This is one of the penultimate drafts of my chapter in a volume forthcoming with Routledge, Fabian, M. and Breunig, R. (eds.), "Hybrid Public Policy Innovations: Contemporary Policy Beyond Ideology".
How to appropriately balance the state and the market in public policy was arguably the defining question of the 20th century. The Western experiment with communism ended symbolically with the fall of the Berlin Wall in 1989. By that stage, public policy in the capitalist countries had grown quite sophisticated, and was much more than unchecked free markets. Notably, many of the liberal economies of the West had extensive welfare states with public health, education, transport and social security. These ‘social wages’ could be paid in large part because the use of markets to efficiently allocate resources to their most productive use in these economies had the led to the accumulation of significant wealth that could be redistributed by government. Liberal-democratic and social-democratic institutions ensured that this wealth was actually redistributed, or at least provided an avenue for protest when it wasn’t. Citizens of these societies could have their cake and it eat it too—they could enjoy both the private wealth of a market system and the social protections of a socialist one.
How to appropriately balance the state and the market in public policy was arguably the defining question of the 20th century. The Western experiment with communism ended symbolically with the fall of the Berlin Wall in 1989. By that stage, public policy in the capitalist countries had grown quite sophisticated, and was much more than unchecked free markets. Notably, many of the liberal economies of the West had extensive welfare states with public health, education, transport and social security. These ‘social wages’ could be paid in large part because the use of markets to efficiently allocate resources to their most productive use in these economies had the led to the accumulation of significant wealth that could be redistributed by government. Liberal-democratic and social-democratic institutions ensured that this wealth was actually redistributed, or at least provided an avenue for protest when it wasn’t. Citizens of these societies could have their cake and it eat it too—they could enjoy both the private wealth of a market system and the social protections of a socialist one.
The success of these economies derived in no small
part from the application of an analytical framework for thinking about public
policy that had been hashed out in the halls of universities over the course of
the 20th century. Economics was ascendant in this discourse, building on
earlier work in political and social theory, extending it into the economic
realm and formalising it into mechanistic tools of analysis. This chapter is an
introduction to that framework. It explains in broad terms the strengths and
weaknesses of markets, states and communities for ensuring an efficient and
equitable allocation of resources in society. In many ways, it is an
introduction to the economic way of thinking, but the student of politics,
sociology or any other social science should recognise the influence of their
own discipline.
Some are starting to question whether the framework
outlined in this chapter has outlived its usefulness, at least as far as the
advanced economies of the developed world are concerned (For example, Quiggin
2012). The framework is arguably struggling to meet the challenge of climate
change, reap the full benefits of new technologies, and provide enough succour
and security to citizens to prevent the re-emergence of xenophobia and
nationalism. This may well be the case, but it is nonetheless important to be
familiar with this paradigm if one wants to get to grips with modern
policymaking. The question of ‘where to next’ is taken up somewhat by chapter
14 in this volume.
1.
Efficiency
as a criterion for good public policy
Public policy is substantially a question of how to
allocate scarce resources in the context of imperfect information, limited
power, competing claims and essentially unlimited wants, in order to maximise
social welfare. Opportunity cost—the cost of forgone alternatives—is
omnipresent in public policy. There are many things a society would like to do,
like fund free tertiary education and
a world-class defence force, but inevitably we have to choose only a subset of
these things because we have a limited pool of resources. How are we to choose
between policy options? In this context of scarce resources, efficiency is a relevant criterion for
deciding allocations. If resources are scarce, then we don’t want to be
wasteful with them. If we allocate our resources efficiently, then we get
maximum bang for each buck, which minimises opportunity costs, ensuring the
maximisation of welfare.
Classical microeconomics is essentially the study of
how to efficiently allocate scarce resources so as to maximise welfare (Sowell
2007). However, before taking a single step further, it is important to
emphasise that economics does not explicitly value efficiency (Samuels 1988, Weston 1994). Economics is not
normative (or at least tries not to be). It endeavours to model the allocation
of resources to show how efficiency can be obtained and what the trade-offs are if society values something else instead,
like equity. Some economists certainly value
efficiency and will trade-off other things in order to maximise it. But these
individual economists should not be mistaken for the economic paradigm or the
profession as a whole.
Economics links efficiency and welfare through the
concept of Pareto-efficiency. A Pareto-efficient outcome is one where nobody
can be made better off without making someone else worse off. Pareto efficient
outcomes need not be equitable. An early step in public policy design is to
identify any Pareto improvements that can be made. These are welfare enhancing
without hurting anyone, and thus win-win. A subsequent step is to identity any
so-called ‘potential’ Pareto improvements.
These are cases where some group can be made so much better-off that they
can compensate those made worse-off by the change such that the end result is
still a net improvement in social welfare. These are so-called ‘positive sum’,
and such efficiency is sometimes called Hicks-Kaldor efficiency.[1]
1.1.Markets
as efficient allocators of scarce resources
Efficiently allocating scarce resources is an
extremely difficult task for policymakers because they lack the requisite
information (Hayek 1945). Consider the case of tractors. In a centrally-planned
economy, the government decides the means of tractor production, the price of
those tractors and the quantity that is produced. How is the government to know
how many tractors people want? If they produce too many, the surplus will sit
idle. The inputs to production used to make those surplus tractors could also
have been used to produce something else, like cars. Furthermore, there are
hundreds of inputs that go into a tractor—rubber for the tyres, copper for the
electronics, steel for the chassis etcetera—all of which involve design
decisions, ongoing technological improvement and their own supply chain. It is
a monumental task for a bureaucracy to manage the production of these inputs
and coordinate their interconnected supply chains as they come together to make
a tractor.
Markets are relatively more efficient at managing this
allocation of resources than the state apparatus because they can tap into a
lot more information through the price mechanism. Prices simultaneously
communicate demand and supply, which reflect the utility people gain from consuming
certain goods relative to others and the cost of producing those goods relative
to others respectively. In order to understand how prices achieve this and how
this results in welfare maximisation, we will need to take a brief look at some
basic principles of economics.
The primary concept in economics is utility (Bruni
& Sugden 2007). Individual agents attempt to maximise their utility by
consuming subject to their budget constraint. Goods are typically traditional
consumables like food, dishwashers and holidays, but the concept can be
extended to more ephemeral goods like leisure and family time. The key thing is
that constraints, whether financial or temporal, mean that people necessarily
make trade-offs, and rational actors will trade-off such that they get as much
utility as possible.
What is utility? Economists don’t engage with this
question. It’s just a vague positive (+) while disutility is a negative
(-).Utility is not happiness or wellbeing or anything descriptive like that. As
soon as you try to define it you start to make value-judgements, and economists
want to avoid that. We can’t measure utility, so attempting to predict
behaviour based on the power of feelings is a dead-end (Robbins 1938). Instead,
economists infer from individuals’ behaviour that they must have expected their choices to result in more
utility than some alternate course of action. This is called revealed
preferences. This approach to utility maximisation does not require computing
precise quantities of utility, but rather a rank-ordering of preferences, for
example, apples over oranges over pears.
Individuals communicate their preferences to producers
of goods in the form of demand for certain goods, which manifests as
‘willingness to pay’. This willingness is derived from the trade-offs
individuals make across goods when subject to their budget constraint. For
example, I am willing to pay $3 for an apple, but only if oranges cost $4 and
only if I don’t already have 3 apples, at which point I start to be more
interested in getting an orange than a fourth apple. Producers compare their
cost base (which determines their ‘willingness to accept’) to consumers’
willingness to pay to determine how much profit they can make selling a
particular good. Private producers will not produce a good in the long run
unless they can make a profit, and they will produce the goods that are the
most profitable. Profit is the difference between the price received for output
and the costs associated with producing that output. As such, profit-maximising
producers will seek to produce the most desired and thus highest-priced good at
the lowest possible cost. Their profit-maximising behaviour forms the supply
side of the market.
Supply and demand find their equilibrium at the market
clearing price. At this point, the price of a good ensures a quantity of it is
produced that balances the utility people get from consuming it with the costs
involved in producing it, all relative to other goods. The last consumer to
enter the market derives close to zero net benefit from the good because their
willingness to pay for it is almost exactly its price, but still gets more
utility from this good than any other they could consume. And the last firm to
enter the industry—the marginal firm—turns close to zero profits, but couldn’t
get more profit in a different industry given its production technology. Thus,
no further demand or supply is attracted to the sector and we can say that the
market has cleared.
Markets are sometimes described as having a rationing
and allocative function. The rationing function channels goods to the consumer
who is most willing to pay for those goods, which has an element of fairness to
it (provided that everyone has capacity to pay for the good). The allocative
function channels inputs to producers who can most productively use those
inputs to produce goods, thereby maximising society’s output.
Markets also have a creative function. The profit
motive incentivises competition amongst firms for custom, which spurs
innovation and ongoing cost reductions (Smith 1776, Schumpeter 1942). Firms
make larger profits when they secure a larger market share, and they secure
market share by providing a higher quality good at a lower price than their
competitors. They achieve this by streamlining their management practices,
improving their production technology and attracting the most talented workers.
If they don’t constantly improve their systems then their advantages over their
rivals will gradually be eroded along with their profits until they become a
loss-making enterprise and are forced out of the industry, releasing their
resources to more productive firms. Competition thus drives ongoing increases
in productivity, which is our ability to create more with less. Productivity is
what makes us materially richer as a society. In the absence of competition,
the impetus for firms to improve their productivity is significantly
diminished, and productivity growth declines, as it has in all centrally
planned economies to date.
The reason why markets are described as ‘welfare
maximising’ is because they produce what people want at least cost and drive
reductions in this cost over time. A classical utilitarian might see this
outcome as a just one because as much utility as possible is generated. Moreover,
the people who most want a good get it but also pay the most for it. These two
points—welfare maximisation and willingness to pay—are the basis of the ethical
principle of ‘market justice’ (Hayek 1978). One advantage of this doctrine is
that it avoids engaging with what goods
ought to be produced, leaving such decisions up to individual preferences. A
hole in the theory is that it assumes that everyone has an equal capacity to
pay for any particular good, which is unlikely for all but the most basic of
goods in a free market economy.
1.2.
Market distortions
The ability of markets to efficiently allocate scarce
resources is undermined by interventions that distort the prices operating in
those markets. Many regulations have this effect, notably subsidies, price
floors and price ceilings (Von Mises 1940; see Bhagwati & Panagariya 2012
for a practical discussion in the Indian context). These include distortions of
the wage and interest rate, which are the price of labour and capital
respectively. In all cases, price distortions lead to information signals that
do not reflect the true social cost and benefit of an activity. For example, if
you subsidise water for farmers, this encourages them to use water-intensive
farming technologies and grow water-intensive products because water is
artificially cheap (Roodman & Peterson 1996). This does benefit the farmers
and people who want to consume water-intensive crops. However, from a
society-wide, utility maximising point of view, there are likely more efficient
ways of allocating the water resources available.
In general, while price controls might seem useful for
equity reasons in many cases, the efficiency costs typically outweigh the
equity benefits. A post- or pre-market intervention may be able to improve
equity without so dramatically undermining the efficiency of the market. For
example, simply transferring money to the farmers to spend as they wish would
see them allocate that capital towards the most efficient production
technologies in the context of the true cost of water (Jha et al. 2013). The
financial benefit to the farmers is the same, but it is attained without the
misallocation of water resources. This idea of using markets for efficiency and
operating around the market to achieve equity is a major theme of this volume
and especially the case studies in part 3.
1.3.
Market Failure
If free markets are functioning well in terms of
delivering efficient outcomes, there is no case on efficiency grounds for
government intervention. What are the prerequisites for a well-functioning
market? The theory outlined above concerning the efficiency of markets requires
certain basic assumptions to be met. These are:
· Competition:
there must be a large number of buyers and sellers in the market.
· Information:
actors must be well informed regarding the price and quality of different
suppliers and alternative goods.
· The
market must be for a private good. These are rivalrous and excludable.
Rivalrous
means that consumption of the good by one person prevents it being consumed by
another person. The simplest example is food. If I eat an apple, you cannot eat
that apple. Excludable means that the consumption of a good can be prevented.
If consumption cannot be prevented then people can consume without paying the
producer. An example of a non-excludable good is a defence force. Citizens
cannot be prevented from benefiting from the existence of an army to defend
their nation. Goods that are non-rivalrous and/or non-excludable are discussed
below under public goods.
· There
can be no externalities associated with the market. An externality is a cost or benefit associated with a transaction that is not included in the price
underpinning that transaction. An example of a negative externality is
pollution—individuals who are not parties to a transaction incur costs from it
in the form of the pollution it generates. An example of a positive externality
is education. There are diffuse benefits associated with a more educated
population that are not included in the private costs of tuition.
Perfect
markets where all of these criteria are met entirely are extremely rare if they
exist at all. However, markets where these conditions are largely met exist in
abundance. Furthermore, even somewhat inefficient markets may still be a superior
tool for allocating resources compared to alternatives like a planning
committee. Perhaps the most powerful evidence for this proposition comes from
the natural experiments of East and West Germany and North and South Korea
(Ferguson 2012). In both cases, a largely homogenous population with similar
access to resources was split in two and almost randomly assigned to either a
market-led economic system or a centrally planned one. In both cases, the
wealth of the citizens in the market-led systems rapidly outstripped that of
their peers in the centrally planned system. A visceral example comes from the
automotive industry. Competition or lack thereof meant that by 1988, just
before the fall of the Berlin Wall, West Germany produced the iconic Mercedes
Benz 300E, while East Germany produced the Trabant, an infamously terribly car.[2]
There are some situations where markets are clearly
unlikely to produce an efficient outcome if left to their own devices. These
are grouped under the heading of ‘market failures’ and often result from a
break-down of the assumptions outlined above. They include the following:
· Monopolies
· Imperfect
information
· Public
goods
· Externalities
This is not an exhaustive list of market failures, but
does cover some of the most common ones. They are reviewed in detail below.
Monopoly
A monopoly occurs when only one entity is producing a
certain good. When only one entity is consuming a certain good it is called a
monopsony. Entities in these positions can abuse their market power to shift
the price away from the market-clearing optimum but in their favour in the form
of increased profits.
Monopolies arguably occur most commonly in situations
of natural monopoly (Berg &
Tschirhart 1988). This is where there are very large fixed costs associated
with getting started in an industry, or very large economies of scale
associated with that industry such that existing hegemonic firms are far more
profitable than newcomers. For example, to become a player in the energy
industry you need to make very large, long-term investments in plants and
distribution networks before you can make any money. However, once a plant is
up, you can expand your distribution network to reach more customers relatively
cheaply because you don’t need to build anymore plants, only grid. As such,
once there is an existing power provider in the market, new entrants will
struggle realise profits and be easily undercut in the short term, which makes
it less appealing for them to make the initial capital outlays required to join
the sector. This entrenches the monopoly.
Monopolies can also be created by regulation.
Historical examples include ‘national champions’ that were given privileged
access to certain markets, like the East India Company. More recently, patents
have allowed certain high-tech companies to essentially act like monopolies, at
least for the duration of the patent (Boldrin & Levine 2008).
Imperfect
information
The most common market failure resulting from
imperfect information is asymmetric information (Akerlof 1970). This is where
one-side of a market has far more information relevant to transactions in that
market than the other side, which results in an inefficient market equilibrium.
A textbook example is health insurance. Unhealthy people have an incentive to
hide their ailments in order to secure lower premiums, and it is difficult for
insurance firms to find out for certain whether a new custom is unwell or
fit-as-a-fiddle (Krugman & Wells 2006). The firm consequently suffers from
what is known as ‘adverse selection’ and will inefficiently provide health
insurance.
Public
Goods
Public goods are non-rival and non-excludable. Private
actors will not supply non-excludable goods because they essentially cannot
stop consumers from stealing their product. A common example is street lights.
There is obvious demand for street lights, but it is difficult to charge some
kind of entrance fee to any street equipped with them. As private providers
will not supply the good, there is thus a strong case for state provision.
Private actors will provide non-rivalrous goods as
long as they are excludable, but they will tend to undersupply them. This is
because the marginal cost of providing a non-rivalrous good to an additional
consumer is very low. As such, once any initial fixed-cost is paid for, it is
socially beneficial to make the good available to as many people as possible on
the cheap to derive maximum benefit from it. An example is a lecture. The
teacher has a reserve price for preparing and delivering the lecture, but the
marginal cost of extending the lecture to one more audience member is close to
zero. Their entry into the lecture theatre does not impede the consumption of
any other audience member, nor require any extra effort on the part of the
lecturer. The benefit to this additional audience member is greater than zero,
so the maximising social welfare would mean allowing them into the lecture.
However, if the lecturer wants to maximise their personal profit they may well
charge a higher than zero fee that is only acceptable to very interested
parties, and thereby exclude many people who would benefit. As this privately
optimal behaviour is not socially optimal, there is a case for public provision
from an efficiency point of view.
Externalities
Markets undersupply goods associated with positive
externalities and oversupply goods associated with negative externalities. This
occurs because the prices that markets set do not take into account the costs
and benefits incurred by third parties (Pigou 1932). An example is noise from
live concerts, which can irritate people around the venue who do not want to
participate in the concert. Unless these costs are factored into the ticket
price, private markets will oversupply live concerts. The opposite is true in
the case of positive externalities wherein social benefits are not factored in
to private transactions.[3]
The most straightforward way to correct for an
externality is to fold the non-market social costs and benefits of a good into
its market price. This can be done through mechanisms like subsidies, such as
for education, and taxes, such as on carbon. However, in order to do this
effectively, it is necessary to be able to accurately assess the value of the
externality. This is often very difficult in practice (see Dobes, chapter 6
this volume). Another common approach is to try to extent property rights of
some kind to the actors adversely affected by the externality. For example, if
a river is being polluted by a factory and harming the livelihoods of fisherman
who depend on it, extending property rights over the river to those fishers
would allow them to sue the firm. This may encourage the firm to negotiate with
the fishers to achieve a mutually amicable outcome (Coase 1960).
Anti-rival
goods
A final cause of market failure worth discussing
because of its increasing prominence is the case of goods that increase in
value with greater use, which are sometimes called additive or anti-rival goods
(Kubiszewski et al. 2003). Information is the most common example, but many
others have emerged during the ‘information age’ that has accompanied the
growth of the internet. Many contemporary goods like social media grow
exponentially in value as greater numbers of people use them more frequently.
It is difficult to design pricing mechanisms for such goods, especially when
the benefits are diffuse and hard to quantify. There is an argument to be made
for certain such products to be state or community funded and made open source
so that their full value can be fully realised.
2.
Alternatives
to the market
When markets fail to efficiently allocate scarce
resources due to the presence of market failures, what should policymakers do?
One option is to try and bring prevailing conditions closer to those of a
perfect market (Friedman 1962). This is common practice with externalities, and
is utilised in some hybrid models, like privatised utility companies that have
to operate within a regime of price controls. In many cases though, the
deviation from socially optimal outcomes that accompanies the market provision of
goods in the presence of market failures is too large to be tolerable, and some
(potentially also flawed) alternative is preferable. These alternatives can be
lumped into two very rough categories: community provision and state provision.
2.1
Community
That community is perfectly capable of providing many
services that markets fail to manage is a core tenet of libertarianism (Nozick
1974, Rothbard 1962, Chomsky 2002). People left to their own devices will
arrange mechanisms to combat social problems and promulgate social goods. The
most obvious case is charity, especially large contemporary organisations that
do front-line service delivery of things like homeless shelters and emergency
aid. The Red Cross and Medicins sans Frontiers are good examples. Simplistic
libertarian arguments sometimes overlook the fact that the modern state is
arguably a manifestation of (secular) community organisation for action. This
is especially evident when the state provides funding for large charitable
organisations through the fund-raising mechanism of tax-collection, which is
administratively more efficient than seeking donations. More sophisticated
libertarian theories acknowledge this point, but argue that state provision of
services dissolves the social bonds that emerge as a consequence of community
organisation. Critics would reply that this is a good thing—state delivery or
finance of non-market goods allows for collectivism without the oppressive
features of communitarianism, like family coercion. A longer discussion of
these very interesting issues is unfortunately outside the scope of this
chapter.
The primary shortcoming of community approaches to the
provision of non-market goods is their weakness to the tragedy of the commons
(Hardin 1968). In situations where resources are shared, there is typically an
incentive to free-ride off the charity of others. This situation is on
prominent display in contemporary international negotiations to find a
cooperative solution to global climate change. In the absence of some sort of
punishment mechanism, states always have an incentive to renege on their
commitments to any climate change mitigation treaty and thereby receive the
benefits from the carbon abatement policies of other countries while not having
to contribute anything themselves.
The free-rider dynamic also emerges in the laboratory
(Binmore 2012). In so-called public goods games, individual players contribute
some portion of their individual resources to a common pot. At the end of a
round, the pot is doubled by the experimenter and its total value distributed
evenly back to the players. The highest social benefit is achieved when all
players put their entire individual allocation into the pot, but the highest
individual payoff is attained when a player contributes nothing to the communal
pot and then receives an additional payment from it at the end of the round. In
public goods games without any opportunities to punish free riders, some
individuals almost invariably free ride and the number of players contributing
to the public pot diminishes over subsequent rounds of the game. However, when
players are able to spend some of their own funds to punish players who
free-ride, those free-riders typically start contributing to the common pot in
subsequent rounds.
The lesson of these examples is that you need some way
to punish free-riders if a community solution to a resource allocation problem
is to be effective. States employ explicit coercion through the legal system
and their monopoly on physical violence. This is the approach taken by many
successful international agreements, like the World Trade Organisation, which
include an arbitration mechanism with punitive powers to punish signatories to
the treaty who do not abide by its tenets. Communities can employ similar
mechanisms in the form of ‘frontier justice’ and the like, but community
coercion typically takes more tacit forms, like soft norms that encourage
adherence to the authority of the family, elders or key institutions like the
church. It is the coercive function of these institutions that many advocates
of state-provided social services would like to do away with, but of course
they can only achieve this by replacing the personable coercion of the
community with the impersonal coercion of the modern state. Community approaches
can also rely on the goodwill of all involved, which is sometimes enough. For
example, many charitable organisations that deliver frontline services are
viable because they have access to a small army of volunteers. They choose to
participate. Their only reward is personal gratification. Community approaches
are quite efficient in such circumstances because there is limited ability to
free ride.
In recent decades, public policy has started to take
community approaches to common resource management more seriously following the
pioneering work of Eleanor Ostrom (1990). She noted that efficient,
community-based solutions to policy problems for common resource management can
emerge when the following 8 design principles are surmountable:
1. Strong
group identity and understanding of purpose
2. Proportional
equivalence between costs and benefits, meaning that people who produce
benefits or bear costs are rewarded appropriately.
3. Collective-choice
arrangements
4. Effective
monitoring
5. Graduated
sanctions, meaning that actors who break rules are punished in increasing
severe ways the more frequent their transgressions.
6. Conflict
resolution mechanisms
7. Community
groups must have minimal rights to organise granted by the state
A simple example she provides is of fishermen from Alanya
in Turkey. They have devised a system for the daily rotation of individual
fishing spots so that each fisher gets equal access to the best spots over the
course of the year, and the area is not overfished leading to collapse. A state
apparatus is unlikely to have been able to craft such an efficient system, and
a market approach involving property rights to spots allocated to particular
fishers would not have been as equitable.
2.2.
The State
If both the community and the market result in
inefficient outcomes, that leaves the state as a potential source of solutions to the problem of resource
allocation. Modern states have some clear strengths: they have enormous
financial capacity, technology resources and access to expertise, and they have
the ability to enforce laws and often the authority to do so. States also have
some advantages in administrative efficiency. While the bureaucracy is
notoriously inefficient, it has some features, notably its institutional
longevity and regulatory capacity, which can make it very efficient for
administering large-scale programs like income-contingent loan financing (see
chapter 8, this volume). However, it should be stressed that market failure or
some other departure from a theoretical optimum does not automatically justify
or demand state intervention (Demsetz 1969). The medicine may be worse than the
poison, as it were. Interventions must be justified on their own merits after
careful analysis.
The strengths of states allow them to overcome many of
the inefficiencies that plague markets and community. An authoritative,
organised legal system can punish those who deviate from agreements and norms
that ensure cooperative, collectively beneficial outcomes, like good-faith
contracting and freedom from violence. Financial resources and the power to
collect tax make it relatively easy for states to provide public goods. The
ability to tap expertise to design and enforce sophisticated (though not
necessarily complex) regulation makes it possible for states to correct some
externalities, such as by setting up carbon markets or subsidising public
transport. States’ capacity also allows them to overcome some information
problems by collecting information through their many arms, collating it and
sharing it with relevant parties. For example, the Australian Renewable Energy
Agency collects information from industry partners it works with and
disseminates that information publically to bring Australia’s energy market and
associated industries to improve market efficiency.
States also have weaknesses, of course. For a start,
the ethics of state coercion are extremely fraught.
There is also the sclerotic
pace of the bureaucratic process. This is the inevitable result of requiring
extensive checks on officials when they spend taxpayer dollars. Shareholders
choose to bear the risk of fraud in private companies. This isn’t feasible in
government because taxpayers have very little ‘choice’ when it comes to buying
government shares, because governments have a systemic role to play in society
and the economy, and because governments have intergenerational obligations to
people who aren’t born yet. The private sector also overcomes the need for a
lot of red tape by making individual line managers more accountable for certain
decisions. Decisions need to travel a shorter distance up the management
hierarchy before they are signed off on, which accelerates the pace of
processing. The flip side of this increased accountability for junior managers
is that they can be fired much more easily than equivalent public sector
managers. The end result is that there is less need to ensure all decisions are
good ones in the private sector, but also a greater risk of bad decisions being
made. Governments can much less readily afford to take such risks.
There are two other major sources of inefficiency
commonly associated with state provision: moral hazard and principle-agent
problems. Moral hazard involves excessive risk-taking because the agent is
sheltered from the risks. Public servants make decisions that affect others
much more than themselves, notably in the case of regulating far-off
individuals. When these decisions have adverse consequences, the public servant
is largely insulated from the fallout. Even politicians have more skin in the
game. Moral hazard occurs in the private and community sectors as well, but is
acute in the public sector because bureaucrats spend other people’s money, work
in flatter management structures that make apportioning blame harder, lack a
strong incentive to maximise profit and minimise costs, and typical try to
fulfil objectives are hard to measure, making success and failure more open to
interpretation.
A principle-agent problem is where the interests of an
individual, the principle, diverge from those of an agent they hire to perform
a service for them. The textbook example is voters and politicians. Voters want
politicians to govern for them because they have better things to do with their
lives. Politicians want votes, so there appears to be a convergence of interests.
However, politicians also need money to fund their election campaigns. In the
absence of public election finance and controls on fundraising, this forces
budding politicians to find political donors. The interests of these donors may
diverge from those of the voters who ultimately elect the politicians.
3.
Equity
and Justice
There is a lot more that could be said about the
comparative advantages of governments, markets and community for efficiently
allocating resources to desired goods, but it is outside the scope of this
chapter. What is more valuable to discuss is the other fundamental criterion
for the allocation of resources besides efficiency: equity.
A good foundation for this discussion is the
distinction between relative and proportional equity. Relative equity means
that nobody should have substantially more resources than somebody else. There
are instrumental and intrinsic arguments for why relative inequality needs to
be minimised. On the instrumental front, some argue that greater inequality is
correlated with various forms of social breakdown, including crime, drug use,
teenage pregnancy and the capture of democratic institutions by rent-seeking
elites (Wilkinson 2011, Stiglitz 2013). The empirical veracity of these claims
is hotly contested (Snowden 2011).
The intrinsic arguments are more ethical in nature.
Principle among these arguments is that in a liberal setting, one’s life
outcomes in terms of wealth, health and so on are substantially determined by
the genetic lottery. It seems unfair that we should have less than others
through no fault of our own, so society should correct for these perverse
outcomes of luck. The second intrinsic argument for combatting inequality is
that there seems to be diminishing marginal returns to utility from greater
access to resources. In layman’s term, a dollar makes a poor person much
happier than it does a rich person. As such, we can improve the wellbeing of
society as a whole by taking some money from the rich and giving it to the poor
(Layard 2006). Finally, there is a rights-based argument that because we are
all human we are all entitled to some portion of the collective pie. Perhaps
the most well-known manifestation of this approach to economic justice is
Amartya Sen’s definition of development as freedom, wherein the objective of
economic policy should be to enhance the capabilities of individuals to be who
they want to be and do what they want to do (Sen 1999).
Proportional equality emphasises getting what you
deserve. Libertarians and those in favour of strict meritocracies tend to
emphasise proportional equity, especially when it comes to keeping the rewards
of your own hard work (Mankiw 2013). It is hard to reconcile these two kinds of
equity because it is hard to fund redistribution for the purposes of addressing
relative inequality without taxation, which infringes upon proportional equity.
The situation is further complicated by the fact that
a normative inclination towards either proportional or relative equity seems to
be hard-wired into our biology (Haidt 2012, Greene 2013). Recent research in
the evolutionary psychology of moral cognition shows that the
neural-architecture that incenses people when they are confronted by inequity
is the same for advocates of proportional and relative equity, even though
their intuitions about particular examples of inequality often run in opposite
directions. For example, welfare payments to the unemployed are critical for
addressing relative inequality, but these payments are anathema to advocates of
proportional equity because it seems that bludgers are getting something for
nothing. There is now a suspicion that our species promotes both value systems
at the genetic level for evolutionary reasons: a group that doesn’t care about
relative inequality can’t compete effectively against other groups, but a group
that doesn’t care about proportional equity fails to provide sufficient
incentives for innovation and initiative and quickly succumbs to the tragedy of
the commons.
When policymakers engage with proportional and
relative equity considerations they often start with some kind of social
welfare function (SWF). Arguably, the most basic SWF is the classical
utilitarian one, which simply adds up the utility of all individuals in
society:
Utilitarianism is interested in maximising total
utility, and will engage in redistribution so long as it results in a potential
Pareto improvement or a Hicks-Kaldor improvement. As such, there is a degree of
equity in Utilitarian notions of justice, but the primary concern is
efficiency.
A slightly more complex social welfare function that
informs a lot of public policy thinking, though typically only implicitly, is
the Rawlsian social welfare function (Rawls 1971). This tries to maximise the
utility of the worst off person in society[4]:
Rawlsian social welfare functions require policy
makers to consider whether a policy that will grow the size of the economic
pie—that is, increase efficiency and/or productivity in the economy—will also
increase the size of the slice of the pie attained by the worst-off members of
society. So for example, Rawlsians would likely be in favour of taxation for
redistribution, but not if it stymied economic activity such that the poor
couldn’t find jobs. Similarly, they would be in favour of tax cuts for the rich
if they increased total tax receipts with which to fund transfer programs
(Sowell 2012), but not if the cuts simply resulted in the more economic
activity benefitting the middle and upper classes.
4.
Achieving
equity efficiently
It is generally taken for granted that some degree of
equity is desirable. What is more contested is the extent to which we should
trade off efficiency for equity. Metaphorically, how much are we willing to
sacrifice the total size of the pie to ensure it is split and shared more
equally? Continuing on from the analysis above, the first thing to note in this
regard is that while markets are remarkably effective at ensuring efficiency,
they do not produce equitable outcomes, quite the opposite in fact. However,
inequity is not a market failure because perfect markets care about Pareto
efficiency, not equity. From any given initial endowments, individuals in
operating in free, perfect market will trade to a Pareto efficient point. To
improve equity without interfering with the ability of markets to produce this
efficient outcome, policymakers need to change the initial endowments that
people have and then leave people to trade for the specific goods that they
want (Edgeworth 1881). For this adjustment of initial endowments you need
instruments of redistribution, notably taxes. Here we come to one of the
stickier issues in economics and public policy, namely the efficiency-equity
trade-off.
In practice, while we would ideally like to achieve
equity efficiently, redistribution is almost invariably somewhat inefficient
because of its disincentive effects (see chapter 13, this volume). If people
know that some of what they work hard to earn will be taxed away and that they
can get a transfer payment even if they do nothing, then they will be inclined
to work less (Mirrlees 1971). Similar inefficiencies pop up in all forms of
taxation (Okun 1975). Taxes on goods distort those markets and encourage an
inefficient allocation of resources to substitute goods. Payroll taxes
discourage firms from hiring labour and they instead invest in capital beyond
the point where it would otherwise be efficient to do so. Ironically, many
largely efficient taxes, that is, taxes without large behavioural effects nad
associated dead-weight losses in economic activity, have undesirable
implications for equity. For example, goods and services taxes applied to all
markets uniformly are efficient because they maintain relative prices, but they
are also regressive because they impact the budgets of the poor proportionally
more than the budgets of the rich.
There are, however, some redistributive policies where
trade-offs between equity and efficiency are minimised. A prominent example is
in the provision of social mobility programs, notably public health and public
education, which help people improve their human capital and thereby get a good
job, and public transport, which helps people to get to their jobs. The
positive impact of these programs on productivity means that they pay themselves
off, at least to some extent. Programs that effect this kind of ‘equality of
opportunity’ tend to receive support from both the left and right wing, unlike
policies that are oriented more strictly at proportional or relative equity.
Another case where equity policies don’t necessarily result in inefficiency is
when they involve addressing market failure. This is arguably true of all
equality of opportunity policies. For example, public health overcomes the
adverse selection problems that plague private health insurance markets by
requiring everyone to sign up to a single insurance provider, while public
education and transport both correct for positive externalities like better
informed voters and less congested roads.
More broadly, by assiduously combined a variety of
policy tools, sophisticated policy design can minimise the need for trade-offs
across equity and efficiency. This idea, which we call ‘hybrid’ policy, is the
central theme of this volume. There are often opportunities in contemporary
public policy to make substantial improvements to both the efficiency and
equity of the status quo with better policy design or technology. Better design
or technology can also allow policymakers to identify and realise ‘bargains’,
where large gains in efficiency can be had at relatively low cost in terms of
equity and vice versa. It is only after the low-hanging fruit are picked and
the good deals exhausted that we need to start making strong normative
judgements about the relative value of efficiency and equity, which is most
appropriately left to voters. Unfortunately, it is these normative debates that
dominate politics and electioneering, often at the expense of the tremendous
gains that could be made if this passion were focused on hybrid policies and
ensuring bipartisan outcomes instead. Modern public policy combines the
strengths of state, market and community tools to offset their individual
weaknesses, thereby overcoming the old (false) dichotomy of markets for
efficiency and governments for equity to achieve both outcomes simultaneously.
A range of examples are explored through case studies in section three of this
volume.
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[1] Whether the losers of economic
change in the late 20th century were in fact compensated is important for understanding many
contemporary sociological trends, notably the backlash to globalisation.
Crudely speaking, nations that undertook structural adjustment through the 80s
and 90s towards more open markets and exposure to international competition
under left-leaning governments, including Canada, Australia and the
Scandinavian countries, have seen far less harm to their working and middle class
in the subsequent decades compared to nations that prosecuted structural
adjustment without much care for compensation, like the United States under
Reagan and Britain under Thatcher. Prospering in an (efficient) open-economic
environment requires mobility in the form of education, health and the ability
to relocate (Garnaut 2016). Taxing those who gain from open-economic settings
to fund these services for everyone else so that they too can prosper has been
critical to the sustainability and success of structural adjustment. Where due
heed was not paid to these compensatory dimensions, whole communities have gone
under, feeding the current revival of protectionist and nativist sentiment.
However, where structural adjustment towards more efficient systems was not
undertaken at all, as arguably is the case in France and Japan, growth has
stalled and unemployment (often disguised in the form of irregular work) has
crept upwards.
[2] It is also worth noting that in
theory, a benevolent and omniscient planner, to be efficient, would end up
making exactly the same production decisions as the competitive free market
(Barone 2012)
[3]
Merit goods are a curious
case of market failure that is sometimes analysed in terms of externalities.
Merit goods are things society thinks should be distributed on the basis of
need rather than ability or willingness to pay, like a basic education or food
stamps (Musgrave 1959). Another way to think about them is that they have some
ethical value that transcends their economic value. This conception is
particularly stark in the case of some demerit goods, like paedophilia. Free
markets would not factor in these ethical dimensions and thus result in the
inefficient production of these goods. These ethical dimensions can arguably be
thought of as negative and positive externalities.
[4] The thought experiment Rawls uses
as the foundation of his argument for redistribution is the ‘original
position’, in which the individual makes decisions under the ‘veil of
ignorance’. In this situation, individuals understand human nature and social
organisation, but don’t know who they will be in society, including things like
income, caste and even their own moral preferences. Rawls argues that under
these conditions, individuals will opt to design institutions such that they
protect fundamental rights and liberties and ensure that policy always benefits
the least well-off members of society, as there is an equal chance that all
people involved in the veil of ignorance might be that worst-off person.
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