chap2 - Principles for analyzing government.pdf

CHAPTER 2 Principles for Analyzing Government

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CHAPTER 2

Principles for Analyzing GovernmentOne of the most important lessons that economics has to offer is that the unfettered market system does an exceptionally good job of allocating economic resources. This lesson is hardly new. More than two hundred years ago, Adam Smith noted that in a market economy, individuals pursuing their own self-interests are led as if by an invisible hand to pursue the best interests of the society. The market system is based on the principle of voluntary exchange, which means that two people will not make an exchange unless they both view the trade as beneficial. It follows that the society in which such mutually beneficial trade takes place also must be made better off by the trade because the trade benefits some people (the traders) but does not harm anyone else. In essence, a market economy provides all citizens with the incentive to produce the most valuable output possible so that they can trade it for the most valuable possible output of others. This chapter begins by discussing the efficiency of a competitive market economy, noting that under ideal circumstances the market allocates resources in the most efficient possible manner. One might then wonder why we should even have a government. First, government protects the rights of individuals, which enables them to engage in voluntary market transactions. Second, the government can be viewed as an institution that acts in the public interest. Because the concept of public interest is difficult to define precisely, several definitions of the public interest are considered in this chapter. Ultimately, one's definition of the public interest becomes a value judgment. The distinction between fact and value judgment also will be discussed in this chapter. THE MARKET ECONOMY We tend to take the productivity of the market economy for granted. But imagine that instead of trading for the goods you consume, you had to make them yourself. You would have to grow your own food, make your own clothes (including making the cloth), build your own living quarters, make your own automobile (including manufacturing the steel, glass, and plastic; refining the oil to make gasoline, and so on), build your own stereo, make your own watch ... well, you get the idea. Because of the cooperation involved in the market economy, we all consume far more than we could produce individually. By specializing in one economic activity, our productivity is enhanced, which is reflected in the increased value of the goods we exchange. In short, specialization and gains from trade are the key elements in the productivity of the market economy. In a market economy, people exchange the output they produce for output of equal value produced by others. The value of one persons output is determined by how much others are willing to pay for it, so the market assesses the value of everybody's contribution and rewards them accordingly. The more highly valued an individual's output, the greater the income the individual will receive for it. The market economy depends on two characteristics to make it so productive. First, the process of voluntary exchange encourages specialization and gains from trade. Second, the right of people to receive the value of their output as determined by the


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market provides the incentive to produce output that others consider valuable. The amazing economic progress of the past two centuries is a tribute to how well the market system works in allocating resources. Economies that have relied primarily on market production have thrived, leaving economies that have tried other economic systems far behind. Economic Efficiency and the Competitive Market The efficiency of a competitive market can be illustrated graphically with the supply and demand diagram in figure 2.1. The demand curve D represents the value of the output produced in the market, according to the consumers of the output, because it shows how much consumers are willing to pay for the output. The supply curve S represents the opportunity cost of producing the output because it shows how much producers must be paid in order for them to agree to produce the output. As long as the value of additional units of output, measured on the demand curve, exceeds the opportunity cost of output, measured on the supply curve, then additional output will be more valuable than the cost of producing it. In other words, when the demand curve lies above the supply curve, more output should be produced because more value can be obtained, but when the supply curve lies above the demand curve, the cost of producing additional output exceeds its value, so the output should not be produced.

Thus, in figure 2.1 the level of output that will maximize the value of output to the economy is Q*. If less than Q* is produced, the value of output to demanders is greater than the opportunity cost to suppliers. This is shown in the figure because the demand curve lies above the supply curve, and where the demand curve is above the supply curve, the value of the output to those who consume it is greater than the opportunity cost imposed on those who produce it. Therefore, a mutually beneficial exchange can be made between suppliers and demanders.


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Conversely, when the supply curve lies above the demand curve, to the right of Q*, suppliers require more compensation to produce additional units than demanders are willing to pay. Because the cost home by suppliers to produce the units would exceed the value of those units to demanders, it is inefficient to produce output beyond Q*. Reflect on this a little further. The value of output to the purchaser is the amount that the purchaser is willing to pay for the output. This can be read directly from the demand curve. The value of the output to the seller is the amount the seller would be willing to sell for, which can be read directly from the supply curve. It follows that if the demand curve lies above the supply curve, the value of output to the potential purchasers is greater than the value of the output to the potential sellers, and an exchange at the market price P* would make both suppliers and demanders better off, thus increasing the well-being of the society. Production and exchange is beneficial as long as the demand curve lies above the supply curve but is detrimental when the supply curve lies above the demand curve. This should be familiar to anyone who has studied economics. The level of output that maximizes the value of an economys output is found at the intersection of the supply and demand curves and will be the level produced by a competitive market. Thus, as Adam Smith noted in his Wealth of Nations more than two centuries ago, in a competitive market economy, each individual pursuing his own self-interest is led as if by an invisible hand to pursue the best interests of the entire society. If markets always worked as well in practice as they could in theory, there would be little reason to have a public sector of the economy. Forces can interfere with the operation of the market, however, that might prevent trades from taking place so that less than Q* is produced, or inefficient trades might result in output greater than Q* being produced. The problems that give rise to government activity will be discussed at length throughout the book. But before analyzing the role of government, it is important to understand how the invisible hand of the market leads individuals in the economy to be as productive as possible. Often, government is used to improve the operation and efficiency of markets when markets fail to allocate resources efficiently. THE ROLE OF GOVERNMENT The voluntary exchanges that occur in the market economy comprise the private sector of the economy. The public sector of the economy consists of government activity and has a different economic character. Typically, government activity is financed by mandatory taxes. After citizens pay their taxes, they can choose to consume some public sector output, such as highways and parks, often without additional charges. Citizens receive some output, such as national defense, whether they like it or not. Furthermore, they are obligated to live under the governments rules or face the penalties imposed by the police and court systems. The principle underlying the private sector of the economy is voluntary exchange. People engage in market transactions because they want to, and the basis of all transactions is voluntary agreement between buyer and seller. In the public sector of the economy, the government forces people to obey its rules and pay for its output. People may be very supportive of their government and agree with what the government is doing, but no matter how much they are in agreement, ultimately the government forces those who are not in agreement. Coercion and force underlie government activity, whereas voluntary agreement underlies market activity.1 If the market economy works so well, as the previous section has argued, why is any government necessary?


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Although some people would argue that we would be better off with no government at all, most people think that there is a role for government and that many government activities make them and their fellow citizens better off. This provides a good starting place for analysis because people want the government to undertake activities that are in the public interest. Because presumably we all benefit from public parks, police protection, and national defense, we all share in paying for these services through our tax dollars. But this raises a whole new set of questions. How do we know that we all benefit from the governments programs? Should someone who never uses a park be forced to pay for it? If these things really benefit us, why do we have to be forced to pay for them? These are the types of questions that will be addressed throughout the text as we analyze the activities of government within the context of the economic system within which the government exists. The governments activities can be analyzed within the framework of two general categories. The first category concerns the scope of governmental activities-what types of activities the government does undertake, and why it chooses to undertake those activities. A related issue concerns how much of each activity the government should undertake. Should the government provide a police force? Parks? Highways? Dams? If so, how much of a police force? How many roads? How many dams? Clearly, what the government does do is related to what the government should do, but it is just as clear that the two are not necessarily the same. The second category concerns how the government finances its activities. Briefly, the government can raise revenues through taxation, the issuance of debt, and the creation of new money. In addition, the government sometimes sells its output, as for example when it builds toll roads or charges admission to its parks. The financing of governmental activities through taxes, user charges, and other types of fees makes up a major area in the study of public finance. Thus, the subject matter of public finance falls into the two general categories of revenue generation and government spending. A few paragraphs earlier, the activities of government were justified by saying that the government can act in the public interest. Considering the efficiency of a market economy, one still might wonder why a government must act in the public interest when the invisible hand of the market guides us so well. There are three possible reasons. First, the market system might not function at all without certain government activities to protect the rights of those engaged in production and exchange. Second, the government might be able to undertake some economic activities better than the market and, for efficiency reasons, should be used in those cases. Third, market allocation might treat some individuals in a manner generally viewed as inequitable, so programs to benefit the least fortunate members of the society might be desired on equity grounds.2

THE MARKET SYSTEM AND INDIVIDUAL RIGHTS The market system is able to allocate resources efficiently because all individuals have the right to exchange the output they produce for output produced by others. This presupposes that individuals have the right to the output they produce and have the right to freedom of exchange. These rights are protected by police, by national defense, and by the court system. Police protection safeguards individuals from having their rights violated by other members of the society. National defense protects individuals from aggression by foreign countries. The court system settles legitimate disputes that arise among individuals.


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Without government protection of individual rights, people would have to find ways to protect their own rights, which would greatly reduce the efficiency of an economy. People would have no incentive to produce any more than they could individually protect if their rights were not safeguarded. Thus, the productivity of a market economy rests on the foundation of a society that protects the rights of individuals. Even though the strongest and most ruthless individuals in a society would have the ability to take what they wanted from others, such a society would not benefit even them because there would not be very much to take. Think of all the things that people own and leave unattended every day: homes, cars, boats, businesses. If property were not protected, no one would have an incentive to produce it, and the society would be very poor as a result. People have no incentive to produce goods that they expect would just be stolen from them. The Government as Protector of Rights The operation of a market economy depends upon the protection of individual rights, which is the primary function of all governments. Without such protection, any economy would of necessity be very poor. In a feudal society, the king guaranteed protection to the peasants in exchange for some of their output, thus providing an incentive for the less powerful to be productive. In centrally planned economies, even though the structure and function of the governmentCand what the government asks from its citizensCis very different from market economies, the government still provides police protection, national defense, and a court system for its citizens. Indeed, any government is the protector of its citizens rights, even though the rights that government protects and the duties it expects in return vary from nation to nation. The simple fact is that an orderly society would not be possible otherwise.3 How much protection a government should provide is open to debate. The simple answer is that the government should provide enough to protect the rights of its citizens, but this is not very instructive because rights can be protected to various degrees. For example, a change in the size of the police force can make the streets more or less safe, and individuals can take steps to protect their own rights. They can stay off the streets at night, they can buy locks for their doors, they can buy burglar alarms, and they can hire private security guards. Further analysis is needed to determine how much they actually should do. The same is true of courts and national defense. Individuals can use private arbitration to supplement the court system. Military force can serve strictly as protection for a nations borders, or it can be used to protect a nation's interests around the world. An orderly society depends on the protection of individual rights, but how much protection is the right amount? One of the questions to be addressed later in the text is how the optimal level of any type of public sector output is determined. The Government as Violator of Rights The government can be the protector of individuals rights, but the government can also violate the rights of individuals. Residents of the United States are fortunate to live under a government that guarantees its citizens an extensive amount of freedom and that devotes substantial resources to protecting their rights. To a large degree this is because the Founding Fathers recognized the potential for government to violate the rights of its citizens, so they designed a government with checks and balances to try to control the power of government. But the history of the world is


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filled with examples of oppressive and tyrannical governments that violated their citizens rights potential to violate as much as they protected them. Even in the United States, governments sometimes individual rights overstep their bounds and violate the rights of the citizens they are supposed to protect. Because a government powerful enough to protect the rights of its citizens from aggression by others also has the power to abuse the rights of its citizens, careful attention must be devoted toward designing public sector institutions so that they act in the public interest rather than for the interests of those who have political power. Without government there is the potential for anarchy and predation of the weak by the strong, but with too much government, unconstrained in its activities, there is the potential for predation through government. In governments that further the public interest, the predatory impulses of those in the private sector are tempered by government, but a strong market sector of the economy also helps to temper the power of government and push it away from predation and toward serving the public interest.4 Chapters 7, 8, and 9 use economic analysis to discuss the organization of political institutions.

THE PUBLIC INTEREST In theory, the minimal government acts only to protect the rights of its citizens and does nothing more. In reality, however, all governments do more than this. Furthermore, a government is not an entity in itself, independent of the people who run it and the people who are governed by it. Rather, the government's activities result from the choices made by those who run government. In a democratic government, every voter has at least some input into the governing process, so it becomes especially relevant to ask what activities people in a democratic nation would like the government to undertake. Earlier, the simple answer was that government should act in the public interest. Now it is time to try to identify the public interest, which is an issue that has been debated by philosophers for centuries. The Greatest Good for the Greatest Number More than two centuries ago, Jeremy Bentham suggested that the public interest would be served by policies that produced the greatest good for the greatest number. Although this idea is intuitively appealing, in practical terms it is difficult to apply. Using Benthams criterion, a policy that benefited everybody would obviously be desirable, but what about a policy that benefited some people while imposing costs on others? Presumably, a policy with large benefits for most people that imposed small costs on a few would conform to Benthams formula, but some gray areas begin to appear. For example, some method must be derived to weigh the benefits to some against the costs imposed on others. Otherwise, it would be impossible to tell whether a policy that benefited some but harmed others actually did produce the greatest good for the greatest number. Benthams method of considering the public interest is sometimes referred to as utilitarianism because it attempts to take account of the relative satisfaction, or utility, of everyone in a society. If a policy were to cause some people to be worse off-to lose utility-this loss could be offset by a greater gain in the utility of others. Although Benthams concept of the greatest good for the greatest number is a bit imprecise, social scientists have subsequently narrowed the meaning of the concept.


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Utilitarianism In the latter half of the nineteenth century, some utilitariansCJohn Stuart Mill for oneCconsidered the amount of satisfaction, or utility, an individual received from consuming goods or services to be a measurable quantity, at least in theory. One way to measure the public interest, following this line of reasoning, is to add up the total utility of all the individuals in a society. Any policy that increased total utility would then be in the public interest because the utility gained by the gainers would be more than sufficient to offset the utility loss to the losers. Some of the earliest applications of the utilitarian framework applied to the distribution of income. A rich person, it was reasoned, would lose less utility from a dollar reduction in income than a poor person would gain from a dollar increase in income. Therefore, the public interest would be served by taxing income away from the rich and redistributing it to the poor. The use of utilitarianism to decide what policies are in the public interest has several drawbacks. First, there is no valid way to compare the utility of one person with the utility of another. For example, if a dollar were taken away from one person and given to another, how would the utility lost by the first person be compared with the utility gained by the second? Reflect on this for a moment. If a dollar were taken away from you and given to your neighbor, is there any way to tell whether your neighbor's gain is greater than your loss? If a bridge is built with tax dollars, is there any way to tell whether the gain to the users of the bridge is greater than the loss to the taxpayers? Economists simply do not see any way to make interpersonal utility comparisons of this type. Second, taken to its logical consequences, utilitarianism implies social arrangements that most people would find objectionable. Using utilitarianism as the criterion for judging the public interest, one person could be forced to do something for another person as long as the decline in the first person's utility was less than the utility gain for the second person. For example, if one person would gain more utility from having a slave than another person would lose from being a slave, then a strict interpretation of utilitarianism would have to recommend slavery as being in the public interest. Indeed, one must be careful about the logical implications of using utilitarianism as a measure of the public interest. Although there is a big difference between slavery and taxation, a similar type of utilitarian argument is often employed to justify taxing the incomes of some to redistribute income to others.5 In essence, the government forces some people to give their earnings to others whether they want to or not. Do welfare programs paid for by tax dollars actually serve the public interest? Within the utilitarian framework, this question would be answered by weighing the utility loss to taxpayers against the utility gained by welfare recipients. There are other ways that redistribution programs might be justified, as chapter 18 discusses. If one justifies redistribution using the argument that the gain to the gainers outweighs the loss to the losers, however, then an extension of this utilitarian reasoning might lead to substantially more invasive social policies. Contemporary utilitarians argue that in the real world the only practical way to make policy recommendations is to weigh, in an impartial manner, the benefits to some against the costs imposed on others. No conceivable real world policy can benefit everyone. Someone will always be made worse off. One can cloak one's value judgments in scientific-sounding jargon, but ultimately every policy recommendation must weigh the benefits of some against the losses home by others. There are alternatives to utilitarianism, however, that should be considered.


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THE PARETO CRITERIA Economist and sociologist Vilfredo Pareto (1848-1923) developed two criteria, now known as Pareto optimality and Pareto superiority, for judging the public interest. Pareto reasoned that because it is not possible to compare the utilities of two individuals, the only way one can be sure that a change will increase the social welfare is if at least one person better least one person is made better off by the change, but no one is made worse off. Such a change would be called a Pareto superior move, or a Pareto improvement. Conversely a proposed change that makes some people better off but others worse off cannot ever be said with certainty to be in the public interest because there is no way to compare the welfare loss of those harmed with the welfare gain of those who benefit. Whereas Pareto superiority is used to compare two possible situations, Pareto optimality is applied to a single situation. According to Pareto, a situation is optimal if no one can be made better off without making someone else worse off. It follows logically that if a situation is not Pareto optimal, at least one persons welfare could be improved without harming anyone else. In other words, if a situation is not Pareto optimal, it would be possible to make a Pareto superior move. If a situation is Pareto optimal, no Pareto superior moves are possible. Note that Pareto optimality refers to a state of the worldC-a situation either is or is not Pareto optimalCwhereas Pareto superiority compares two states of the world. These concepts can be further clarified by referring to the Edgeworth box in figure 2.2, in which indifference curves for apple and orange consumption for Steve and Janice are depicted. Steves origin is in the lower left comer of the box, and Janices origin is in the upper right. The line from Steves origin to Janices is the contract curveCthe locus of points where Stevens indifference curves are tangent to Janices. Steves indifference curves (one is marked US) are bowed away from his origin, as indifference curves normally would be depicted. Because Janices origin is in the upper right, her indifference curves (one is marked UJ) are also bowed away from her origin and are bowed in the opposite direction from Steves. The total amount of each good is given by the length of the goods axis, and Janices apples are measured at the top. Whatever apples Steve does not consume, Janice consumes. Thus, if Steve has AS apples, measured from Steves origin, then Janice will have the rest of the applesCAJ applesCmeasured from Janices origin. The same is true for oranges, so if Steve has OS oranges, Janice will have OJ, and they will be at point A in the diagram. If this construction is unfamiliar, a review of the appendix to chapter I can help clarify the concepts shown in an Edgeworth box diagram. Starting from point A, Janice is on indifference curve UJ and Steve is on indifference curve US. Both will be better off it they can move to higher indifference curves, which are indifference curves that are farther away from their own origins. For example, by moving from point A to point B, both Steve and Janice will be made better off because both have moved to a higher indifference curve. That represents a Pareto superior move, because at least one person has been made better off (actually, both have), and no one has been made worse off. Thus, point B is Pareto superior to point A, and using Paretos criterion, social welfare has been improved. Note that it would not make sense to say that point B is Pareto superior without reference to some other situation. The concept of Pareto superiority compares two situations, so the point must be compared with some alternative. Point B is Pareto optimal. Steves and Janices indifference curves are tangent at that point, so it would not be possible for one of them to move to a higher indifference curve without the other moving to a lower indifference curve. Point A is not Pareto optimal because it would


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be possible to make at least one person better off without making anyone else worse off, as in the move from A to B. Points C and E, and every other point on the contract curve, are also Pareto optimal points because from those points it would not be possible to make one person better off without making the other person worse off. The concept of Pareto optimality is the same as the concept of economic efficiency. If a situation is not Pareto optimal, the existing resources are not being used efficiently to produce the highest level of satisfaction for the people in the economy. For example, at point A, Steve could trade some of his apples for some of Janices oranges, and both would consider themselves better off. In other words, at point A, the existing resources (apples and oranges) could be used more efficiently to produce a greater level of satisfaction for both Steve and Janice. Would a move from point A to point C be in the public interest? Using the Pareto criteria, there is no way to say. The move is from a point that is not Pareto optimal to one that is, meaning that it is a move from an inefficient allocation of resources to an efficient allocation. But the move makes Steve better off and Janice worse off, and because there is no way to compare the utility lost by Janice with the utility gained by Steve, the Pareto criteria do not offer any way to compare points A and C. We cannot say that the change is in the public interest because there is no way to know whether the benefit to Steve is greater than the cost to Janice. This illustrates one of the drawbacks to relying on the Pareto criteria as indicators of the public interest. Pareto superiority can compare some points with some other points, but it cannot compare all points with all other points. For proposed changes that make some people better off at the expense of others, the Pareto criteria offer no assistance in determining whether those changes are in the public interest.


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A move from A to B would be Pareto superior and in the public interest. A move from B to A would be Pareto inferior and not in the public interest. A move from A to D also would be Pareto superior, even though D is not Pareto optimal. At point D, both Steve and Janice are better off than at A, but there is still the possibility of further Pareto superior moves. Point D is Pareto superior to point A, but it is Pareto inferior to point B. Beginning at point A, a move to any point in the lens-shaped area formed by Steves and Janices indifference curves would be a Pareto superior move because at least one of them would be better off without the other being worse off. Market Exchange and the Pareto Criteria Unless people not involved in the exchange are harmed, every market exchange is a Pareto superior move. People will not agree to an exchange if it is not to their benefit. Market exchange not only satisfies the utilitarian criterion of being in the public interest because no one suffers a loss and some people gain, but it also satisfies the more exclusive test of Pareto superiority. The Pareto criteria become especially relevant in evaluating governmental activities that could also be undertaken in the private sector. For example, when comparing public and private schools, the choice of going to a private school is a voluntary transaction, so it is a Pareto superior move, but the same cannot be said of public schools because some people (most notably taxpayers) may not be in voluntary agreement with the transactions that produce public education. One thing that economists like about the markets allocation of resources is that unless there are negative externalities (discussed in chapter 4), market exchanges are Pareto superior moves that unambiguously increase the social welfare. With government allocation of resources, there is rarely unanimous agreement, and some people gain while others lose, making it hard to say for sure that the social welfare has been enhanced. Political Exchange and the Pareto Criteria Many activities of government produce benefits to some but impose costs on others. The rationale often is that on net, the benefits exceed the costs, so the activity is an efficient reallocation of resources. Figure 2.2 illustrates that if resources are being used inefficientlyCthat is, if the economy is not on the contract curveCthen it is possible to move to an efficient allocation of resources by making a Pareto superior move. In a move from an inefficient allocation of resources to an efficient allocation, the gains can be distributed in such a way that no one is made worse off. Starting from point A, for example, resources are used inefficiently. They can be used efficiently if the government were to propose to redistribute resources to end up at point C. Although this does allocate resources efficiently, it does so by making Janice worse off. But from any inefficient allocation such as point A, there is an efficient allocation that also makes everyone better off, as would the move from A to B. An analysis of the Pareto principles shows that it is never necessary to make someone worse off in a change that allocates resources efficiently. It may be difficult in the real world to figure out a way to distribute the gains from government action so that there are no net losers, but as figure 2.2 illustrates, it is always possible to do so. Another advantage of seeking out a solution in which everyone gains is that political opposition to a change is neutralized. Government action takes place through the political


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process, which requires some form of agreement. In a move from A to C in the figure, Janice will object and may have enough political power to stop the reallocation. But in a move from A to B, everyone will be in agreement. The Pareto criteria also show that agreement can be used as a benchmark for efficiency. If everyone agrees to a change, then the change will be a Pareto superior move, which is a move toward efficiency. If some people are opposed to a change, then the change may not be an efficient reallocation of resources. Note that Janice would favor a move from C to A, even though it is a move from an efficient allocation of resources to an inefficient one. Limitations of the Pareto Criteria The Pareto criteria can be useful indicators of the public interest, but they have some drawbacks as well. For one thing, a Pareto improvement in social welfare requires that the proposed change benefit some people but not harm anyone. Unfortunately, in a complex society composed of millions of people, any proposed policy is almost sure to make someone worse off. Few changes could fulfill to the letter the conditions that must be met for the change to be a Pareto improvement. In practical terms it may not be possible to take any action in the public sector if the strict conditions of the Pareto criteria are adhered to. One might argue that the Pareto concepts are not meant to be applied literally, but if this is the case, the problem remains one of comparing the gains to the gainers against the losses to the losers. To have meaning, it would seem that the Pareto criteria have to be taken literally.6 A second problem with the Pareto criteria is that they lend legitimacy to the status quo. Because any change must improve the welfare of at least one person but not harm anyone to be a Pareto superior move, the status quo enjoys a position that may not be justified if that position was attained through illegitimate or unfair means. Where there are no complaints about the status quo, this is not a problem. However, where the status quo is viewed as unfair, people might argue that the social welfare would be improved by changes that would make some people worse off. Consider, for example, slavery in the pre-Civil War American South and the now defunct system of apartheid that existed in South Africa. Although the freeing of the slaves imposed an economic loss on the former slave owners, many people viewed slavery as an objectionable system and felt that the social welfare would be improved if the slaves were freed. That view was not unanimous, obviously, but those who favored the abolishing of slavery were rejecting the pure Pareto criteria as measures of social welfare. A third problem with the Pareto criteria is that they do not rank all possible states of the world. A change that makes everyone better off is a Pareto improvement, but what about a change that makes some people better off and others worse off? The Pareto criteria offer no evaluation of such changes, even though most public policy proposals fall into this category. The fact that the Pareto criteria do not offer advice on many issues limits the usefulness of the criteria. OTHER MEASURES OF THE PUBLIC INTEREST Accepting that most changes will benefit some people and harm others, we can evaluate various methods that might be used to assess whether the proposed policy change is in the public interest. One method evaluates the compensation that gainers from a public policy might pay to


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losers to make the change Pareto superior. Another method uses an explicit social welfare function, which is the modem incarnation of utilitarianism. Potential Compensation According to this method of evaluating the public interest, if a proposed change benefits the gainers by enough that they could take some of their gains and compensate the losers so that everyone could be made better off, then the proposed change is in the public interest.7 Using this criterion, the compensation does not have to be paid, however, so some people will be made better off while others will be left worse off by the change. The idea behind this criterion of potential compensation is that the gains to the gainers are large enough that the proposed change could be a Pareto superior move if some of the gains were redistributed to the losers. The criterion says that a change is in the public interest when the gainers place a higher value on their gains than the losers place on their losses. But whereas no one is harmed by a Pareto improvement, in this case it may be little consolation to someone who is made worse off that the gainers could have provided compensation and still have been left with some net gains. There is some justification for favoring policies that would have been Pareto superior moves if the gainers had compensated the losers, however. Any compensation scheme would be both costly and difficult to administer, but, on the average, individuals are compensated for those instances in which they are made worse off by other policies that make them better off. The government is constantly undertaking new policies, and, under each of the policies, some people gain while others lose. But different people will gain and lose from different policies, so, over the course of a large number of policy decisions, people should enjoy a net gain if the test of potential compensation is used. Referring back to figure 2.2, we can see that many moves like that from point A to point C might be made, and, while in this instance Janice is made worse off and Steve benefits, other policies will benefit Janice but hurt Steve. Trying to rig a compensation scheme that would always be a Pareto superior move would be so cumbersome that many efficiency-generating policy changes would not be made. Both Janice and Steve would be better off over the long run with policy changes that allocated resources more efficiently, even when they sometimes imposed a net cost on one or the other. The argument on the other side is that if one person is made better off while the other is made worse off, there typically will be no way to tell whether the gains to the gainers were sufficient to compensate the losers for their losses. In addition, there is the fairness aspect of such policies. Even if net benefits are produced, is it fair to give benefits to some at the expense of others? Sometimes we believe that it is, as government income transfer programs illustrate. Other times we believe that actual compensation should be paid, as in cases in which private land is taken by the government for some public purpose. The Social Welfare Function A social welfare function can be thought of as a set of indifference curves that depict the welfare of the entire society rather than just one individual. The concept is illustrated in figure 2.3, which extends the analysis that appeared in figure 2.2. The utility possibilities frontier, PP, shows the maximum amount of utility that one individual can have given the level of utility of the other. The curve will be downward sloping, but we do not know any more about its shape


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than that. The utility possibilities frontier corresponds with the contract curve in the Edgeworth box diagram because both show all the Pareto optimal points, where it is not possible to make one person better off without making someone else worse off. Inside the utility possibilities frontier are nonoptimal points where it would be possible to make a Pareto superior move.

Point A in figure 2.3 corresponds with point A in figure 2.2. Both are not Pareto optimal, so it is possible to make a Pareto superior move that would efficiently allocate resources and would make both Steve and Janice better off. In both figures, a move from point A to point B is a Pareto superior move that gives both Steve and Janice more utility. In contrast to the Pareto criteria, the social welfare function does allow the ranking of all possible outcomes. For example, a movement from point A to point C in both figures makes Steve better off and Janice worse off, but it is a move from a non-Pareto optimal point to a Pareto optimal point. Using the Pareto principles alone, it is not possible to say whether social welfare is enhanced by such a move, but using the social welfare function in figure 2.3, points A and C both are on the same social indifference curve, UN, so both represent the same level of social welfare. Of course, if the social welfare function weighted Janices utility more heavily than this one, point C would be a reduction in social welfare when compared with A, and if Steve's utility were weighted more heavily, it would be an increase in social welfare. Critics of the social welfare function charge that it makes interpersonal utility comparisons that in fact cannot be made. In this sense, the social welfare function is really a type of utilitarianism. Supporters of this approach argue that in the real world such comparisons must constantly be made for purposes of public policy and are better made explicitly rather than obscured by devices such as potential compensation. In fact, economists who accept the principle of the social welfare function often use it in a manner similar to the utilitarians of the


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nineteenth century. For example, they frequently apply it to income distribution problems to determine the optimal amount of redistribution through the tax system. By contrast, the Pareto criteria are not well suited to distributional issues because, by their very nature, redistribution benefits those who receive income but harms those who lose it.8 Cost-Benefit Analysis In actual practice, a frequently used method of deter-mining whether public sector projects are in the public interest is cost-benefit analysis. In a cost-benefit analysis, a dollar value is placed on all the costs and all the benefits associated with a particular project. Quite simply, if the benefits are greater than the costs, then the project is deemed to be in the public interest. However, the cost-benefit analysis method of assessing the public interest is not without its problems. The main difficulty arises in trying to place an accurate dollar value on all the benefits and costs of a particular project. For example, consider a cost-benefit analysis of whether the government should build a dam in a particular area. If some people do not want to move from the land on which the lake will form, how should the cost to them be weighed? If boating is possible on the new lake, how should the recreational benefits be translated into dollar figures? And how can a dollar value be placed on the environmental impact, particularly when some aspects of the environment may be improved whereas others will deteriorate? Ultimately, a cost-benefit analysis must rely on one of the previously discussed methods for assessing whether a project is in the public interest. Interpersonal utility comparisons in costbenefit analyses are made by converting utility to dollar values and weighing the dollar value of one persons utility to the dollar value of anothers, making cost-benefit analysis a variant of utilitarianism. Chapter 17 discusses the use of cost-benefit analysis in more detail. POSITIVE AND NORMATIVE ECONOMICS The distinction between positive and normative economics is an important one, especially as it relates to the economics of the public sector. Positive economics examines the real world to discover what it is like and how it works. Within the realm of positive economics, there is no concept of the public interest, nor of what the world ideally should be like. Normative economics makes value judgments as to how the world should be. Normative analysis assesses the desirability of the facts determined through positive economics. Because positive analysis makes no value judgments, conclusions reached through positive analysis will be either right or wrong. Of course, the real world is a complex place, and it may not always be easy to tell whether positive conclusions are correct. But even when disagreements arise over the facts, the facts themselves cannot support both sides of the disagreement. For example, one might argue that the minimum wage law causes unemployment. By holding the wages of some people at a rate higher than the market equilibrium, employers (the demanders of labor) will want to hire fewer low-skilled workers than if the minimum wage law did not exist. Meanwhile, the higher wages produced by the minimum wage law will cause more low-skilled workers (suppliers of labor) to want to work. With more workers looking for jobs, and with fewer jobs available, the result is that the minimum wage law will cause unemployment. This is an example of positive analysis. We have simply analyzed the facts of the world and determined that the minimum wage law causes unemployment. That conclusion is either


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correct or incorrect, in that either this reasoning accounts for the facts of the real world or it does not. The argument might continue that because unemployment is not a desirable result, the minimum wage law itself is undesirable. Now the argument has shifted from positive analysis to normative analysis, from simply describing the facts of the real world the minimum wage law causes unemployment-to making value judgments that the consequences of the minimum wage law are undesirable. A counter argument to this normative conclusion can be made. Even if the minimum wage law does cause unemployment, the benefits generated for those who receive higher wages offset any unemployment that might be generated. If a person cannot earn the minimum wage, then the most humane alternative is for society to care for the person through some type of welfare program rather than to allow a large group of people to try to get by earning substandard wages. It is impossible to say which of these normative arguments is correct. The first argument places a high value on reducing unemployment and allowing everyone to work, whereas the second places a high value on making sure that everyone receives a sufficient income so that they are not exploited through the economic system. Because there is no scientific evidence that one persons values are any better than any other's, there is no way to conclude that one persons normative argument is any more correct than anyone elses. Compare that with a situation in which two people disagree not about whether the minimum wage is desirable but about whether the minimum wage actually causes unemployment. The difference is no longer one of normative conclusions. Because the two people disagree about the facts, the disagreement is positive. This positive disagreement might lead people to different normative conclusions, but when they disagree about the facts, at best one of them can be right. On the other hand, if they disagree because they make different value judgments, there is no way to say that one person is any more right than another. The distinction between positive and normative applies any time a value judgment is made, in economics or anywhere else. For example, one person might assert that Franklin Roosevelt was a great president, and another might disagree. They could concur about the facts of his presidency and the consequences of his policies, but while a political liberal is likely to interpret those consequences favorably, a conservative is not. And there is no scientific way to resolve a normative disagreement such as this one. As another example, one person might look out the window, see that it is raining, and say that the weather is bad. Another person, who wants rain for her garden, would argue that the weather is good. Their positive analysis is in agreement. Both accept the fact that it is raining. Yet their value judgments are different, and one arrives at the normative conclusion that the weather is good while the other concludes that the weather is bad. In economics and elsewhere, there is no way to determine whether one persons values are more correct than anothers. Thus, there may be no resolution to normative disagreements. Normative Analysis and the Public Interest The distinction between positive and normative analysis is crucial to the study of public finance because the public sector institutions we study are our own creation and can be designed as we see fit. In a course in macroeconomic theory, for example, one is interested mainly in how the economy works in the real world and not in attaching any value judgments to it (although once


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the facts are understood, it would certainly be possible to make value judgments). When studying public finance, the normative elements necessarily enter into the picture because the governments activities are the result of choices made by individuals in a society. In a democracy the choices extend to every voter, each of whom has some input into the decisionmaking process. One can use positive analysis to evaluate the potential effects of a particular government policy, but because policies can be chosen through the political process, it is a short step indeed from analyzing the effects of governmental actions to evaluating their desirability. Furthermore, whether those actions are viewed as desirable or not will have an impact on how likely they are to be implemented. Although normative questions have no easy answers, some possible criteria for shaping those answers, or at least for framing the questions, were discussed earlier in the chapter. Benthams dictum of the greatest good for the greatest number has intuitive appeal, even though it is not always clear when this criterion is met. The Pareto criteria are especially appealing because they find a change to be desirable only when no one is hurt by it. Recall, however, that many changes benefit some people but at a cost to others. The Pareto criteria offer little help in resolving such cases. Determining what is in the public interest is a normative problem for which there is no single, easy answer. All the methods discussed-the Pareto and utilitarian criteria, the concept of the social welfare function, and the possibilities of cost-benefit analysisaddress the issues to various degrees, but which offers the most guidance? When looking at possible criteria for evaluating the public interest, the Pareto criteria stand out from the others because they do not require interpersonal utility comparisons. Something furthers the public interest, according to Pareto, only when someone benefits but no one is harmed. Thus, there is no need to weigh the benefits of some people against the costs imposed on others. Because there is no good way to make interpersonal utility comparisons, we can state with more confidence that the public interest is being served when a change is Pareto superior. Furthermore, Pareto optimality means the same thing as economic efficiency: both mean that resources are used efficiently because there is no reallocation that could make someone better off without harming someone else. But again, because most changes will help some people but harm others, the Pareto criteria will be limited in their practical applications. Their real value is in allowing the public interest to be judged without making interpersonal utility comparisons. EQUITY AND EFFICIENCY: THE GOALS OF PUBLIC POLICY Ultimately, public policy strives to reallocate resources in ways that are both equitable and efficient. To state that these are the goals of public policy is a normative conclusion, but a nonnative conclusion that is widely accepted. Most people want resources to be allocated efficiently, and most people place a high value on fairness. Whether policies further the goal of efficiency is something that falls within the realm of positive analysis. A policy either furthers efficiency and moves closer to a Pareto optimal allocation or it does not. Actually determining whether a change is efficient may be a difficult undertaking, and different analyses might arrive at different conclusions, but there is only one right answer no matter how hard the answer might be to find. Whether a change allocates resources more efficiently is a positive issue. The goal of equity is fundamentally a normative issue. What is each persons fair share of the tax burden? If a new program is established, who should pay for it? Should more income be


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redistributed to the neediest segment of the population? What criteria should determine who is eligible for government redistribution? One would certainly want to consider the positive elements of each of these questions. What are the actual effects? But given these facts, what is fair amounts to a value judgment, and there are no absolutely right answers in the same way that there are right answers to positive issues. This does not mean that equity issues are less important than efficiency issues for purposes of determining optimal public policy. Quite the contrary, many people would argue that fairness is the most important criterion for any public policy. How can equity issues be resolved when ultimately they come down to the making of a value judgment? The first step is to make sure that the positive issues leading up to equity questions are clearly understood. Many apparently normative disagreements are the result of people not being in agreement on the underlying facts. Second, although normative issues ultimately do amount to value judgments, there are many shared values that people have, which help societies to arrive at policies that generally are accepted as fair. It is reasonable to undertake an analysis of normative principles to develop a set of normative criteria for evaluating the equitability of public policy options. For example, chapter 11 explicitly analyzes normative principles of taxation. In a democracy, every voter has some say in the types of public policies that are developed. Both equity and efficiency are important determinants of the acceptability of public policy, and some general principles of both equity and efficiency can be developed. If people agree on criteria for evaluating equity, it then becomes a positive issue to see whether the agreedupon criteria in fact have been met. The next part of the book concentrates mainly on efficiency issues, but equity comes more into play in part 3, where the democratic decision-making process is analyzed, and in part 4, which analyzes taxation. In evaluating the Pareto principles earlier in the chapter, we saw that in any movement toward efficiency, the gains to the gainers always exceed the losses to the losers, so compensation could be paid to make every change a Pareto improvement. Sometimes compensation might not be paid because of practical difficulties, but other times compensation might be deemed inequitable. If some people have an unfair advantage, then perhaps they should bear more of the cost in a move toward efficiency, An inheritance tax might be viewed in this way, for example, because it creates a more level playing field for all members of a society in addition to raising revenues to finance government programs. CONCLUSION The market system of economic organization has been responsible for a tremendous amount of economic progress over the past several centuries. In general, the market allocates resources quite effectively, but there are times when a market economy benefits from government activity. The primary function of government is to protect the individual rights of its citizens. No economy can expect to operate at any more than a subsistence level without the order provided by the protection of these rights. Furthermore, as a society we expect the government to carry on other activities that are in the public interest. However, defining the public interest ultimately depends on normative analysis, which does not produce conclusions that can be scientifically proved. Nevertheless, the government does make choices to try to further the public interest, and because all voters in a democratic country are a part of the public choice process, we should at least have some idea of what might generally be considered the public interest. For example, a change that would


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benefit at least one person and harm no one, according the criterion of Pareto superiority, would be in the public interest. If the market functioned perfectly, we could leave all economic activity to the market. We would require minimal government providing only police protection, national defense, and a court system. In reality, the market does not always work perfectly, in which case governmental activity to improve on the shortcomings of the market might be desirable. However, it is not enough to merely show a problem with the market. One must also show that the government could do better than the market. This requires a two-step process. First, problems with the market have to be identified. Second, the effects of possible government intervention must be evaluated. Only then can the market's shortcomings be compared with governmental policies designed to deal with those shortcomings. This process of evaluation points the direction for the next two parts of the book. Part 2 discusses problems that might arise in the market allocation of resources to identify areas where government intervention has the potential to be profitably employed. Part 3 examines the democratic decision-making process and the nature of the public sector supply process to see how governmental intervention might deal with the market's problem areas. These two parts enable us to analyze how government activity can be used to allocate resources within the context of a market economy. QUESTIONS FOR REVIEW AND DISCUSSION 1. Using a graph, explain why in a competitive market economy each individual, in pursuing his own self-interest, is led as if by an invisible hand to pursue the best interest of the entire society. Is your explanation positive or normative? 2. Why does the operation of a market system presuppose that individual rights are protected? What would an economy in which individual rights are not protected be like? What institutions of government protect individual rights, and how do these institutions work? 3. What is utilitarianism? What are the advantages and disadvantages of using utilitarianism to determine the public interest? Is some form of utilitarianism currently used to measure the public interest? Explain. Should some form of utilitarianism be used? 4. Explain the concepts of Pareto optimality and Pareto superiority. How do the concepts differ? Would the Pareto criteria or utilitarianism provide a more effective measure of the public interest? 5. Relate the notion of potential compensation to the concept of Pareto superiority. If the beneficiaries of a change could potentially compensate the losers, is the change in the public interest? Are there some conditions under which potential compensation would suffice as a measure of the public interest and others under which actual compensation should be demanded? 6. What is a cost-benefit analysis? What problems might arise in trying to carry out such an analysis? Is a cost-benefit analysis more similar to utilitarianism or the Pareto criteria? Given the necessity of determining what is in the public interest, is a cost-benefit analysis a


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reasonable method of making that determination? What additional criteria could be used to supplement a cost-benefit analysis? 7. What is the distinction between positive and normative economics? Why is this distinction especially relevant to the study of public finance? 8. Is there a trade-off between equity and efficiency in public policy or can the two goals be reached simultaneously? Explain how policies might be designed that are both equitable and efficient. NOTES FOR CHAPTER 2 1. This idea is explored in Leland B. Yeager, Rights, Contract, and Utility in Policy Espousal, Cato Journal 5, no. I (Summer 1985): 259B294. 2. Murray Rothbard, For a New Liberty (New York: Macmillan, 1973), argues that markets will be more efficient than government in producing all goods, from laws to roads to national defense. Rothbards book provides a very readable defense of the virtues of eliminating all government. 3. These issues are discussed from an economic and philosophical standpoint by John Rawls, A Theory of Justice (Cambridge, Mass.: Belknap, 1971); Robert Nozick, Anarchy, State, and Utopia (New York: Basic Boosk, 1974); and James M. Buchanan, The Limits of Liberty: Between Anarchy and Leviathan (Chicago: University of Chicago Press, 1975). An interesting commentary on these three works can be found in Scott Gordon, The New Contractarians, Journal of Political Economy 84, no. 3 (June 1976): 573B590. 4. See Dan Usher, The Welfare Economics of Markets, Voting, and Predation (Ann Arbor: University of Michigan Press, 1992), for an excellent discussion on the balancing of market and government power. 5. This argument is made as a critique of the optimal tax literature by Martin Ricketts, Tax Theory and Tax Policy, in The Political Economy of Taxation, ed. Alan T. Peacock and Francesco Forte (New York: St. Martins Press, 1981.) 6. However, Knut Wicksell, A New Theory of Just Taxation, reprinted in Classics in the Theory of Public Finance, ed. Richard A. Musgrave and Alan T. Peacock (New York: St. Martins Press, 1967), 72B118, argues for approximate unanimity as a criterion for approving public sector decisions, which might be thought of as approximating a Pareto superior move. 7. This is sometimes called the Hicks-Kaldor criterion, after two economists who advocated it as a measure of the public interest. 8. However, Harold M. Hochman and James D. Rogers, Pareto Optimal Redistribution, American Economic Review 59 (September 1969): 542B557, argue that redistributional programs may satisfy the Pareto criteria if the redistribution is a type of public good.

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