U.S. Economy
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.
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.
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
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