Prof. Bryan Caplan

Econ 103

Spring, 2000


Week 14: Externalities, II: Government Failure

I.                  Externalities as a Rationale for Government Intervention

A.                 Externalities/public goods are probably the main economic rationale for government intervention.

B.                 When economists see negative externalities, their usual reaction is to say "Government should tax (or ban) that."

C.                When economists see positive externalities, their usual reaction is to say "Government should subsidize (or produce) that."

D.                Big problem: Couldn't there be externalities in government as well?  If so, we face a choice between market failure and government failure.

II.               Externalities in Government, I: Rational Ignorance

A.                 What is the probability that one vote decides an election?  Close to zero?

B.                 So what incentive is there for voters to gather political information?  Close to none.

C.                Economic prediction: Voters won't know much about democracy.

D.                Is this true?  Absolutely.  Very few people can even e.g. name their Congressman, much less know how he voted.

E.                 Most of the political "information" people do acquire is for entertainment value, not quantitative importance.

F.                 Consequence: A lot of special interest legislation harmful to majority interests gets passed in democracies because the electorate invests little in political information acquisition.

G.                In short: Making democracy work is a public good.

III.            Externalities in Government, II: Rational Irrationality

A.                 While rational ignorance plays a big role in government, I would argue that it is a minor force compared to what I call "rational irrationality."

B.                 Recall that the probability that one vote decides an election is near-zero.

C.                So what incentive is there for voters to think rationally and try to figure out the truth?  Zero.

D.                Economic prediction: People will be more irrational (buying crazy "feel-good" theories, closed-minded, etc.) in politics than in areas of life where they pay the costs of their delusions.

E.                 Consequence: Politicians respond to the beliefs people have when their intellectual self-discipline is weakest.  You therefore get a lot of foolish and counter-productive policies.

F.                 Rational ignorance and rational irrationality compared: The case of the orange tariff.

IV.            The Comparative Approach to Markets and Government

A.                 The tale of the Roman emperor and the two minstrels.

B.                 Moral: The sensible approach is comparative.

C.                What are the main public goods problems markets face?  The main public goods problems governments face?

D.                How can markets and governments solve public goods problems?

E.                 Market solutions to market's public goods problems:

1.                  Most general: Have private property rights whenever possible, and don't restrict bargaining.

2.                  The unanimous contract (condo association)

3.                  The privileged minority (mowing your lawn)

4.                  Bundling (commercials on radio and TV)

5.                  Merger (orchard owner marries beekeeper)

F.                 Market solutions to government's public goods problems: ?

G.                Government solutions to market's public goods problems: get around high transactions costs by coercion.

1.                  Subsidize/mandate (national defense)

2.                  Tax/regulate (air pollution)

H.                 Government solutions to government's public goods problems: ?

1.                  Constitutional reform is a popular answer, but there is every reason to think that constitutional politics works just like regular politics.

I.                     Important: If the government is unable to solve the public goods problems of government, then there is no reason to think that government will want to solve the public goods problems of markets that it can solve!

1.                  This explains why most of what actual governments do has nothing to do with public goods: Social Security, Medicare, education...