In Chapter 1 We Discussed in Broad Outline Some of the Institutions That Comprise Any Economy

5 The Institutions of a Modern Market Economy

In chapter 1 we discussed in broad outline some of the institutions that comprise any economy and in chapter 4 we visited the issue of market failure and looked at some of the ways that the government acts to attempt to remedy this. In this chapter we will look in more detail at the framework of a “developed market economy,” and how the institutions that have been established operate to shape and steer the functions of the economy. We start with a discussion of the various objectives of government policy and how they ﬁt together, and sometimes conﬂict, in an overall picture of government activity.

THE OBJECTIVES OF GOVERNMENT POLICY

It seems almost too obvious to state, but in a mixed market economy the government is one of the most important institutions. Even in those countries that are popularly regarded as the bastions of “free enterprise” and capitalism, a large part of the gross domestic product (GDP) passes through the government sector and public employment represents a considerable share of the total. The revenues of
industrial giants like General Motors, Exxon, or Microsoft are quite small compared to the receipts and expenditures of governments in developed industrial economies. The debts of banks, corporations, and households similarly pale when compared to government debt. Government regulations, civil, criminal, and administrative law control or shape almost every aspect of our lives. One way of viewing government activity is to see government as being divisible into three functions: allocation, distribution, and stabilization.1 This functional distribution enables us to view the operation of government systematically. However, we must always bear in mind that policies implemented to achieve goals related to one function will inevitably have “spillovers” that impact the others.

The Allocation Function

Chapter 4 dealt with issues of market failure. The existence of such failures suggested the need for government intervention because the market alone either failed to supply some goods altogether or supplied certain goods at allocatively inefﬁcient quantities and prices. We also discussed the problem of government failure, which occurs when the costs of government intervention are greater than any potential social gain, or when the action of the governmental/political process frustrates the possibility of socially advantageous intervention. Nevertheless, governments of all mixed capitalist societies are involved in the production of goods and the regulation of business, with overt justiﬁcation of improving the allocative efﬁciency of the economy. This is what we term the allocation function of government.

Government Production of Pure and Quasi-Public Goods.We established in chapter 4 that although pure public goods are theoretically important, operationally they are a rather limited class of goods. Most goods provided by
the government could also be provided by the market. A list of what is actually produced, at least in part, by some level of the government in the United States, includes national defense, passenger rail transportation, urban mass transit, law enforcement, electricity supply, education, health services, information, public health measures, research and development, water supply, postal services, and housing. We would obtain a similar list if we looked at most of the developed market economies, in Europe or in Japan. As a general, but not universal, rule, the lower the overall level of development, the greater is the likelihood that the government assumes more extensive production responsibilities. What is striking, however, is that almost all of the goods produced by governments are either also produced at the same time in the private sector or have close substitutes that are.

Some of the goods or services on the list of government production can be justiﬁed by the fact that the market would supply the goods only in suboptimal quantities and at prices that are too high. These goods are the ones that generate substantial positive externalities, or spillovers, that are socially beneﬁcial but are not captured in the private market. Production by the public sector causes these goods to be supplied closer to the optimal level and priced more efﬁciently through the operation of a public subsidy, or at least priced at less than the proﬁt maximizing rate. Goods of this type might include information, education, electricity supply, public transportation, and water supply.2 Finally, some goods are provided by the government as a form of income transfer—housing, health care, and to some degree education—ﬁt this category.

Table 5.1 shows the structure of current government expenditure in 12 nations using standardized Organization for Economic Cooperation and Development (OECD) classiﬁcations. The ﬁrst thing that strikes us is the wide variation in the scope of government as a percentage of GDP; Korea is the lowest followed by Japan and the United States. In general, the continental European nations have the highest levels of government activity, reaching a peak in the Scandinavian states of Denmark and Sweden. There is less variation between nations in terms of current expenditures, though the features of individual economies can be quite important. Some nations have especially high levels of particular social expenditures, for example, health, while others have relatively high levels of defense spending.

Information as a Public Good.The provision of information is an important function of a modern government. Without good information on a wide range of topics (from the weather to the unemployment rate), it is impossible for the
economic actors to make informed and therefore rational decisions. Information
is not, however, a pure public good. While the marginal cost of providing information to additional users is very low (especially in the age of television and the Web), it is quite possible to charge for information and exclude nonpayers from receiving it. A whole industry of consultants relies on the charging of a fee for “proprietary” information, at prices that reﬂect a monopoly rent rather than the cost of dissemination.

Nevertheless, information gathering is costly, and social resources can be saved if needless duplication can be avoided. Thus a government’s role in the collation and dissemenation of information is justiﬁable on efﬁciency grounds. When information ﬂows are improved, better decisions are made, and the overall efﬁciency of the market system is enhanced.

Regulation of Products.A large part of government activity is concerned with product regulation of one form or another. In the United States, for example, it sets standards for the safety, quality, and efﬁcacy of many products. The economic basis for this, in terms of improving the allocative efﬁciency of the economy, lies in the fact that it economizes on information costs for consumers.

Regulation of Industry.Moreover as we discussed in chapter 4, governmentshave extensive powers to regulate prices and outputs in industry and they use these powers most frequently to address market failure due to monopoly.

The Distribution Function

Income Support.The second broad function of government lies in redistributing income. While this is not a new activity (even ancient Egypt and Rome had income support policies) it has grown enormously in importance in recent decades. A large part of government expenditure is directed toward some form of amelioration of income distribution. In previous centuries, assistance was oriented toward poverty relief and intended only to raise the indigent to the subsistence level.

In the 20th century the government assumed increased responsibility for stabilizing the economy. It also came to be held increasingly responsible for the individual as well as the aggregate consequences of joblessness. “Social security” became a common feature (and a burgeoning bureaucracy) in all developed economies during the 20th century. Support was provided not only for the unemployed but also for the elderly, single parents, and the disabled. As a result, transfer payments took a larger share of government expenditure.

The economic consequences of this steady progress toward guaranteed income are much debated. Today the prevailing orthodox view is that redistributive payments have sharply reduced the ﬂexibility of labor markets. Providing support for people without jobs reduces the urgency of job search, lowers incentives to ﬁnd work, and encourages higher wage demands. This in turn leads to higher levels of unemployment. In the countries of Western Europe, where the reduction in take-home income on losing a job can be as little as 10 percent, the cost of being unemployed is correspondingly low, and unemployment rates are high.

Concern over the disincentive consequences of income transfer schemes has grown. Steps to reduce unemployment beneﬁts and tighten accessibility rules have been undertaken in some market economies. They have been accompanied by sharp falls in unemployment. Britain is a case in point, which following a trimming of the welfare state now experiences its lowest unemployment rate in decades. On the other hand, countries that have maintained high beneﬁt rates have seen unemployment continue to grow (for example, France). While this suggests a strong link, evidence that transfers payments actually cause unemployment is slight. Some income support for the jobless can be justiﬁed in terms of raising the allocative efﬁciency of the economy since it allows a more rational process of job search and a better resultant ﬁt.

Redistribution in-Kind.Economic theory tells us that an individual’s welfare is raised by increasing his or her ability to choose. Consequently, welfare-maximizing redistribution, at least from the recipient’s viewpoint, should consist of unrestricted cash grants. However, much redistributive activity actually takes the form of public provision of goods that might well be supplied privately. These include health care, education, housing, and food. The adoption of such a system can be justiﬁed in two ways. First, it is claimed that these goods generate social externalities. Consequently, the loss of an individual recipient’s welfare through constraining choice is compensated by a rise in the welfare of third parties. Second, some may argue that the recipients may be ill-informed or irrational and act against their own long-run welfare. If given free control over resources they would dispose of them in a fashion that would favor short-term gratiﬁcation over long-term well-being. Hence an element of paternalism is used to justify the public provision of such goods, rather than providing cash to purchase the appropriate amount in private markets. This interference with individual preferences creates a class of goods that are referred to in the literature as merit goods, and they are widespread in most economies.

In recent years the state-owned industries and bureaucracies created by the public provision of these goods have come under attack because of their inefﬁciency and inﬂexibility relative to the private sector. In the United States criticism has focused on publicly provided education. In Britain the National Health Service has been under siege. One possible avenue of reform is use of voucher systems. Although these still involve interference with personal preferences, since they are (unlike cash) service speciﬁc, they introduce consumer choice between suppliers and therefore foster competition, leading, it is hoped, to greater efﬁciency.

The Stabilization Function

The idea that governments should be responsible for the level of macroeconomic activity—the level of unemployment, the rate of inﬂation, and the rate of growth—is a relatively recent one. It had two sources. One was political reform that broadened the franchise and gave a louder voice to those most affected by unemployment. The second lay in the developments in macroeconomic theory and statistical collation that occurred in the 20th century, especially in the Depression-troubled 1930s, which made government management of the economy more feasible. Emphasis on government responsibility for the macroeconomy reached its height in the 1960s when it was widely held that the principles underlying economic activity were so well-understood that the economic task of government was merely to ﬁne-tune the economy. However, faith in the ability of government to deliver low inﬂation and high employment faltered in the economically turbulent 1970s. Stabilization policy apparently failed and came to have negative connotations. Conﬁdence in the effectiveness of ﬁscal policy waned, and government activity came to be seen by a growing number of economists as the cause of instability rather than its antidote.

While in the 1960s much of stabilization policy had been framed in terms of
the judicious trade-off between inﬂation and unemployment, a new orthodoxy emerged in the 1970s suggesting that unemployment, at least below a threshold “natural” level, was, after all, not something that the government could do much about. Attempts to raise employment accelerated the rate of inﬂation, without having any long-term results. Slow growth was seen as the result of government interference in demand management as public expenditure crowded out private investment. Today we are back in the middle of the road. While conﬁdence in our ability to guarantee stability has been shaken, most economists believe that economic policy is effective in shaping economic outcomes for the better.

The Instruments of Stabilization.In most mixed market economies governments have at their disposal two distinct sets of policy measures: ﬁscal (those that involve the changing of tax rates and government expenditure) and monetary(those that involve the manipulation of the money stock in the hands of the public).

Fiscal Policy.To be effective, ﬁscal policy requires a well-developed and deﬁned tax system in which tax rules are both visible and enforced. This, in turn, presupposes that the government is supported by a well-established and competent bureaucracy. In less developed economies, and also in the transition economies of Eastern Europe, the lack of the essential infrastructure for tax-gathering limits the effectiveness of ﬁscal policy. Fiscal policy is concerned not only with the changing of taxes and tax rates, but also with the role of government expenditures on macroeconomic activity. Stabilization can be effected by shifts in government expenditures (for example, by the initiation of public expenditure projects or the curtailment of unemployment insurance payments). Government expenditures, like taxes, tend to have an automatic stabilizer effect, since even in the absence of policy shifts they rise as the economy contracts.

In modern mixed market economies, tax capabilities are by and large similar. Some countries have more efﬁcient tax systems and greater degrees of tax compliance than others, and this affects economic performance. However, the larger differences lie in the kind of tax structure adopted. The United States, for example, relies heavily on income taxes, social security taxes, and corporate income taxes at the federal level.3 State ﬁnance is predominantly based on sales taxes, supplemented by individual and business income taxes. Other economies rely much more heavily on indirect taxes at the national level. In Europe, for example, much greater reliance is on indirect taxation, largely through value-added taxes.