PRINCIPLE 7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES

If the invisible hand of the market is so great, why do we need government? One purpose of studying economics is to refine your view about the proper role and scope of government policy.

One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. Most important, markets work only if property rights are enforced. A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before they leave; and a music company won’t produce CDs if too many potential customers avoid paying by making illegal copies. We all rely on government-provided police and courts to enforce our rights over the things we produceand the invisible hand counts on our ability to enforce our rights.

Yet there is another, more profound reason we need government: The invisible hand is powerful, but it is not omnipotent. Although markets are often a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy and change the allocation of resources that people would choose on their own to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to
change how the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate resources efficiently, this is not always the case. Economists use the term market failure to refer to a situation in which the market on its own fails to produce an efficient allocation of resources. One possible cause of market failure is an externality, which is the impact of one person’s actions on the well-being of a bystander. The classic example of an externality is pollution. Another possible cause of market failure is market power, which refers to the ability of a single person (or small group) to unduly influence market prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. In the presence of externalities or market power, well-designed public policy can enhance economic efficiency.

The invisible hand may also fail to ensure that economic prosperity is distributed equitably. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world’s best basketball player earns more than the world’s best chess player simply because people are willing to pay more to watch basketball than chess. The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate healthcare. Many public policies, such as the income tax and the welfare system, aim to achieve a more equitable distribution of economic well-being.

To say that the government can improve on market outcomes at times does not mean that it always will. Public policy is made not by angels but by a political process that is far from perfect. Sometimes policies are designed simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. As you study economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or equity and when it is not.