Third Venue of Rational Exchange, Part I

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GEM macro modeling, focusing on rational exchange in both the marketplace and information-challenged workplaces, is obviously incomplete. Thorough analysis of highly specialized economies needs a third venue, in which exchange is arranged and implemented by government and is atypically price mediated. Its objective functions, mechanisms of exchange, and constraints (including the government’s monopoly on coercion) differ substantially from the other two venues. This and next week’s posts outline economic thinking on government exchange, captured by public-goods and public-choice theories. The Project’s scant attention paid to the third venue of exchange does not imply unimportance. In the United States, government expenditures exceed 30% of total GDP, up from less than 20% after World War II. Other Western democracies typically have even higher public-expenditure ratios. What follows is a brief review of the public-goods literature upon which the GEM Project will eventually expand its aggregate model to three venues.

Samuelson.  Paul Samuelson, a colleague of mine at MIT, pioneered the rigorous analysis of public goods, which he defined as “collective consumption goods”. Public goods critically demonstrate nonrivalness in consumption, i.e., an individual’s consumption of such goods results in no reduction of any other person’s consumption. Goods that are nonrival also tend to demonstrate nonexcludability in supply. It is not cost-effective to block nonpayers from consuming the good once it is offered. Freeloading is, of course, a rational self-interest strategy.

Samuelson and Nordhaus (1989, 13th edition, p.45): “… private provision of these public goods will not occur because the benefits of the goods are so widely dispersed across the population that no single firm or consumer has an economic incentive to produce them. Because private provision of public goods will generally be insufficient, government must step in to provide public goods.” The implication is the welfare-enhancing necessity of compulsion.

A central issue in the analysis of pure public goods, which are nonrivalrous positive and for which there is no cost-effective means to prevent free riders, is whether the first characteristic alone is sufficient to compel compulsory funding of production. If some potential consumers of the collective consumption good are only willing to pay amounts less than private-cost pricing rooted in some imperfect exclusion technology, zero marginal costs imply that unexploited welfare gains from the market exchange must exist. From White (2012, p.342): “If a nonrival good is excludable… then it can be withdrawn from nonpayers, allowing a producer to induce payment from those who want it and thereby to finance its provision. But any positive price, Samuelson argued, means that too little is consumed. Where the social marginal cost of adding another beneficiary is zero because of nonrivalness, any positive price blocks potential net social benefits. The benefits to additional users will be all gravy.”

That interesting issue will set aside in this brief overview of the economic modeling government exchange. Suffice it to note that pure public goods, their identification, production, financing, and distribution, are at the core of a significant public-policy problem for which the use of homogeneity simplifications in associated modeling is particularly problematic. The assumption obscures the critical “demand-revelation” issue that occupies center stage in any government attempt to calibrate taxes (or other forms of compulsion) to individual willingness to cooperate.

Musgrave. Richard Musgrave (1959), a teacher of mine at Princeton, became the father of public economics as a result of his comprehensive effort, building on Samuelson, to provide a blueprint for the government’s role in market economies. Musgrave pioneered the integrated analysis of both the spending and taxation sides of public budgets. More generally, he identified three economic functions of the state: managing externalities that arise from rational price-mediated exchange, improving resource allocation; influencing the distribution of income and wealth, balancing incentives and social cohesion; and intervening in total demand, using spending and tax policies, in pursuit of macroeconomic stabilization. The first and third functions already play a critical roles in the GEM Project.

When the GEM Project’s macro model is extended to the entire economy, Musgrave will be the principal guide. It will use his simplified version in which universally efficient design and execution of fiscal policy as well as universally selfless motivation of fiscal policymakers is assumed. The path not taken will be Buchanan and Tullock’s powerful modeling of government policymaker preferences and constraints pioneered that is summarized next week.

Blog Type: Wonkish Chicago, Illinois

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