The government is unique among economic institutions insofar as it can use coercion legally. But not all activities are coercive. Clearly, taxation is overwhelmingly coercive. Some people say that they are happy to pay taxes, but the voluntary gifts to the US Treasury are itsy-bitsy (just over $1m for FY 2023). Most regulations also include the threat of fines or jail time for non-compliance.
But once the government has the money in their coffers, there is plenty that they can do consensually. Once they have the resources, they are often just another potential transactor in the markets for goods and services. While the government can transact as well as anyone else, there is a fundamental theoretical difference for how we should interpret those transactions. Specifically, there is a principal-agent problem such that we can’t quite identify the welfare that is enjoyed by consumers when the government makes purchases. We really have very little idea.
Garett Jones uses the analogy of the government confiscating potatoes. The worst use would be for the government to throw the valuable resources into the river. Those resources help no one. Improved welfare would be yielded if the government just transferred those potatoes back to people. Sure, there’s the transaction cost of administration, but people get their potatoes back. Finally, the great hope is that the government takes the potatoes and makes tasty potato fritas such that they return to the public something more valuable than they took. These might be things that fall into the public goods category or solving collective action problems generally.
The above examples illustrates that how the government spends matters a lot for the welfare implications of the newly purchased government resources. But, we need to recall that there is an entire private segment of the market that is affected by the government transactions.
Short-Run Analysis
In a competitive market, firms face increasing marginal costs and make decisions about their levels of output. When the government makes purchases, it’s simply acting as another demander. How does the entry of a larger demander affect everyone else in the market? See the below GIF.
When the government makes purchases, they solicit greater production from suppliers at a higher marginal cost. The suppliers increase their price and enjoy both higher prices and greater quantities sold (producer surplus rises). However, private sector demanders also face the higher price and, consequently, purchase a lower quantity (consumer surplus falls). The market for this good experiences an increase in total welfare because the producer surplus gains are greater than the consumer surplus losses.
Once we accept the above model on principle, we’re just arguing about degrees. The take-away is that every single purchase by the government reduces consumer surplus insofar as the price of scarce resources are bid higher.
Long-Run Analysis
While my libertarian heart enjoys the above conclusion, my economist heart is ready to burst a bubble. I’ve written about reducing demand via boycotts in the past. Increasing demand with government purchases has a complementary logic.
In the long-run, suppliers compete economic profits down to zero and lower the price to the minimum average cost. That minimum average cost is determined by the price of inputs and production methods. When profits are positive, firms enter the market, increase supply, and drive profits down to zero. When profits are negative, firms leave the market, reduce supply, and drive losses to zero.
Therefore, adding government demand to a market does not change the price in the long run. Consumer surplus is unaffected and producer surplus continues at zero. Therefore, government purchases have no welfare implication in the long run equilibrium (Aw, snap!).
The above analysis is a partial equilibrium and not a general equilibrium. Of course, collecting the revenue by whatever means did have a welfare implication, but that’s a different, albeit necessary, activity. The purchases that are made with the tax revenue dollars don’t affect long-run prices.
Another thing that is missing from the above analysis is the dynamic effects. Insofar as human attention is necessary for productive innovation, the government purchases entice human attention away from the production of goods in other markets. After all, those long-run supplier entrants must come from somewhere. Therefore, markets with government purchases have the potential to attract average cost lowering innovation away from markets that serve consumer surplus and toward markets that serve the government. In a world where the government makes tasty potato fritas, that’s not so bad. In a world where the government throws potatoes in the river, it adds insult to injury.
Finally, all of the above analysis speaks to the strength and resilience of competitive markets. In the short-run, it’s still the demanders who place the highest value on goods who can purchase them. It’s still the most efficient producers who supply the goods. And in the long-run, entry and exit ameliorate the negative impact on consumers. Indeed, we are lucky that the government purchases on markets rather than directs resources by fiat. It’s the market which helps to ration and direct resources away from the lowest valued alternatives and to minimize the impact of government transactions.
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