Effectiveness of Government Interventions when Human Beings are not Rational
The financial crisis of 2008 made it difficult for businesses to rely on the market forces and deregulation. This tendency emerged in the early 1980s when Margaret Thatcher and Ronald Reagan proclaimed their conviction that markets were more significant determinants of freedom and prosperity than the government. In the1990s, Tony Blair and Bill Clinton put forward the idea of the market-friendly liberalism where they viewed markets as the main means of gaining the public good. However, in the contemporary economy, the proposition is questionable. The financial crisis was one of the indicators that markets have less ability to achieve efficiency in risk allocation. It also revealed that markets cannot achieve the desired level of ethics and morals, and there is a need to connect the market with government interventions.
Competitive markets can result in socially inefficient allocations. One of the reasons for inefficient allocation is that the agents tasked with production and distribution of goods and services in the competitive markets pursue their self-interests. Therefore, when companies have the power to fix prices and discourage competition, they create barriers to entry. They fail to consider the information that is necessary for making proper product choices. The market allocations may lead to inequalities in income and wealth distribution. Market exchanges exclude the people who are not a part of the transactions. These circumstances indicate a market failure, which requires the government to take appropriate measures to correct it.
The traditional economic thinking before Keynesian theory stated that markets would ensure full employment. The classical economic theory that was dominant suggested that all the people who wanted jobs would acquire them as long as workers exhibited flexibility in their wage demands. However, the Keynesian theory has a different perspective. It asserts that aggregate demand, which is the sum of spending by businesses, households, and the government, is the most important determinant of supply. Keynes argued that free markets lack a self-balancing mechanism that leads to full employment. For this reason, the Keynesian approach implies government intervention through public policies to achieve price stability and full employment. The following situation results from irrationality of people and requires government interventions.
According to Keynes, insufficient general demand may result in long-term unemployment. The productivity of goods in the economy depends on investment, consumption, net exports, and government purchases. Increases in demand result from these components. However, consumers develop little confidence during recession. The consumers respond by reducing their spending, especially discretionary purchases. Reduced consumer purchases prompt businesses to lower investment spending as firms respond to decreased demand for their products. Therefore, in order to increase output, the government should interfere in the situation. Keynes stated that the government intervention is crucial to boost economic activity and neutralize downturns.
In case the market cannot achieve optimum demand and investment expenditure, one of the successful government measures is the utilization of fiscal policy. It can reduce taxes in order to increase consumer and investment spending during recession. The government may also increase its spending to raise demand. It can provide funds to the financial institutions to encourage lending. The increase in credit will encourage private consumption and investment. Employment increases if the businesses anticipate greater demand and production.
Sometimes, the free market results in economic activities that impose costs or bring benefits to the parties that are not involved in relevant actions. An example is a steel firm that emits smoke causing respiratory diseases in the neighborhood. Other externalities cause benefits. If students pay for their education, the whole society accrues benefits in terms of more virtuous behavior. The rest of the society enjoys the benefit of education without paying for it. The market fails when the private costs and benefits do not match with social ones.
Government intervention is crucial if externalities lead to negative consequences. The Keynesian’s fiscal policy can help reduce the adverse impacts of externalities. An appropriate government action is the imposition of taxes on the actions exacerbating externalities. The more pollutants a company emits, the more taxes it pays. The high tax discourages the emission of the substances. For example, the European Union permits the companies to emit carbon dioxide into the air after they pay $10.50 per metric ton. If there is no regulation, the market cannot contain the pollution.
Insufficient Supply of Public Goods
Public goods are characterized as non-rivalry and non-excludable in consumption. It is costly to prevent people who do not pay for the goods from consuming them. This fact causes the need for investment in goods that are unattractive for private investors. The market may not provide sufficient supply of these goods. Some of the public goods such as roads and stadiums are essential. It is responsibility of the government to provide these goods since the society cannot manage without them. The government obtains funds to maintain the products through taxing complimentary goods. An example of these goods is roads. A motorist using a road does not prevent other motorists and pedestrians from using it. If private investors provide the goods, it will be difficult to charge the motorists for using the roads. The government builds the roads and taxes the petrol that motorists must acquire in order to drive. Various cities use government interventions to ease traffic congestion. For instance, Houston introduced carpool lanes where drivers pay to drive in the lanes during traffic congestion. The rates that apply to driving on the roads differ according to the traffic.
Increasing market power makes a business monopolistic. A monopolist charges high prices and cuts supply of goods and services. If the monopolists dominate the market, they will erode the consumer surplus and compel customers to buy the products at a price higher than the value they obtain. The government needs to intervene in these situations to provide consumer protection.
Stabilizing the Economy
In typical market conditions, changes in supply and demand cause slow alterations in prices. The condition results in periodic surpluses and shortages in the labor market. The temporary shocks in demand and supply lead to changes in real output and employment. The government intervenes in these conditions to achieve stability in the market. During the period of demand reduction, the government increases its spending to stimulate demand. The growth in demand also raises output. Government policies can also reduce the adverse effects of business cycles. According to Keynes, the government can utilize counter-cyclical policies that neutralize business cycles. In case of economic slump, the government can employ deficit spending on sectors that offer jobs to a great number of people in order to increase employment. The government uses the monetary policy to recover the economy. When the demand-side exhibits vast growth, the government raises taxes to prevent inflation and achieve price stability. Monetary policies are means of robust government intervention to correct instability in the economy. When the economy experiences slump, the government can reduce interest rates to make loans affordable and encourage investment. The market exchanges cannot fix the instabilities in the economy. The government can create a vast range of policies to increase employment. For example, the United States provides permanent residency to the foreigners who invest more than $500,000, and creates ten or more full-time jobs in areas affected by high unemployment. The government has the responsibility to correct the anomalies in the short run rather than rely on the market forces to self-adjust. The economy can sustain full employment if the government maintains corrective actions.
Most people lack the savings culture. Saving is necessary to help people accumulate capital for investment and provide them with funds during the time of low productivity. The government supports the elderly by helping them save for retirement. Some governments also direct employers to subsidize and pay for their employees’ pension contributions. The savings grant tax exemption and aim at stimulating consumption during the time of low productivity such as old age.
Government interventions are effective when people cannot be fully rational. The paper has presented circumstances when market liberalization failed to achieve optimum employment. A good example is the socially inefficient allocations that competitive markets cause. The competitive markets may result in inadequate demand, which leads the business to reduce production. To maintain sufficient employment, the government increases its expenditure. To correct negative externalities, the government imposes taxes to discourage the acts generating them. Competitive markets may also cause monopolies, which results in high prices and low demand. The government sets standard prices to protect consumers. When the economic downturns destabilize the economy, the government can increase spending to stimulate demand and investment.