds of drugs. After the Civil War (1861-1865) the Constitution was amended to make slavery illegal, resulting in a major change in the structure of U.S. society and the economy.

In other cases, the government allows private markets to operate, but regulates them. For example, the government makes laws and regulations concerning product safety. Some of these laws and regulations prohibit the use of highly flammable material in the manufacture of children’s clothing. Other regulations call for government inspection of food products, and still others require extensive government review and approval of potential prescription drugs.

In still other situations, the government determines that private markets result in too much production and consumption of some goods, such as alcohol, tobacco, and products that contribute to environmental pollution. The government is also concerned when markets provide too little of other products, such as vaccinations that prevent contagious diseases. The government can use its spending and taxing authority to change the level of production and consumption of these products, for example, by subsidizing vaccinations.

Even the staunchest supporters of private markets have recognized a role for the government to provide a safety net of support for U.S. citizens. This support includes providing income, housing, food, and medicine for those who cannot provide a basic standard of living for themselves or their families.

Because the federal government has become such a large part of the U.S. economy over the past century, it sometimes tries to reduce levels of unemployment or inflation by changing its overall level of spending and taxes. This is done with an eye to the monetary policies carried out by the Federal Reserve System, which also have an effect on the national rates of inflation, unemployment, and economic growth. The Federal Reserve System itself is chartered by federal legislation, and the president of the United States appoints board members of the Federal Reserve, with the approval of the U.S. Senate. However, the private banks that belong to the system own the Federal Reserve, and its policy and operational decisions are made independently of Congress and the president.

Correcting Market Failures

The government attempts to adjust the production and consumption of particular goods and services where private markets fail to produce efficient levels of output for those products. The two major examples of these market failures are what economists call public goods and external benefits or costs. 

Correcting Market Failures - Providing Public Goods

Private markets do not provide some essential goods and services, such as national defense. Because national defense is so important to the nation’s existence, the government steps in and entirely funds and administers this product.

Public goods differ from private goods in two key respects. First, a public good can be used by one person without reducing the amount available for others to use. This is known as shared consumption. An example of a public good that has this characteristic is a spraying or fogging program to kill mosquitoes. The spraying reduces the number of mosquitoes for all of the people who live in an area, not just for one person or family. The opposite occurs in the consumption of private goods. When one person consumes a private good, other people cannot use the product. This is known as rival consumption. A good example of rival consumption is a hamburger. If someone else eats the sandwich, you cannot.

The second key characteristic of public goods is called the nonexclusion principle: It is not possible to prevent people from using a public good, regardless of whether they have paid for it. For example, a visitor to a town who does not pay taxes in that community will still benefit from the town’s mosquito-spraying program. With private goods, like a hamburger, when you pay for the hamburger, you get to eat it or decide who does. Someone who does not pay does not get the hamburger.

Because many people can benefit from the same pubic goods and share in their consumption, and because those who do not pay for these goods still get to use them, it is usually impossible to produce these goods in private markets. Or at least it is impossible to produce enough in private markets to reach the efficient level of output. That happens because some people will try to consume the goods without paying for them, and get a free ride from those who do pay. As a result, the government must usually take over the decision about how much of these products to produce. In some cases, the government actually produces the good; in other cases it pays private firms to make these products.

The classic example of a public good is national defense. It is not a rival consumption product, since protecting one person from an invading army or missile attack does not reduce the amount of protection provided to others in the country. The nonexclusion principle also applies to national defense. It is not possible to protect only the people who pay for national defense while letting bombs or bullets hit those who do not pay. Instead, the government imposes broad-based taxes to pay for national defense and other public goods.

Correcting Market Failures - Adjusting for External Costs or Benefits

There are some private markets in which goods and services are produced, but too much or too little is produced. Whether too much or too little is produced depends on whether the problem is one of external costs or external benefits. In either case, the government can try to correct these market failures, to get the right amount of the good or service produced.

External costs occur when not all of the costs involved in the production or consumption of a product are paid by the producers and consumers of that product. Instead, some of the costs shift to others. One example is drunken driving. The consumption of too much alcohol can result in traffic accidents that hurt or kill people who are neither producers nor consumers of alcoholic products. Another example is pollution. If a factory dumps some of its wastes in a river, then people and businesses downstream will have to pay to clean up the water or they may become ill from using the water.

When people other than producers and consumers pay some of the costs of producing or consuming a product, those external costs have no effect on the product’s market price or production level. As a result, too much of the product is produced considering the overall social costs. To correct this situation, the government may tax or fine the producers or consumers of such products to force them to cover these external costs. If that can be done correctly, less of the product will be produced and consumed.

An external benefit occurs when people other than producers and consumers enjoy some of the benefits of the production and consumption of the product. One example of this situation is vaccinations against contagious diseases. The company that sells the vaccine and the individuals who receive the vaccine are better off, but so are other people who are less likely to be infected by those who have received the vaccine. Many people also argue that education provides external benefits to the nation as a whole, in the form of lower unemployment, poverty, and crime rates, and by providing more equality of opportunity to all families.

When people other than the producers and consumers receive some of the benefits of producing or consuming a product, those external benefits are not reflected in the market price and production cost of the product. Because producers do not receive higher sales or profits based on these external benefits, their production and price levels will be too low–based only on those who buy and consume their product. To correct this, the government may subsidize producers or consumers of these products and thus encourage more production.

Maintaining Competition

Competitive markets are efficient ways to allocate goods and services while maintaining freedom of choice for consumers, workers, and entrepreneurs. If markets are not competitive, however, much of that freedom and efficiency can be lost. One threat to competition in the market is a firm with monopoly power. Monopoly power occurs when one producer, or a small group of producers, controls a large part of the production of some product. If there are no competitors in the market, a monopoly can artificially drive up the price for its products, which means that consumers will pay more for these products and buy less of them. One of the most famous cases of monopoly power in U.S. history was the Standard Oil Company, owned by U.S. industrialist John D. Rockefeller. Rockefeller bought out most of his business rivals and by 1878 controlled 90 percent of the petroleum refineries in the United States.

Largely in reaction to the business practices of Standard Oil and other trusts or monopolistic firms, the United States passed laws limiting monopolies. Since 1890, when the Sherman Antitrust Act was passed, the federal government has attempted to prevent firms from acquiring monopoly power or from working together to set prices and limit competition in other ways. A number of later antitrust laws were passed to extend the government’s power to promote and maintain competition in the U.S. economy. Some states have passed their own versions of some of these laws.

The government does allow what economists call natural monopolies. However, the government then regulates those businesses to protect consumers from high prices and poor service, and often limits the profits these firms can earn. The classic examples of natural monopolies are local services provided by public utilities. Economies of scale make it inefficient to have even two companies distributing electricity, gas, water, or local telephone service to consumers. It would be very expensive to have even two sets of electric and telephone wires, and two sets of water, gas, and sewer pipes going to every house. That is why firms that provide these services are called natural monopolies.

There have been some famous antitrust cases in which large companies were broken up into smaller firms. One such example is the breakup of American Telephone and Telegraph (AT&T) in 1982, which led to the formation of a number of long-distance and regional telephone companies. Other examples include a ruling in 1911 by the Supreme Court of the United States, which broke the Standard Oil Trust into a number of smaller oil companies and ordered a similar breakup of the American Tobacco Company.

Some government policies intentionally reduce competition, at least for some period of time. For example, patents on new products and copyrights on books and movies give one producer the exclusive right to sell or license the distribution of a product for 17 or more years. These exclusive rights provide the incentive for firms and individuals to spend the time and money required to develop new products. They know that no one else will copy and sell their product when it is introduced into the marketplace, so it pays to devote more resources to developing these new products.

The benefits of certain other government policies that reduce competition are not always this clear, however. More controversial examples include policies that restrict the number of taxicabs in a large city or that limit the number of companies providing cable television services in a community. It is much less expensive for cable companies to install and operate a cable television system than it is for large utilities, such as the electric and telephone companies, to install the infrastructure they need to provide services. Therefore, it is often more feasible to have two or more cable companies in reasonably large cities. There are also more substitutes for cable television, such as satellite dish systems and broadcast television. But despite these differences, many cities auction off cable television rights to a single company because the city receives more revenue that way. Such a policy results in local monopolies for cable television, even in areas where more competition might well be possible and more efficient.

Establishing government policies that efficiently regulate markets is difficult to do. Policies must often balance the benefits of having more firms competing in an industry against the possible gains from allowing a smaller number of firms to compete when those firms can achieve economies of scale. The government must try to weigh the benefits of such regulations against the advantages offered by more competitive, less regulated markets.

Promoting Full Employment and Price Stability

In addition to the monetary policies of the Federal Reserve System, the federal government can also use its taxing and spending policies, or fiscal policies, to counteract inflation or the cyclical unemployment that results from too much or too little total spending in the economy. Specifically, if inflation is too high because consumers, businesses, and the government are trying to buy more goods and services than it is possible to produce at that time, the government can reduce total spending in the economy by reducing its own spending. Or the government can raise taxes on households and businesses to reduce the amount of money the private sector spends. Either of these fiscal policies will help reduce inflation. Conversely, if inflation is low but unemployment rates are too high, the government can increase its spending or reduce taxes on households and businesses. These policies increase total spending in the economy, encouraging more production and employment.

Some government spending and tax policies work in ways that automatically stabilize the economy. For example, if the economy is moving into a recession, with falling prices and higher unemployment, income taxes paid by individuals and businesses will automatically fall, while spending for unemployment compensation and other kinds of assistance programs to low-income families will automatically rise. Just the opposite happens as the economy recovers and unemployment falls—income taxes rise and government spending for unemployment benefits falls. In both cases, tax programs and government-spending programs change automatically and help offset changes in nongovernment employment and spending.

In some cases, the federal government uses discretionary fiscal policies in addition to automatic stabilization policies. Discretionary fiscal policies encompass those changes in government spending and taxation that are made as a result of deliberations by the legislative and executive branches of government. Like the automatic stabilization policies, discretionary fiscal policy can reduce unemployment by increasing government spending or reducing taxes to encourage the creation of new jobs. Conversely, it can reduce inflation by decreasing government spending and raising taxes. .

In general, the federal government tries to consider the condition of the national economy in its annual budgeting deliberations. However, discretionary spending is difficult to put into practice unless the nation is in a particularly severe episode of unemployment or inflation. In such periods, the severity of the situation builds more consensus about what should be done, and makes it more likely that the problem will still be there to deal with by the time the changes in government spending or tax programs take effect. But in general, it takes time for discretionary fiscal policy to work effectively, because the economic problem to be addressed must first be recognized, then agreement must be reached about how to change spending and tax levels. After that, it takes more time for the changes in spending or taxes to have an effect on the economy.

When there is only moderate inflation or unemployment, it becomes harder to reach agreement about the need for the government to change spending or taxes. Part of the problem is this: In order to increase or decrease the overall level of government spending or taxes, specific expenditures or taxes have to be increased or decreased, meaning that specific programs and voters are directly affected. Choosing which programs and voters to help or hurt often becomes a highly controversial political issue.

Because discretionary fiscal policies affect the government’s annual deficit or surplus, as well as the national debt, they can often be controversial and politically sensitive. For these reasons, at the close of the 20th century, which experienced years with normal levels of unemployment and inflation, there was more reliance on monetary policies, rather than on discretionary fiscal policies to try to stabilize the national economy. There have been, however, some famous episodes of changing federal spending and tax policies to reduce unemployment and fight inflation in the U.S. economy during the past 40 years. In the early 1980s, the administration of U.S. president Ronald Reagan cut taxes. Other notable tax cuts occurred during the administrations of U.S. presidents John Kennedy and Lyndon Johnson in 1963 and 1964.

Limitations of Government Programs

Government economic programs are not always successful in correcting market failures. Just as markets fail to produce the right amount of certain kinds of goods and services, the government will often spend too much on some programs and too little on others for a number of reasons. One is simply that the government is expected to deal with some of the most difficult problems facing the economy, taking over where markets fail because consumers or producers are not providing clear signals about what they want. This lack of clear signals also makes it difficult for the government to determine a policy that will correct the problem.

Political influences, rather than purely economic factors, often play a major role in inefficient government policies. Elected officials generally try to respond to the wishes of the voting public when making decisions that affect the economy. However, many citizens choose not to vote at all, so it is not clear how good the political signals are that elected officials have to work with. In addition, most voters are not well informed on complicated matters of economic policy.

For example, the federal government’s budget director David Stockman and other officials in the administration of President Reagan proposed cuts in income tax rates. Congress adopted the cuts in 1981 and 1984 as a way to reduce unemployment and make the economy grow so much that tax revenues would actually end up rising, not falling. Most economists and many politicians did not believe that would happen, but the tax cuts were politically popular.

In fact, the tax cuts resulted in very large budget deficits because the government did not collect enough taxes to cover its expenditures. The government had to borrow money, and the national debt grew very rapidly for many years. As the government borrowed large sums of money, the increased demand caused interest rates to rise. The higher interest rates made it more expensive for U.S. firms to invest in capital goods, and increased the demand for dollars on foreign exchange markets as foreigners bought U.S. bonds paying higher interest rates. That caused the value of the dollar to rise, compared with other nations’ currencies, and as a result U.S. exports became more expensive for foreigners to buy. When that happened in the mid-1980s, most U.S. companies that exported goods and services faced very difficult times.

In addition, whenever resources are allocated through the political process, the problem of special interest groups looms large. Many policies, such as tariffs or quotas on imported goods, create very large benefits for a small group of people and firms, while the costs are spread out across a large number of people. That gives those who receive the benefits strong reasons to lobby for the policy, while those who each pay a small part of the cost are unlikely to oppose it actively. This situation can occur even if the overall costs of the program greatly exceed its overall benefits.

For instance, the United States limits sugar imports. The resulting higher U.S. price for sugar greatly benefits farmers who grow sugarcane and sugar beets in the United States. U.S. corn farmers also benefit because the higher price for sugar increases demand for corn-based sweeteners that substitute for sugar. Companies in the United States that refine sugar and corn sweeteners also benefit. But candy and beverage companies that use sweeteners pay higher prices, which they pass on to millions of consumers who buy their products. However, these higher prices are spread across so many consumers that the increased cost for any one is very small. It therefore does not pay a consumer to spend much time, money, or effort to oppose the import barriers.

For sugar growers and refiners, of course, the higher price of sugar and the greater quantity of sugar they can produce and sell makes the import barriers something they value greatly. It is clearly in their interest to hire lobbyists and write letters to elected officials supporting these programs. When these officials hear from the people who benefit from the policies, but not from those who bear the costs, they may well decide to vote for the import restrictions. This can happen despite the fact that many studies indicate the total costs to consumers and the U.S. economy for these programs are much higher than the benefits received by sugar producers.

Special interest groups and issues are facts of life in the political arena. One striking way to see that is to drive around the U.S. national capital, Washington D.C., or a state capital and notice the number of lobbying groups that have large offices near the capitol building. Or simply look at the list of trade and professional associations in the yellow pages for those cities. These lobbying groups are important and useful to the political process in many ways. They provide information on issues and legislation affecting their interests. But these special interest groups also favor legislation that often benefits their members at the expense of the overall public welfare.

The Scope of Government in the U.S. Economy

The size of the government sector in the U.S. economy increased dramatically during the 20th century. Federal revenues totaled less than 5 percent of total GDP in the early 1930s. In 1995 they made up 22 percent. State, county, and local government revenues represent an additional 15 percent of GDP.

Although overall government revenues and spending are somewhat lower in the United States than they are in many other industrialized market economies, it is still important to consider why the size of government has increased so rapidly during the 20th century. The general answer is that the citizens of the United States have elected representatives who have voted to increase government spending on a variety of programs and to approve the taxes required to pay for these programs.

Actually, government spending has increased since the 1930s for a number of specific reasons. First, the different branches of government began to provide services that improved the economic security of individuals and families. These services include Social Security and Medicare for the elderly, as well as health care, food stamps, and subsidized housing programs for low-income families. In addition, new technology increased the cost of some government services; for example, sophisticated new weapons boosted the cost of national defense. As the economy grew, so did demand for the government to provide more and better transportation services, such as super highways and modern airports. As the population increased and became more prosperous, demand grew for government-financed universities, museums, parks, and arts programs. In other words, as incomes rose in the United States, people became more willing to be taxed to support more of the kinds of programs that government agencies provide.

Social changes have also contributed to the growing role of government. As the structure of U.S. families changed, the government has increasingly taken over services that were once provided mainly by families. For instance, in past times, families provided housing and health care for their elderly. Today, extended families with several generations living together are rare, partly because workers move more often than they did in the past to take new jobs. Also the elderly live longer today than they once did, and often require much more sophisticated and expensive forms of medical care. Furthermore, once the government began to provide more services, people began to look to the government for more support, forming special interest groups to push their demands.

Some people and groups in the United States favor further expansion of government programs, while others favor sharp reductions in the current size and scope of government. Reliance on a market system implies a limited role for government and identifies fairly specific kinds of things for the government to do in the economy. Private households and businesses are expected to make most economic decisions. It is also true that if taxes and other government revenues take too large a share of personal income, incentives to work, save, and invest are diminished, which hurts the overall performance of the economy. But these general principles do not establish precise guidelines on how large or small a role the government should play in a market economy. Judging the effectiveness of any current or proposed government program requires a careful analysis of the additional benefits and costs of the program. And ultimately, of course, the size of government is something that U.S. citizens decide through democratic elections.

More information about the US Government.