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Although the market system in the United States relies on private ownership and decentralized decision-making by households and privately owned businesses, the government does perform important economic functions. The government passes and enforces laws that protect the property rights of individuals and businesses. It restricts economic activities that are considered unfair or socially unacceptable.

In addition, government programs regulate safety in products and in the workplace, provide national defense, and provide public assistance to some members of society coping with economic hardship. There are some products that must be provided to households and firms by the government because they cannot be produced profitably by private firms. For example, the government funds the construction of interstate highways, and operates vaccination programs to maintain public health. Local governments operate public elementary and secondary schools to ensure that as many children as possible will receive an education, even when their parents are unable to afford private schools.

The government attempts to adjust the production and consumption of particular goods and services where private markets fail to produce efficient levels of output for those products. The two major examples of these market failures are what economists call public goods and external benefits or costs.

Providing Public Goods ¹

Private markets do not provide some essential goods and services, such as national defense. Because national defense is so important to the nation’s existence, the government steps in and entirely funds and administers this product.

Public goods differ from private goods in two key respects. First, a public good can be used by one person without reducing the amount available for others to use. This is known as shared consumption. An example of a public good that has this characteristic is a spraying or fogging program to kill mosquitoes. The spraying reduces the number of mosquitoes for all of the people who live in an area, not just for one person or family. The opposite occurs in the consumption of private goods². When one person consumes a private good, other people cannot use the product. This is known as rival consumption. A good example of rival consumption is a hamburger. If someone else eats the sandwich, you cannot.

The second key characteristic of public goods is called the nonexclusion principle: It is not possible to prevent people from using a public good, regardless of whether they have paid for it. For example, a visitor to a town who does not pay taxes in that community will still benefit from the town’s mosquito-spraying program. With private goods, like a hamburger, when you pay for the hamburger, you get to eat it or decide who does. Someone who does not pay does not get the hamburger.

Because many people can benefit from the same public goods and share in theirconsumption, and because those who do not pay for these goods still get to use them, it is usually impossible to produce these goods in private markets. Or at least it is impossible to produce enough in private markets to reach the efficient level of output. That happens because some people will try to consume the goods without paying for them, and get a free ride from those who do pay. As a result, the government must usually take over the decision about how much of these products to produce. In some cases, the government actually produces the good; in other cases it pays private firms to make these products.

Adjusting for External Costs or Benefits

There are some private markets in which goods and services are produced, but too much or too little is produced. Whether too much or too little is produced depends on whether the problem is one of external costs or external benefits. In either case, the government can try to correct these market failures, to get the right amount of the goods or services produced.

External costs³occur when not all of the costs involved in the production or consumption of a product are paid by the producers and consumers of that product. Instead, some of the costs shift to others. One example is drunken driving. The consumption of too much alcohol can result in traffic accidents that hurt or kill people who are neither producers nor consumers of alcoholic products. Another example is pollution. If a factory dumps some of its wastes in a river, then people and businesses downstream will have to pay to clean up the water or they may become ill from using the water.

When people other than producers and consumers pay some of the costs of producing or consuming a product, those external costs have no effect on the product’s market price or production level. As a result, too much of the product is produced considering the overall social costs. To correct this situation, the government may tax or fine the producers or consumers of such products to force them to cover these external costs. If that can be done correctly, less of the product will be produced and consumed.

An external benefit⁴occurs when people other than producers and consumers enjoy some of the benefits of the production and consumption of the product. One example of this situation is vaccinations against contagious diseases. The company that sells the vaccine and the individuals who receive the vaccine are better off, but so are other people who are less likely to be infected by those who have received the vaccine. Many people also argue that education provides external benefits to the nation as a whole, in the form of lower unemployment, poverty, and crime rates, and by providing more equality of opportunity to all families.

When people other than the producers and consumers receive some of the benefits of producing or consuming a product, those external benefits are not reflected in the market price and production cost of the product. Because producers do not receive higher sales or profits based on these external benefits, their production and price levels will be too low-based only on those who buy and consume their product. To correct this, the government may subsidize producers or consumers of these products and thus encourage more production.

Competitive markets are efficient ways to allocate goods and services while maintaining freedom of choice for consumers, workers, and entrepreneurs. If markets are not competitive, however, much of that freedom and efficiency can be lost. One threat to competition in the market is a firm with monopoly power. Monopoly power occurs when one producer, or a small group of producers, controls a large part of the production of some product. If there are no competitors in the market, a monopoly can artificially drive up the price for its products, which means that consumers will pay more for these products and buy less of them. One of the most famous cases of monopoly power in U.S. history was the Standard Oil Company, owned by U.S. industrialist John D. Rockefeller. Rockefeller bought out most of his business rivals and by 1878 controlled 90 percent of the petroleum refineries in the United States.

Largely in reaction to the business practices of Standard Oil and other trusts or monopolistic firms, the United States passed laws limiting monopolies. Since 1890, when the Sherman Antitrust Act⁵was passed, the federal government has attempted to prevent firms from acquiring monopoly power or from working together to set prices and limit competition in other ways. A number of later antitrust laws were passed to extend the government’s power to promote and maintain competition in the U.S. economy. Some states have passed their own versions of some of these laws.

In addition to the monetary policies of the Federal Reserve System, the federal government can also use its taxing and spending policies, or fiscal policies⁶, to counteract inflation or the cyclical unemployment that results from too much or too little total spending in the economy. Specifically, if inflation is too high because consumers, businesses, and the government are trying to buy more goods and services than it is possible to produce at that time, the government can reduce total spending in the economy by reducing its own spending.Or the government can raise taxes on households and businesses to reduce the amount of money the private sector spends. Either of these fiscal policies will help reduce inflation. Conversely, if inflation is low but unemployment rates are too high, the government can increase its spending or reduce taxes on households and businesses. These policies increase total spending in the economy, encouraging more production and employment.