PART 3: ECONOMIC PROGRESS

AND THE ROLE OF

GOVERNMENT

Common Sense Economics ~

What Everyone Should Know
About Wealth and Prosperity
1

http://CommonSenseEconomics.com/ Turn on the learning light!

INTRODUCTION TO POWERPOINT
SLIDES
 The PowerPoint slides for the Common Sense Economics
(CSE) electronic package provide an overview of the most
important points covered in the text. Students should read
the text, watch the assigned videos, and listen to the
podcasts prior to reviewing the slides.
 The PowerPoint slides are organized by module, which
reflects the approximate amount of material most
instructors will cover weekly during a regular school term.
The 15 core modules cover all of the CSE text. Modules 8, 9,
10, and 11 covering part 3 of CSE are presented here. The
slides for each module are organized as follows: (1) module
title and list of concepts covered, (2) highlights and
explanation of text material, including the CSE elements
covered by the module, and (3) questions for thought.
 Some instructors may want to use the PowerPoint slides for 2
classroom instruction. The slides will provide students with a
comprehensive set of notes and explanatory material for the
PART 3 INTRODUCTION
 Economists use the standard of economic
efficiency to assess the operation of an
economy.
 When resources are used efficiently, only actions
that yield more benefits than costs are
undertaken.
 In part 3, the tools of economics will be used to
analyze the operation of both markets and the
political process and compare performance with
the idealized concept of economic efficiency. We
will consider the shortcomings of both.
 During the past half century, application of
economic tools to the political process has 3
become an integral part of economics. The term
Public Choice is used to describe this analysis.
MODULE 8: MARKET FAILURE AND
THE ROLE OF GOVERNMENT
 CSE Part 3, Elements 1, 2, and 3
 Concepts Covered:
 Protective and productive roles of government
 Market failure: monopoly
 Market failure: externalities
 Market failure: public goods

4
GOVERNMENT AND THE
ECONOMY
 Government expenditures are now more than
a third of our economy. This highlights why it
is important to understand how the political
process affects resource allocation.

5
ELEMENT 1. GOVERNMENT
PROMOTES ECONOMIC PROGRESS BY
PROTECTING THE RIGHTS OF
INDIVIDUALS AND SUPPLYING A FEW
GOODS THAT ARE DIFFICULT TO
PROVIDE THROUGH MARKETS.
A wise and frugal government, which shall
restrain men from injuring one another,
which shall leave them otherwise free to
regulate their own pursuits of industry and
improvements, and shall not take from the
mouth of labor the bread it has earned.
This is the sum of good government. 6
—Thomas Jefferson
PROTECTIVE AND PRODUCTIVE
FUNCTIONS OF GOVERNMENT
 Government serves a protective function
when it
 Creates, upholds and maintains a legal
framework.
 Protects and enforces the rights of individuals to
their person and property.
 Government provides a productive
function when it
 Supplies goods that are difficult to supply
efficiently through markets.
 National defense and regional flood control projects
provide examples.
7
ELEMENT 1. GOVERNMENT
PROMOTES ECONOMIC PROGRESS BY
PROTECTING THE RIGHTS OF
INDIVIDUALS AND SUPPLYING A FEW
GOODS THAT ARE DIFFICULT TO
PROVIDE THROUGH MARKETS.
A wise and frugal government, which shall
restrain men from injuring one another,
which shall leave them otherwise free to
regulate their own pursuits of industry and
improvements, and shall not take from the
mouth of labor the bread it has earned.
This is the sum of good government. 8
—Thomas Jefferson
ELEMENT 2. WHEN MONOPOLY IS
PRESENT AND BARRIERS TO ENTRY
HIGH, MARKETS WILL FAIL TO
ACHIEVE IDEAL EFFICIENCY.

9
WHAT IS MONOPOLY?
 Monopoly: A market characterized by (1) a
single seller of a well-defined product for
which there are no good substitutes and (2)
high barriers to entry.
 There are two major sources of monopoly:

economies of scale and grants of privilege.

 Economies of scale: tendency for a market to be
dominated by a single seller because per unit
costs decline as firm size increases.
 Grant of privilege: government permission
required to compete in the market.
10
MONOPOLY AND ECONOMIC
EFFICIENCY
 Price and Output Under Monopoly
 Monopolists have an incentive to restrict output
and raise price.

 Restrictingoutput and raising price will often

increase the revenue of the monopolist.

 Inefficiencyresults because the monopolist fails

to produce some units of the good or service that
customers value more than their costs.

11
MONOPOLY AND GOVERNMENT
 Anti-Trust action: To promote competition,
governments may prohibit actions such as
collusion, the merger of dominant firms in an
industry, and interlocking ownership of firms.
In the U.S. anti-trust laws have performed
this function.

 The record of government in this area has

been mixed. Sometimes government actions
(e.g. licensing requirements and
discriminatory taxes) have restricted entry
into markets, protected existing producers 12
from rivals, and limited price competition.
ELEMENT 3. PUBLIC GOODS AND
EXTERNALITIES RESULT IN
INCENTIVES THAT MAY ENCOURAGE
SELF-INTERESTED INDIVIDUALS TO
UNDERTAKE ACTIVITIES THAT ARE
INCONSISTENT WITH IDEAL
ECONOMIC EFFICIENCY.
 The nature of some goods makes them
difficult to provide through markets.

 Market allocation may result in inefficiency in

the case of public goods and externalities.
13
WHAT IS A PUBLIC GOOD?
 Public goods have the following two
characteristics:
1. Jointness in consumption: provision of the good
to one party simultaneously makes it available
to others
2. Nonexcludability: it is difficult or virtually
impossible to exclude non-paying customers.
 It is the good’s characteristics, not the sector
in which it is produced, that distinguishes it
as a public good.
 Examples of public goods:
 national defense
 radio broadcast signal
14
 flood control
MARKET FAILURE: PUBLIC GOODS
 Because potential suppliers are unable to
establish a one-to-one link between payment
for and receipt of the good, it will be difficult
to provide public goods through markets.
 If a public good is made available to one, it is

simultaneously made available to others.

 Because those who do not pay can not be

excluded, no one has much of an incentive to

pay for such goods; each has an incentive to
become a free rider.
 When a lot of people become free riders, too
15
little of the good is produced.
EXTERNALITIES: EXTERNAL COSTS
AND BENEFITS
 Externalities exist when the market fails to
fully register costs and benefits.
 External costs:
 Present when the actions of an individual or group
harm the property of others without their consent.
 The problem arises because property rights are

imperfectly defined and/or enforced.

 External benefits:
 Present when the actions of an individual or group
generate benefits for nonparticipating parties.

16
MARKET FAILURE: EXTERNAL COSTS
 Because some of the costs of production are
not fully registered when external costs are
present, the supply curve understates the
true cost of production.
 Units may be produced that are valued less than
their true cost.
 From the viewpoint of efficiency, market price is
too low and too many units are produced.

17
MARKET FAILURE: EXTERNAL COSTS
 In this market, under Ideal price
initial supply and and output
demand conditions, Price S2 (including
output Q1 and price P1 are external costs)
present.
S1
 If all economic costs were P2
measured and included
the supply curve S2 Actual price
and output
would result in output Q2 P1
< Q1 and price P2 > P1.
 With external costs, too D
many units are produced Quantity/time
and price is below that Q2 Q1
which would prevail if all
costs were identified and 18
factored into the market
process.
MARKET FAILURE: EXTERNAL
BENEFITS
 When external benefits are present, the
demand curve understates the total value of
the output.
 Units that are more highly valued than their
costs may not be produced.
 From the viewpoint of efficiency, too few units
may be produced.

19
MARKET FAILURE: EXTERNAL
BENEFITS
 In this market, under
present supply and Ideal price
demand conditions, output Price and output
Q1 and price P1 are present.
S1
 If all benefits were
measured and included the
new demand curve D2 Actual price
P2
would result in output Q2 > and output

Q1 and price P2 > P1. P1

(including
 With external benefits too D2 external
few units are produced and D1 benefits)
price is below that which Quantity/time
would prevail if all the Q1 Q2
benefits were identified and
reflected in the market 20
process.
IMPLICATIONS OF MARKET FAILURE
 Market Failure:
 When monopoly, public goods and externalities
are present, markets may fail to achieve ideal
economic efficiency.
 Economists use the term market failure to
describe the situation where the existing
structure of incentives creates a conflict between
personal self-interest and getting the most out of
resources.
 Market failure creates the potential for
government action to improve economic
efficiency.
 But, the political process is merely an alternative
21
form of economic organization. We need to know
more about how that form of organization works
MODULE 8: QUESTIONS FOR
THOUGHT
1. What is a monopoly? Why will monopoly
often result in economic inefficiency?

2. Why are public goods difficult for markets to

allocate efficiently?

3. When external costs are present, how will

the price and output of a good compare
with that associated with ideal economic
efficiency?
22
MODULE 9: THE ECONOMICS OF
GOVERNMENT FAILURE
 CSE Part 3, Elements 4, 5, and 6
 Concepts Covered:
 Government failure
 Political versus the market process
 Special interest and political allocation
 Political incentives and short-sightedness

23
ELEMENT 4. ALLOCATION THROUGH
POLITICAL VOTING IS
FUNDAMENTALLY DIFFERENT THAN
MARKET ALLOCATION.
The first lesson of economics is scarcity:
there is never enough of anything to fully
satisfy all those who want it. The first
lesson of politics is to disregard the first
lesson of economics.
—Thomas Sowell, Professor of
Economics, Stanford
University
24
THE POLITICAL PROCESS
 The political process is merely an alternative
form of social organization.
 There are four major differences between the

political and market process.

1. Majority rule provides the basis for government
action, while market activity is based on mutual
agreement and voluntary exchange.
2. There is little incentive for voters to search for
and acquire information about either issues or
candidates because their choices will not be
decisive. Economists refer to this as the rational
ignorance effect. Thus, individuals will be better
informed when making market choices than 25
political choices.
THE POLITICAL PROCESS
CONTINUED…
3. The political process imposes the same option
on everyone, while markets allow for diverse
representation.
4. The political process does not have anything
like profit and loss that can be counted on to
direct resources toward productive, and away
from counterproductive, activities.
 The modern political process can be viewed
as a series of “exchanges” between
coalitions and politicians. Concentrated-
interest groups provide support (e.g. votes,
financial contributions, high-paying jobs) in
exchange for spending and regulatory favors. 26
In turn, politicians seek to arrange these
MARKET FAILURE AND GOVERNMENT
FAILURE
 Market failure: As explained in the two
previous elements, there are cases where
markets will fail to allocate resources
efficiently.

 Government failure: A situation in which the

structure of incentives is such that the
political process, including democratic
political decision-making, will encourage
individuals to undertake actions that conflict
with economic efficiency.
27

 We now turn to consideration of the analysis

ELEMENT 5. UNLESS RESTRAINED BY
CONSTITUTIONAL RULES, SPECIAL
INTEREST GROUPS WILL USE THE
DEMOCRATIC POLITICAL PROCESS TO
OBTAIN GOVERNMENT FAVORS AT
THE EXPENSE OF OTHERS.

28
SPECIAL INTEREST ISSUE
 Special-interest issue: An issue that
generates substantial individual benefits to a
small organized minority while imposing a
small individual cost on many other voters.
 Interest group members feel strongly about
issues that provide them with substantial
personal benefits. Such issues will dominate their
political choices.
 In contrast, voters bearing the cost of such
legislation often are uninformed on the issue
because it exerts only a small impact on their
personal welfare and because of the rational
ignorance effect. 29
GOVERNMENT FAILURE: SPECIAL
INTEREST EFFECT
 Special-interest effect: The bias of the
political process that encourages politicians
to support the views of special interests.
 Politicians have a strong incentive to support
special interests in exchange for campaign
contributions and other forms of political
support. This is true even if the action is
counterproductive.
 Interest group members will decide whom to
support primarily on the basis of a politician’s
stand on the special interest issue. As the
rational ignorance effect illustrates, the bulk of
voters will generally be uninformed and 30
disinterested.
 Logrolling and pork-barrel legislation strengthen
LOGROLLING AND PORK-BARREL PROJECTS
REINFORCE THE SPECIAL INTEREST EFFECT.

 As Exhibit 10 illustrates, projects can be

bundled together and obtain majority 31
approval even when each of the projects is
counterproductive.
THE SPECIAL INTEREST EFFECT: A “SWEET”
EXAMPLE
 The sugar program provides an example of

the special interest effect.

 Federal price supports and import quotas cause
the price of sugar in the U.S to be 50 to 100
percent above the world level.
 Approximately 20,000 sugar growers derive huge
personal gains at the expense of millions of
sugar consumers.
 The sugar lobby contributed more than $16
million to legislators and candidates during the
most recent election cycle.
 The program continues even though Americans
are worse off because their resources are wasted
producing a good we are ill-suited to produce.
32
SPECIAL INTEREST EFFECT,
INNOVATION, AND COMPETITION
 The special-interest effect tends to stifle
innovation and the competitive process.

 Politicians will tend to favor established

businesses with a stronger record of political
contributions and better knowledge of
lobbying techniques than newer innovative
upstart firms.
 Theexperience of Uber and Tesla provide
examples.

33
ELEMENT 6. UNLESS RESTRAINED BY
CONSTITUTIONAL RULES,
LEGISLATORS WILL RUN BUDGET
DEFICITS AND SPEND EXCESSIVELY.
The attractiveness of financing spending
by debt issue to the elected politicians
should be obvious. Borrowing allows
spending to be made that will yield
immediate political payoffs without the
incurring of any immediate political cost.
—James Buchanan,
1986 Nobel 34
Laureate
BUDGET DEFICITS AND THE
NATIONAL DEBT
 When government spending exceeds
revenues, a deficit will occur.
 When the government runs a deficit, it

is financed by borrowing, the issuing of

Treasury bonds.
 The borrowing increases the national

debt, the total outstanding bonds on

which the government must pay
interest.
 In contrast, a budget surplus (excess of
35
revenue relative to spending) would
reduce the government’s outstanding
KEYNESIAN REVOLUTION AND
BUDGET DEFICITS
 Prior to 1960, it was widely believed
that the federal government should
balance its budget. Except during war,
this was pretty much the case.
 Keynesians argued that budget deficits

should be run when the economy was

weak.
 The Keynesian view released politicians

from a balanced budget constraint.

 During 1960-2015 the federal
36
government has run 52 deficits and four
surpluses.
  The federal government has run a budget
deficit most every year since 1960. Given the
political incentive structure, is this 37
surprising? See the following slide.
Source: Office of Management and Budget, President’s Budget *FY 2011 Budget, Table 1.3. http://www.whitehouse.gov/omb/budget/historicals/
GOVERNMENT FAILURE: THE
SHORTSIGHTEDNESS EFFECT
 Shortsightedness Effect: Issues that yield
current, highly visible benefits at the expense
of future costs that are difficult to identify.
 The political process is biased toward the
adoption
of such proposals even when they are inefficient.

 The shortsightedness effect explains why

politicians will find debt financing and unfunded
promises attractive—they make it possible for
politicians to provide current benefits to voters
without levying an equivalent amount of taxes
(to pay for them). 38
SPENDING WATCHDOGS
 Each member of Congress has a strong
incentive to fight hard for expenditures
beneficial to his or her constituents.

 But, there is little or no incentive for a

legislator to be a spending “watchdog”.
 Consider the incentives to overspend if every
member of Congress decides to go to dinner one
night and split the bill by 1/535th. What are the
incentives to spend “efficiently” if each member
has to pay for each item ordered? How is this
altered when each pays 1/535th of the bill?
39
SHORTSIGHTEDNESS EFFECT AND
UNFUNDED PROMISES
 The shortsightedness effect also
provides a strong incentive for
politicians to support unfunded
promises—programs promising benefits
that are greater than revenues
generated by the tax rates levied for
their support.
 The federal government has promised senior
citizens future payments under the Social
Security and Medicare programs that are far
greater than the payroll tax revenues that
provide their financing. 40
 The debt implied by the unfunded Social Security and
Medicare liabilities is almost four times the size of the
WHAT WILL HAPPEN IF THE FEDERAL
GOVERNMENT DOES NOT BRING ITS FINANCES
UNDER CONTROL?
 There will be repercussions in credit
markets (higher interest rates, others
will be less willing to lend to the U.S.
federal government, etc).
 The excessive debt could fuel another

financial crisis in the future (consider

what has recently happened in Greece).
 There will be higher personal and

business taxes in the future.

 The debt could lead to additional money
41
creation and inflation in the future.
CONTROL OF FEDERAL SPENDING AND
BORROWING
 How can Federal spending and borrowing be
controlled? This is unlikely to happen without
a change to the political rules. Here are some
ideas.
 Amend the Constitution to require the federal
government to balance its budget annually.
 Require a two-thirds or three-fourths approval by
both Houses of Congress for spending proposals
and increases in the federal government’s
borrowing power.
 Limit this year’s spending to last year’s level of
revenues.
42
MODULE 9: QUESTIONS FOR
THOUGHT
1. Carefully define market failure and
government failure. How do they relate to
idealized economic efficiency?
2. How does the individual’s incentive to make
well informed choices as a consumer
compare with their incentive to make well
informed choices as a voter?
3. Why is deficit spending attractive to
politicians?
4. How does the incentive for members of
congress to spend on programs beneficial to
43
their district compare to their incentive to
control federal spending?
MODULE 10: THE ECONOMICS OF
TAXES AND TRANSFERS
 CSE Part 3, Elements 7, 8, and 9
 Concepts Covered:
 Transfers, incentives, and the “welfare” of
recipients
 Unintended consequences of transfers and
subsidies
 Central planning, politics, and resource allocation

44
ELEMENT 7. WHEN GOVERNMENTS
BECOME HEAVILY INVOLVED IN
PROVIDING FAVORS TO SOME AT THE
EXPENSE OF OTHERS, INEFFICIENCY
RESULTS AND IMPROPER, UNETHICAL
RELATIONSHIPS DEVELOP BETWEEN
GOVERNMENT OFFICIALS AND
BUSINESSES.
The tool of politics (which frequently becomes its
objective) is to extract resources from the general
taxpayer with minimum offense and to distribute
the proceeds among innumerable claimants in
such a way to maximize the support at the polls.
45
—James R. Schlesinger,
Former Secretary of
TWO WAYS OF ACQUIRING WEALTH
 There are two ways of acquiring wealth.
 Production:
 People can get ahead by producing goods or
services of value and exchanging them for
income. This method of acquiring income helps
the exchanging partners and enhances the
wealth of society.
 Plunder:
 Sometimes people get ahead by “plundering”
what others have produced. Plunder not only
fails to generate additional income but also
consumes resources and thereby reduces the
wealth of society. 46
 Governments promote prosperity when they
IMPACT OF POLITICAL FAVORITISM
 Subsidies and government favoritism
endanger both political democracy and
economic efficiency.
1. Subsidies distort prices and encourage
businesses to seek government favors
rather than producing better products at a
lower cost.
2. Subsidies to some firms and sectors place
other firms at a disadvantage.
3. Subsidies and favoritism will create an
improper, unethical relationship between
47
business and political officials. Businesses
will seek government favors in order to
GOVERNMENT FAILURE: RENT
SEEKING
 Rent Seeking: Actions by individuals and
interest groups designed to restructure public
policy in a manner that will either directly or
indirectly transfer income to themselves.
 Widespread use of the taxing, spending, and
regulatory powers of government that favor
some at the expense of others will encourage
rent seeking.
 Rent seeking diverts resources away from
productive activities. The output of economies
with substantial amounts of rent seeking will fall
below their potential.
48
POLITICAL FAVORITISM, CRONY CAPITALISM,
AND GOVERNMENT FAILURE
 As government spending, subsidies, income
transfers, and regulatory favors grow,
businesses and other well-organized groups
will expend more resources seeking to obtain
government favors.
 As a result, crony capitalism grows relative to

market allocation.
 Crony capitalism: The situation where the

allocation of resources is determined by

political favors rather than by consumer
preferences translated through the market
profit and loss system. 49
MARKET ENTREPRENEURS
VERSUS CRONY CAPITALISTS
 Market entrepreneurs get ahead by
providing consumers with products that are
more highly valued than the resources
required for their production.
 Crony capitalists get ahead by providing

political players with campaign contributions

and other political resources in exchange for
government contracts, subsidies, tax
benefits, and other forms of political
favoritism.

50
 Crony capitalism reflects govt. failure and
endangers the legitimacy of the democratic
ELEMENT 8. THE NET GAIN OF
TRANSFER RECIPIENTS IS LESS, AND
OFTEN SUBSTANTIALLY LESS, THAN
THE AMOUNT OF THE TRANSFER.
 To non-economists, income transfers look like
an effective way to help targeted
beneficiaries.
 However, economic analysis indicates that it

is actually quite difficult to transfer income to

a group of recipients in a way that will
improve their long-term well-being.
 The unintended secondary effects explain
51
why this proposition is true.
SECONDARY EFFECTS OF TRANSFERS
 Three reasons why transfers and subsidies
are largely ineffective.
1. They reduce the incentive of both taxpayer-
donors and transfer recipients to earn.
2. Competition for transfers erodes most of the
long-term gain of the intended beneficiaries.
 Criterion (e.g. own something, do something, or be
something) for receipt of the transfers must be
established and competition to meet the criterion will
erode net benefits.
3. Transfer programs reduce the adverse
consequences suffered by those who make
imprudent decisions, and this reduces their
motivation to take steps to avoid the adversity. 52
SECONDARY EFFECTS OF TRANSFERS
 Thinking About the Secondary Effects
 When beneficiaries have to do something (for
example, wait in line, fill out forms, lobby
government officials, take an exam, endure
delays, or contribute to selected political
campaigns) in order to qualify for a transfer,
much of their potential gain will be eroded.
 When beneficiaries have to own something in
order to get a subsidy, people will bid up the
price of the asset needed to acquire the subsidy.
 The agriculture subsidy programs, taxi licensing
that results in higher prices, and the homestead
act provide examples of how secondary effects 53
erode the net gain of transfer recipients.
 Even though per capita income has more
than doubled since the late 1960s, the
poverty rate is virtually the same today as
when the War on Poverty began. 54

Source: U.S. Dept. of Commerce, Characteristics of the Population Below the Poverty
Level: 1982, Table 5; and U.S. Census Bureau, Historical Poverty Tables—Families.
SECONDARY EFFECTS OF ANTI-
POVERTY TRANSFERS
 Why weren’t the anti-poverty transfer
programs more effective? The transfers
generate three unintended secondary effects
that slow progress against poverty.
1. The income-linked transfers reduce the
incentive of low-income individuals to earn,
move up the income ladder, and escape
poverty.
 High Implicit Marginal Tax Rates: If they earn more,
their transfer benefits are reduced and the
combination of the additional taxes owed and
transfers lost means that they get to keep only 10,
20, or 30 percent of the additional earnings.
55
SECONDARY EFFECTS OF ANTI-
POVERTY TRANSFERS
2. Transfer programs that reduce the hardship of
poverty also reduce the opportunity cost of
risky choices such as dropping out of school or
the workforce, childbearing by teenagers and
unmarried women, divorce, abandonment of
children by fathers, and drug use.

3. Government antipoverty transfers crowd out

private charitable efforts.
 When the government does more to help the poor,
predictably families, churches, and civic
organizations will do less.

56
REDUCING THE LIKELIHOOD OF
POVERTY
 Three things young people can do that will
reduce the likelihood of future poverty
1. Complete high school (at a minimum).
2. On entering the work force, continue working
and seek a full-time job.
3. Get married before having a child.

 The people who choose these three options

are unlikely to spend much time in poverty.

57
ELEMENT 9. THE ECONOMY IS FAR
TOO COMPLEX TO BE CENTRALLY
PLANNED AND EFFORTS TO DO SO
WILL RESULT IN INEFFICIENCY AND
CRONYISM.
The man of system is apt to be very wise
to his own conceit. He seems to imagine
that he can arrange the different members
of a great society with as much ease as the
hand arranges the different pieces upon a
chess-board.
—Adam Smith (1759), The
Theory 58
of Moral Sentiments
CENTRAL PLANNING AND THE FATAL
CONCEIT
 Central planning replaces markets with
government. It can involve direct command
and control, as under the old Soviet system.
But it can also occur when elected political
officials substitute their verdicts for those of
consumers, investors, and entrepreneurs
directed by market forces.
 Economics, however, indicates that central

planning will be inefficient. There are five

major reasons why this will be the case.

59
CENTRAL PLANNING AND THE FATAL
CONCEIT
1. Central planning merely substitutes politics
for market decisions.
 Subsidies and investment funds disbursed by
governmental planners are influenced by
political rather than economic considerations.
 “Old” firms tend to be favored over “new”,
growth-oriented firms.
 “Pork-barrel” projects will be pursued.

60
CENTRAL PLANNING AND THE FATAL
CONCEIT
2. The incentive of government-operated firms
to keep costs low, be innovative, and
efficiently supply goods is weak.
 Managers of government firms gain little from
improved efficiency and lower costs.

3. Central planners spending the money of

taxpayers will invest less wisely than
investors risking their own money.
 Private investors bear the consequences of poor
investments directly. In contrast, the success or
failure of government projects seldom affects the
61
personal wealth of government planners.
CENTRAL PLANNING AND THE FATAL
CONCEIT
4. The efficiency of government spending will
also be undermined because the budget of
an unconstrained government is something
like a common pool resource.
 When money and resources are owned in
common, there is little motivation to consider the
future.
 This common resource characteristic explains
why, when interest groups are pursuing
government spending, they have little incentive
to consider either the future or the adverse
impact of their actions.
 In their view, if they do not grab more of the 62
government budget some other interest group
will.
CENTRAL PLANNING AND THE FATAL
CONCEIT
5. There is no way that central planners can
acquire enough information to create,
maintain, and constantly update a plan that
makes sense.
 Markets channel information to both producers
and consumers via the price system.
 Market profit and loss disciplines individuals and
holds them accountable for constantly retrieving,
maintaining and updating present and future
plans based on efficiency, not political
considerations.
 The political process does not have anything like
profit and loss that will persistently channel 63
resources into productive projects.
MODULE 10: QUESTIONS FOR
THOUGHT
1. What are the two ways of acquiring wealth?
From the viewpoint of the society, does it
make any difference which of the two
methods is used most extensively? Explain.

2. In recent years, the grant and subsidized

loan programs directed toward college
students have expanded substantially. Have
these programs enhanced the well-being of
college students? Why or why not?

64
MODULE 10: QUESTIONS FOR
THOUGHT
3. Is there reason to believe that elected
officials and government experts will do a
better job of allocating resources than profit
seeking business entrepreneurs? Why or
why not?

65
MODULE 11: FEDERALISM AND
CONSTITUTIONAL STRUCTURE
 CSE Part 3, Element 10 and concluding
thoughts on constitutional rules
 Concepts Covered:
 Competition among governments, incentives,
and resource allocation
 Constitutional rules and sound economics

66
ELEMENT 10. COMPETITION IS JUST
AS IMPORTANT IN GOVERNMENT AS
IN MARKETS.
 Decentralization allows people to move
toward governmental units that provide
desired public services at a low cost.
 In turn, the movements of voters will

discipline governments and help keep them

in line with the preferences of citizens.

67
COMPETITION AND THE
PERFORMANCE OF GOVERNMENT
 Competition is a disciplinary force. In the market
sector, it weeds out inefficiency and provides a
strong incentive for firms to serve consumers.

 Competition among decentralized governmental

units can also improve the performance of
government.
 Efficiency will be improved when private firms are
given the opportunity to compete with government
enterprises. Vehicle maintenance, printing shops,
postal services, garbage collection, street
maintenance, and schools provide examples where
this is feasible. 68
COMPETITION AND THE PERFORMANCE OF
GOVERNMENT CONTINUED…
 Competition among decentralized government units
will provide each with an incentive to operate more
efficiently. If a government levies high taxes
(without providing a parallel quality of service) and
regulates excessively, some individuals and
businesses that make up their tax base will choose
the exit option.

 With decentralization, citizens will be able to group

together with others desiring similar combinations of
government services and taxes, and this grouping
will make it possible for more people to obtain
services consistent with their preferences.
69
COMPETITION AND STRUCTURE OF
GOVERNMENT
 If competition is going to serve the interests
of citizens, it must not be stifled by the
federal government.

 When the national government subsidizes,

mandates, and regulates the bundle of
services provided by state and local
governments, it undermines the competitive
process among them.

 Competition among governments will not

70
evolve automatically. It will have to be
incorporated into the political structure.
THINKING ABOUT
CONSTITUTIONAL RULES FOR
PROSPERITY
There is enormous inertia—a tyranny of the
status quo—in private and especially
government arrangements. Only a crisis—
actual or perceived—produces real change.
When that crisis occurs, the actions that are
taken depend on the ideas that are lying
around. That, I believe, is our basic function: to
develop alternatives to existing policies, to
keep them alive and available until the
politically impossible becomes politically
inevitable.
71
—Milton Friedman,
1976 Nobel Laureate
CONSTITUTIONAL DESIGN FOR
PROSPERITY
 What would a constitution designed to
promote economic freedom and prosperity
look like?
 Ifgovernment is going to be a positive force for
economic prosperity, the rules of the political
game must bring the self-interest of voters,
politicians, and bureaucrats into harmony with
economic progress.
 Limited government, equal treatment under the
law, protection of property rights, and federalism
are cornerstones of a sound constitution.
 When a government supports private ownership,
freedom of exchange, competitive markets, the 72
rule of law, and monetary stability, it will provide
the environment for economic growth and
WHAT WOULD A CONSTITUTION DESIGNED TO
PROMOTE ECONOMIC FREEDOM AND
PROSPERITY LOOK LIKE?
 Promotinggovernment action based on
agreement rather than coercion is important.
 People will agree to an action only when each party
gains. Thus, actions based on agreement, whether
undertaken through markets or government, will be
mutually advantageous and will therefore promote the
general welfare rather than the interests of some
parties at the expense of others.

 The challenge before us is to restore the

intent of the constitutional rules and to
develop a few new ones that will promote
government action based on agreement and
73
bring the political process back into harmony
with economic progress.
MODULE 11: QUESTIONS FOR
THOUGHT
1. Does competition among governmental
units improve its responsiveness to the
views of citizens? Explain.

2. Did the framers of the U.S. Constitution get

the general structure of government
correct? Was the design supportive of
political action based on agreement?

3. Evaluate the proposed nine constitutional

reforms suggested by the authors. Indicate
74
why you would agree or disagree with each
of the reforms.