14. Government intervention in the market

14

Government Intervention in the Market

Chapter Summary

The government plays a significant role in any economy. Although competitive private markets provide the best

mechanism for allocating society’s resources, there are occasions when government’s need to intervene in these

markets. For example, governments are required to enforce the rule of law, particularly over contract and property

rights, or to overcome externalities.

However, whilst government intervention is sometimes necessary, there are also situations where government

intervention occurs, but is not required. For example, the private interest view states that politicians can sometimes

intervene in markets largely because of the rent-seeking claims of a small group of individuals or firms. This type

of intervention leads to government failure, as the net result to the overall economy is often a loss of efficiency.

The difficulty in correctly pricing insurance policies stems from asymmetric information, which happens when

one party to a transaction has less information than the other party. Asymmetric information is also present in the

market for used cars. Asymmetric information leads to adverse selection. Adverse selection occurs when one

party to a transaction takes advantage of knowing more than the other party. The insurance industry is also subject

to moral hazard, which is the tendency of people to change their actions because they have insurance. Insurance

companies use deductibles and co-payments to reduce moral hazard.

Adverse selection and moral hazard also affect firms and investors in financial markets. When a firm has sold

stocks and bonds it may spend the funds in ways not in the owners’ best interests. Since the owners of the firm’s

stock also own the firm itself, this can be a major problem. Moral hazard can also be present in labour markets.

Once hired, workers may shirk their obligations and not work hard. Firms may deal with this form of moral

hazard by closely monitoring workers and making their jobs seem more valuable than other jobs.

Learning Objectives

When you finish this chapter you should be able to:

1. Know the nature and extent of government expenditure in Australia. The government plays a

significant role in Australia’s economy, accounting for around 16% of total employment, and 22% of

GDP. The main expenditures of the Australian government are in social security and welfare and health.

2. Understand why a market economy with competition is generally efficient. Chapter 5 outlines in

more detail how a competitive market results in the economically efficient level of output. In a

competitive market, the interaction between supply and demand results in an equilibrium price and

quantity, where the marginal benefit to consumers from the last unit consumed equals the marginal cost of

providing that unit.

3. Understand the economic bases for government intervention in a market economy. There are a

number of situations where government intervention is required, to correct instances of market failure.

These include: the rule of law, maintaining competitive markets, natural monopolies, externalities,

common resources, public goods, merit goods, asymmetric information, equity and macroeconomic

stabilisation.

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4. Distinguish between market failure and government failure. Market failure occurs when the market

does not result in an economically efficient outcome. Government failure can occur when regulations are

enforced not to improve efficiency, but to protect certain vested interests.

5. Define asymmetric information and distinguish between moral hazard and adverse selection.

Asymmetric information occurs when one party to an economic transaction has less information than the

other party. Adverse selection refers to a situation in which one party to a transaction takes advantage of

having more information than the other party. Moral hazard occurs when people change their actions as a

result of having insurance.

6. Apply the concepts of adverse selection and moral hazard to financial markets. Asymmetric

information exists in financial markets because firms know more about their financial situation than do

potential buyers of its stock and bonds. Moral hazard exists in financial markets because firms may use

funds raised through the sale of stocks and bonds to reduce profits or even steal funds. The larger the firm

and the more carefully analysts follow their activities, the less likely moral hazard will be a problem.

Chapter Review

Chapter Opener: Selling Noodles is Harder Than You Think

The chapter opener outlines the case of Ken Lee, a migrant to Australia from Hong Kong. Mr Lee wanted to set up

a restaurant in Canberra, following on from the successful restaurant he ran in Hong Kong. However, the

regulatory burdens he faced in trying to set his business up, including health and safety regulations and

compulsory staff training requirements, plus the additional labour market regulations, led him to question whether

it was worthwhile to set his business up in the first place. This chapter looks at the (economic) role of the

government in the Australian economy.

The Size of the Public Sector

There are a number of ways to measure the size of the public sector: government production as a proportion of

Gross Domestic Product (22% in Australia in 2007/8), or public sector employment as a proportion of total

employment (16% in Australia in 2007/8), or by public expenditure as a proportion of total expenditure (35% in

Australia in 2007/8). This final measure is larger due to the fact that the government also makes transfer payments

to individuals and households (pensions, unemployment benefits and so on).

In relative terms, the size of Australia’s public expenditure is smaller than the UK, Canada and Scandanavian

countries, but a similar size to the US, Japan and Switzerland. Although government expenditure (net of transfer

payments) has fluctuated since 1960, there was a general upwards trend through to mid-1980s and then a decline

until 2003. This decline was due to microeconomic reforms undertaken, and the fact that many public enterprises

were privatised during this period.

In terms of the where the government spends its money, the greatest share goes towards social security and

welfare (41% in 2007/8), followed by health (18%) and general government services (14%).

The Economic Bases for Government Intervention

We have learnt in previous chapters that competitive markets produce the most economically efficient use of

resources. Whilst any intervention in these markets by governments that directly distorts outcomes will result in a

loss of efficiency, there are still a number of areas where economists believe government intervention is a

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necessity. These often involve situations of market failure, and include:

• The legal system and rule of law (legislation is required to enforce private contracts);

• Maintaining or enforcing competition (inefficiencies can arise with monopolies or collusive behaviour

between firms, and so the government need to regulate to ensure competitive, or at least contestable,

markets exist);

• Natural monopolies (where economies of scale are so large that one firm can supply the entire market at a

lower cost than two or more firms could);

• Externalities (a benefit or cost that accrues to third parties not directly involved in the production or

consumption of a good – these are covered in Chapter 15);

• Common resources (an extreme case of externalities, where no one can be denied access to a resource, but

their use of that resource reduces the possible use of others – these are also covered in Chapter 15);

• Public goods (where consumption of a good or service is both non-rival and non-excludable, the

government must provide this product to overcome the market failure of ‘free-riding’);

• Merit goods (goods that are deemed to be beneficial to society, such as museums and galleries, that might

otherwise not be provided by the private sector);

• Asymmetric information (regulation is required may be required to reduce the problems that occur when

one side of a market has access to information not available to the other side – see below for more details);

• Equity (often involve normative judgements about what is ‘fair’, and so the government may intervene if a

specific market equilibrium is deemed inequitable);

• Stabilisation (macroeconomic) policy (policies that aim to stabilise the overall economy, and provide low

unemployment, low inflation and strong economic growth).

Market Failure and Government Failure

Although there may be a role for governments in cases of market failure, others argue that, for a variety of

reasons, there may also be government failure that can actually make a situation less efficient. For example, the

private interest view states that the rent-seeking behaviour of groups and individuals can cause government failure.

Rent-seeking behaviour is the unproductive activity of an individual or group in the pursuit of economic surplus

above that which would result in a competitive market. Lobbyists may be employed by an industry, for example,

to convince politicians to enact or maintain specific privileges for that industry. This can often occur because these

groups are more vocal in comparison to the general public, who may not know (or care) of the benefits they would

otherwise receive. Examples of this include lobbying by small business to maintain restricted trading hours (see

An Inside Look on page 456), or by professional groups who try to restrict entry into their profession to ‘protect

the public’, but which therefore restricts supply and keeps their wages high. Whilst not all interest groups could be

considered ‘rent-seekers’, it is still important to understand the actions of these groups with respect to regulation in

the economy.

In some situations, economic efficiency can be improved through deregulation and/or privatisation. Deregulation

can promote competition by reducing barriers to entry, as with the Australian telecommunications industry in the

1990s. The privatisation of government business enterprises (GBEs) in Australia was another method of

promoting efficiency during the 1990s. During this period, many GBEs were sold, including state electricity and

gas assets, as well as the Commonwealth Bank, Qantas and Telstra. Whilst deregulation does not guarantee

economic efficiency will improve, the experience in many industries suggest that this often occurs.

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