The Economic Role of Government

Economics identifies four main reasons for government involvement in the economy:

1. Create a framework of law in which markets operate
2. Market failure rectification: make economy more efficient
3. Redistribution: make economy more equitable
4. Paternalism: when agents don'[t act in their own true interests

'Efficiency' in economics is usually defined as Pareto Efficiency: A situation where it is not possible to make anyone better off, without making at least one person worse off.

The first fundamental theorem of welfare economics states that, if consumers maximise utility and producers maximise profits, the resulting competitive equilibrium allocation of resources is Pareto Efficient under the following assumptions:

1. Perfect competition
   1. Large number of consumers and firms
   2. Homogenous products
   3. Free entry to and exit from the industry
   4. Complete and perfect information
2. No externalities or public goods
3. Complete markets
   1. Negligible transaction costs and therefore also perfect information
   2. Price existing for every asset in every possible state of the world
4. No asymmetric information

But the efficiency is not the only interest of governments. They might be interested in equity. However, Pareto Efficiency only gives information about efficiency and not equity. Furthermore, there is often a trade-off between equity and efficiency, since redistribution can create inefficiency.

…….so, how should policies be designed…….

In theory, a benevolent social planner may:

1. Set an objective
2. Select policies to maximise this objective

A tool often considered when setting the objective is the "Social Welfare Functions (SWF)". Under assumptions that:

• Utility is cardinal
• Utility is interpersonally comparable

The welfarist SWF is defined as a function only of citizens' individual utilities.

The shape of this SWF will differ by the philosophy of the planner, and is often described as

SWF=Ua^alpha+Ub^alpha

Where alpha ranges between 0 and 1. If alpha=1, the SWF will be Utilitarian. If  alpha=0, the SWF will be Rawlsian.

By combining the SWF with the utility possibility frontier, the benevolent social planner may decide the optimal policy.