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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