Prof. Bryan Caplan

Econ 370


Week 13: Problems with Government Ownership

I.         Government Ownership

A.     If you don't like the results of free markets, and aren't impressed by the ability of regulation to make markets work better, you may consider turning to direct government ownership.

B.     Several varieties of government ownership:

1.                  State produces good and gives it away for free to people eligible to receive it. (Ex: Primary and secondary education; police protection)

2.                  State produces good and sells it below AC, incurring losses with each sale; may be accompanied by rationing. (Ex: Low-income housing; public universities).

3.                  State produces good and sells it at AC or at monopoly price (Ex: Post office; state liquor stores)

II.       Ability and Knowledge Problems with Government Ownership

A.     Government ownership seems to offer even simpler solutions to the problems of markets than regulation does.

1.                  Have government-owned firm sell at MC. (Solves Problems #1 and #2)

2.                  Even better have government-owned firm sell as MC adjusted for externalities - >MC when there are negative externalities, <MC when there are positive externalities.

3.                  Have government invest in most socially beneficial technology; make people switch to efficient technology by ceasing production of inefficient technology.

4.                  Have the government produce the socially efficient level of variety.

B.     Ability Problem #1: Government-Owned firms have much higher costs than private firms! A common estimate is that government uses twice the inputs to get the same output. Even without an incentive problem, there is an ability problem:

1.                  Red tape, over-centralization

2.                  Operating way above minimum efficient scale. (If big firms were better, market would already provide them.)

3.                  Foregoing the benefits of selective attrition.

C.    Ability Problem #2: Government enterprises that lose money must make up their deficit with profits from other government firms, or from taxation.

D.    Ability Problem #3: Failure to set market-clearing prices is inefficient. Pricing below MC is just as inefficient as pricing above MC.

E.     Knowledge Problem #1: Government faces the same knowledge problems as regulators (What is MC? What is an inventions full social value? Etc.) But these might be less severe, since the government produces the goods itself.

F.     Knowledge Problem #2: However, as the extent of government ownership becomes greater - it becomes increasingly difficult to calculate MC, because there is no longer any outside market to get prices from.

1.                  Illustration: Transfer prices when there is only one producer. The in-house/contracting out decision.

G.    Knowledge Problem #3: If goods are given away for free or sold at a loss or rationed, it becomes very difficult to know if consumers are getting what they want.

H.     Knowledge Problem #4: A lot of information is local, but government makes decisions centrally. Governments tend to use over-simplified statistics to make decisions, and ignore other facts.

III.      Incentive Problems with Government Ownership

A.     Incentive Problem #1: Government ownership has the same Public Choice problems as regulation does.

1.                  "Special interests" are often government employees themselves.

B.     Incentive Problem #2: Government ownership must also face rational irrationality.

1.                  The larger the government sector becomes, the larger the effects of political irrationality.

C.    Incentive Problem #3: Government officials don't earn profits if they succeed, don't earn losses if they fail, and can't go bankrupt!

1.                  Little incentive to reduce or control costs: Probably a big part of the reason why government firms typically have TWICE the costs of private firms producing the same product.

2.                  Little or no reward for innovation.

3.                  Little incentive to expand or contract production in response to demand shifts.

D.    Incentive Problem #4: Governments often grant monopoly privilege to themselves to eliminate private sector competition.

1.                  Superior performance by private sector is embarrassing.

2.                  Existence of private sector alternatives makes high pricing difficult.

3.                  Predatory pricing can work if you are the government: very "deep pockets."

E.     Incentive Problem #5: Governments often supply a single uniform quality of product, and severely restrict variety. Minority tastes and interests ignored (or forced on everyone).

F.     Incentive Problem #6: "All power tends to corrupt..." As the government-owned sector expands, so does the monopoly power of the government in labor and product markets.

1.                  The larger the government-owned sector becomes, the fewer alternative suppliers consumers have.

2.                  The larger the government-owned sector becomes, the fewer alternative employers workers have.

IV.               The Tragedy of the Commons

A.                 It is possible for something to be unowned, also known as "commonly owned."

B.                 Sometimes governments refuse to recognize private property (land, ocean); in other cases, the costs of establishing property rights is prohibitive (air).

C.                So-called common ownership gives rise to what economists call the "tragedy of the commons." Since no one owns it, people use it without regard to the effect on others i.e. ignoring negative externalities of use.

D.                And, once you realize that people think this way, you also have an incentive to take as much as possible NOW, because the resource won't be useful very long. This can "snowball" into an awful outcome that benefits no one.

E.                  Key idea: If one person owned the fisheries, or a forest, or a pasture, they would have the incentive to maintain it, improve it, and take a long-term perspective.

F.                 That is the benefit of property rights that is absent in the commons - a benefit not just for owners, but for users as well.

G.                Interesting example of a commons: Road congestion. How could private ownership solve this problem?

V.     Central Planning and Socialism, I

A.     "Socialism" can just be a synonym for "government ownership." But "socialism" also means a system of total or near-total government ownership.

B.     Almost impossible to make people vote for full socialism, so it is usually imposed by a revolution or coup d'etat led by a "vanguard Party."

1.                  Lenin's coup

2.                  Hitler's election and subsequent coup

3.                  Stalin's takeover of Eastern Europe

4.                  Mao's revolution

C.    A few quotes on socialism and vanguard parties:



All citizens are here transformed into hired employees of the state,

which is made up of the armed workers... All that is required is that they should

work equally, should regularly do their share of the work, and should receive

equal pay. The accounting and control necessary for this have been simplified by

capitalism to the utmost, till they have become the extraordinarily simple

operations of watching, recording and issuing receipts, within the reach of

anybody who can read and write and knows the first four rules of arithmetic.

(State and Revolution)



In the composition of [the proletariat] there enter various elements,

heterogeneous moods, different levels of development. Yet the

dictatorship pre-supposes unity of will, unity of direction, unity of

action. By what other path can it be attained? The revolutionary

supremacy of the proletariat presupposes within the proletariat

itself the political supremacy of a party, with a clear program of

action and a faultless internal discipline. (The Defense of Terrorism)



We'll ask the man, where do you stand on the question of the revolution?

Are you for it or against it? If he's against it, we'll stand him up

against a wall.



[T]here is more that binds us to Bolshevism than

separates us from it. There is, above all, genuine, revolutionary feeling, which is alive

everywhere in Russia except where there are Jewish Marxists. I have always made

allowance for this circumstance, and given orders that former Communists are to be

admitted to the party at once. The petit bourgeois Social-Democrat and the trade-union

boss will never make a National Socialist, but the Communists always will.



A generation of Marxist and neo-Marxist mythology

notwithstanding, probably never in peacetime has an ostensibly capitalist economy been

directed as non- and even anti-capitalistically as the Germany economy between 1933 and

1939...Wages, prices, working conditions, allocation of materials: none of these were left to

managerial decision, let alone to the market... Investment was controlled, occupational

freedom was dead, prices were fixed, every major sector of the economy was, at worst, a

victim, at best, an accomplice of the regime. As a general rule, business, particularly big

business, declined or flourished in direct proportion to its willingness to collaborate.


D.    Some of the problems result from dictatorship, some result from the far-reaching scale of government ownership; the worst are a combination of both.

E.     Main Ability problems:

1.                  Socialism operates far beyond the minimum efficient scale. Enterprises are simply too big - as should be expected, because markets already take advantage of economies of scale.

2.                  Lack of selective attrition.

3.                  Prices for almost all goods set too low, and accompanied by permanent rationing and line-waiting. (But: Special stores for Party members).

F.     Main Knowledge problems:

1.                  Central planners have to make decisions based on virtually no information, or on grossly oversimplified information (aggregate statistics).

2.                  Lack of prices - or below-market prices - makes it very hard to decide whether to expand or contract production.

VI.   Central Planning and Socialism, II: The Incentive Problems

A.     What incentive does the government have to produce goods people want? Why not concentrate resources on the military and the secret police and the border guards?

B.     Socialist systems can and do offer material rewards. But they are usually rewards for loyal service to the Party, not for production.

C.    Producers have little or no incentive to produce at low cost or to serve consumers. The numerous flaws of the "quota system."

D.    The transition problem. People resist uncompensated socialization of their property.

1.                  This can cause large losses in efficiency (e.g. manufacturing).

2.                  Or it can cause massive man-made famines (agriculture).

E.     The joint problems of government monopoly and the corruption of power. Once the government produces almost everything and employs everyone, there is almost no limit to what it can do to people. In real socialist systems, this has almost always led to:

F.     Large-scale use of slave labor.

1.                  Stalin's Gulag

2.                  Hitler's work camps

3.                  Mao's Laogai

G.    Mass murder of dissident, disloyal, and suspect groups (by execution, man-made famine, and extremely harsh conditions of slave labor camps).

1.                  Lenin's famine

2.                  Stalin's de-kulakization campaign

3.                  Stalin's famine

4.                  Mao's Great Leap Forward

5.                  Cambodia under Pol Pot

H.                 A few quotes on socialist slavery and mass murder:



We know slave-labour; we know serf-labour. We know the compulsory,

regimented labour of the medieval guilds, we have known the hired

wage-labour which the bourgeoisie calls 'free.' We are now advancing

towards a type of labour socially regulated on the basis of an economic

plan which is obligatory for the whole country... This is the foundation

of socialism.

(3rd Trade Union Conference)






"Within the framework of the final solution, Jews will be conscripted for

labour in the eastern territories under appropriate leadership. Large

labour gangs of those fit for work will be formed, with the sexes

separated. They will be made to build roads as they are led into these

territories. A large percentage will undoubtedly be eliminated by natural



PROSECUTOR: What is meant by "natural diminution"?


EICHMANN: That's perfectly normal dying. Of a heart attack or pneumonia,

for instance. If I were to drop dead just now, that would be natural diminution.


PROSECUTOR: If man is forced to perform heavy physical labour and not

given enough to eat, he grows weaker, and if he gets so weak he has a heart



EICHMANN: That undoubtedly would have been reported as natural




He [Hitler] had no intention, like Russia, of "liquidating" the possessing class.

On the contrary, he would compel it to contribute by its abilities towards the

building up of the new order. He could not afford to allow Germany to

vegetate for years, as Russia had done, in famine and misery. Besides, the

present owners of property would be grateful that their lives had been spared.

They would be dependent and in a condition of permanent fear of worse things

to come. (Hitler Speaks)


VII.              Government Ownership as a Cure and Cause of Externalities

A.                 Lesson: While government frequently invoked as "the cure for externalities," the real story is far more complicated.

B.                 Government is able to cure many externalities problems. But in practice it often fails to do so, exacerbates the market's externalities, and creates massive new externalities of its own.

C.                For example, governments have done a considerable amount to reduce air and water pollution.

D.                But giving government this power to do this has enabled it to create a lot of new externalities. The DDT ban may be a good example.

E.                 Alternative? Just living with externalities? Could environmental charity have achieved anything comparable to improve air and water quality?