So far, we have seen how government sets and enforces rules by which economic transactions occur. Government sometimes intervenes to remedy negative externalities and to leverage positive externalities. What other roles has government played in a market economy?
Information and Transparency
The market economy is based on the presumption that buyers and sellers are well enough informed about products to make an informed decision. If a product or service doesn't meet a customer's satisfaction, the customer goes to a competitor. Multiplied over many customers, good firms will be rewarded, and bad firms will go out of business. If I buy a package of zip-lock bags that don't seal well, I'll buy a different brand next time. This works just fine for the vast majority of products we buy.
But what if, instead of bags, a doctor removes your appendix, or an airline pilot is flying you to your destination? The cost of a bad product here is much more costly. In many cases like these, we regulate the business to ensure practitioners meet certain minimal standards and abide by certain practices. The regulation makes the service more costly but dramatically enhances our chances of avoiding a catastrophic scenario.
Financial markets are another place where regulation is essential. Publicly traded corporations are trading shares. Insiders have considerable knowledge about the company. Reporting financial data in ways that mislead investors would often be quite easy. The failure of regulators to create a transparent environment in the financial markets is, in my opinion, one of the primary reasons for the 2008 economic meltdown. The bigger and more complex the corporations, the greater the need for transparency.
Natural Monopolies
Some services don't lend themselves to competitive models. The sewage system and garbage collection are good examples. In these cases, a monopoly is often granted to a firm, but the firm has direct government oversight with the government approving service fees… usually allowing the firm to cover costs and earn a reasonable profit. As with garbage collection, the service is sometimes outsourced to the lowest bidder on a government contract. That introduces some market discipline to the service being provided. But the bottom line, some industries are simply natural monopolies.
Economic Stabilization
Government also influences the economy by trying to make the endless (and likely unavoidable) swings between boom and bust less severe. One approach is through monetary policy. Through a variety of complex transactions, the government manages the money supply. Too much money in circulation, and you will likely get inflation. Too little money in circulation and credit markets seize up, destroying the economy's dynamism.
Monetary policy is controversial with some. The belief is that the money supply should directly correspond to some precious metal like gold. No more money is printed unless a corresponding amount of gold is produced. It is beyond our purposes to dissect this, but we need to be aware that monetary policy is a significant way government intervenes in the market.
A second method is fiscal policy. Government can affect the economy by raising or lowering taxes. In crises, as we have seen over the last few years, government can increase spending to create more demand for goods and services. Again, there is much controversy about the effectiveness and unintended consequence of such measures, but it is seen as a tool in the government's economic toolbox.
Direct Intervention
Another way government sometimes involves itself in the market is to decide that certain key industries are critical to national survival to be allowed to fail. Decades ago, it was argued that having home-grown food supply capabilities was critical to national security. Farm subsidies and protectionism have given American products a favorable position in the market so that those capabilities would not be lost. Many emerging nations use similar tactics to protect industries they want to nurture as part of their national welfare.
There is spirited debate about the wisdom of such interventions. The recent bailouts of large banks and the auto industry were largely justified on these grounds. These firms were "too big to fail," meaning their collapse would have catastrophic consequences for national security and societal well-being. My point is not to adjudicate whether these actions have merit but rather to simply note that direct intervention in the market is an often-used option.
Non-Profit Corporate Charters
Government also facilitates the formation of legal entities created by citizens to accomplish tasks that might not be well served through a market system. Non-profit corporations are like profit corporations except for two significant features. First, there is no share ownership of the corporation, with shareholders receiving dividends or appreciation in stock value. All assets must be turned over to the state or another non-profit entity when the non-profit is dissolved. Non-profits must still receive more than they spend … make a profit … the distinction is in how the profit is used.
Non-profit corporations are different from profit corporations because they usually have two clients. Some people give the money … donors … and the people who receive the services. While there can be overlap between the two, very frequently, there is no overlap at all. One important function of many non-profits is allowing groups of people to amass wealth to be used to provide goods and services to others who might not otherwise be able to receive those goods and services. The government gives groups willing to live by the restriction of non-profit status favorable tax treatment.
In the next post, we turn to the redistribution of income. In the post after that, we will look at the challenges of government effectively and justly intervening in the markets.
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