Markets and Government.

• Author: Murray, Phil R.

Diane Coyle describes herself as "a British economist and policymaker." In her current book on microeconomic policy, her essential question is, "Which activities should be done by the government, which by the market, or in some other way?" To answer that, she builds on traditional economic theory using recent developments.

Pareto efficiency / The cornerstone to her answer is the concept of Pareto efficiency. Coyle states, "An allocation of resources is Pareto efficient if nobody can be made better off without somebody else becoming worse off." If change occurs and we arrive at a Pareto efficient outcome, no further improvements can be made. The distribution of well-being matters, however. Later in the book, Coyle writes, "The claim is that 432 people now own half the country's land area," referring either to Scotland or the Highlands of Scotland (it is unclear which). Scots not among the 432 probably do not think that situation is best. People value efficiency and equity.

"The first theorem" of welfare economics, according to Coyle, "states that if a competitive market equilibrium exists, then it is Pareto efficient." Some think this theorem endorses markets. Coyle seems to share that view, writing, "This theorem is the underpinning of the instinct in favor of competitive markets as a benchmark." "The second theorem," she continues, "says that given an initial allocation of resources, there is a set of competitive prices that support the Pareto efficient outcome." The implication is that even if a government redistributes incomes, markets will re-establish a best situation.

The fundamental theorems are based on unrealistic assumptions such as the absence of barriers to enter markets. "The Pareto efficiency approach and welfare theorems nevertheless hold powerful sway in the worldview of economics in offering a conceptual framework for thinking about why, in any particular real-world context, competition and market exchange are not the social welfare-maximizing approach," she writes. Because there are externalities, for example, markets do not lead to a Pareto efficient outcome. It would be a mistake, Coyle maintains, to downplay the incidence of market failures and adopt "a presumption in favor of 'free markets.'" However, although market failures are omnipresent in her view, she is equally skeptical of government's ability to correct them.

Government intervention / Governments attempt to improve markets by taxing, spending, transferring, and regulating. Take the case of a Pigouvian tax that corrects a negative externality. The social marginal cost of production exceeds the private marginal cost because of a negative externality such as pollution. The market clears at a quantity such that the marginal value is less than the social marginal cost; the quantity and the negative externality it produces are too...