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Government Failure versus Market Failure

Clifford Winston

The Economic Questions — Every year federal and state governments attempt to promote economic growth by investing hundred of billions of dollars in the nation’s physical capital stock-roads, airports, urban rail systems, and the like-and in the nation’s human capital. Investments in the latter include education and R&D subsidies.

My testimony will focus on the following questions: What is the economic justification for public as opposed to private investment in these areas? Are these investments efficient? How can these investments be improved?

The Justification for Government Intervention

In theory, government intervention in economic life is justified to stabilize the macroeconomy, correct market failures such as monopoly and externalities, and to pursue social goals such as reducing poverty and ensuring fairness in the labor market.

How does public investment fit into these justifications? Generally, a private firm will provide a good or service if it can earn a normal profit. Market failure occurs when a socially desirable good or service-that is, a good or service whose social benefits exceed its social costs-is not provided because firms would find it unprofitable to do so. For example, when the nation was developing its road system, a private firm or firms may not have been able to raise sufficient capital (let alone repay the accumulated debt) to build a private interstate highway system. Similarly, a private urban rail system may not be able to attract sufficient ridership and charge sufficiently high fares to be profitable. In such cases, the government can increase economic welfare by financing socially desirable services like roads and public transit that would not be supplied by the private sector. Thus public production of these activities is correcting a market failure.


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