In the previous section, we laid out an argument that democracy is the best form of government. But a second question remains: how large should the government be?

In determining the best size of government, we should first note that both governments and markets do the same thing: they exchange goods and services for money. For example, a customer may pay $10 for a restaurant dinner, whereas a citizen pays tax money for police protection.

But if they both do the same thing, then why not let the market do it all? Or why not let the government do it all? The answer is because it depends on the goods and services being offered. Governments and markets are better suited for providing different things.

Below is a comparison of how government and markets make transactions. First we’ll describe the general model, and then show how both the market and government fit the model. To make the comparison easier, letters will mark the appropriate analogs:

The General Model: A group (A) delegates power to individual providers (B) within an institution (C) to provide goods and services in exchange for money (D). The group has their choice of many providers competing to provide them goods, and they give consumer satisfaction units (E) to their preferred choice. Those providers receiving a sufficient number of units will be delegated to power (F), and those that do not will be denied power (G). This competition keeps prices down, quality high, and incompetent providers out of the system.

The Market: Customers (A) delegate power to individual companies (B) within the market (C) to provide goods and services in exchange for money (D). Customers have their choice of many companies competing to provide them goods, and they give dollars (E) to their preferred choice. Those companies receiving a sufficient number of dollars will stay in business (F), and those that do not will go bankrupt (G). This competition keeps prices down, quality high, and incompetent companies out of the market.

Government: Citizens (A) delegate power to individual representatives (B) within government (C) to provide goods and services in exchange for taxes (D). Citizens have their choice of many candidates competing to provide them goods, and they give votes (E) to their preferred choice. Those candidates receiving a sufficient number of votes will be elected to office (F), and those that do not will be denied office (G). This competition keeps prices down, quality high, and incompetent representatives out of government.

The fact that customers vote with their dollars while citizens vote with their votes is an important difference with enormous implications. Consider how this difference affects the issue of natural monopolies:

In any marketplace, competition is essential to keep things efficient. Providers who have no competitors are called monopolies. Economists consider monopolies to be a market failure, because monopolies can raise prices, drop quality, and receive extra profits for nothing. People could better spend this wasted money elsewhere, on things that actually raise their standard of living.

Monopolies arise in several different ways, but a common one is the natural monopoly. This is a monopoly where competition is prevented by the very nature of the market or technology itself. Examples include telephone, electrical, gas and water utilities. The only way these services could see competition would be to install competing electrical lines and water pipes in the neighborhood — an absurd and wasteful idea. Because private competition is not desirable, public competition is the best solution. Governments restore competition to natural monopolies because the elected officials running them must compete for votes. Most nations allow their governments to run their natural monopolies directly, but the U.S. has a hybrid system, in which private utilities are publicly regulated to avoid monopolistic abuse.

Sometimes improved technology can turn a natural monopoly into a competitive marketplace, as in the case of cable TV eroding the monopoly power of network TV, or fiber optics introducing competition to long-distance phone service. But new natural monopolies are always arising, often created by new technology. For example, the invention of cars created the natural monopoly of roads. (You can't have several competing roads leading to your door). The result is that the number of natural monopolies in the economy remains fairly constant, even if their constituency changes.

Utilities are not the only example of natural monopolies. Most public goods are natural monopolies as well.

To understand this part of the debate, it's important to distinguish between a public and private good. A public good is non-exclusive and non-rival. Non-exclusive means that it’s difficult to keep non-payers from consuming the good. Non-rival means that one person’s consumption doesn’t subtract from another person’s consumption of the same good.

The classic example of a public good is national defense. National defense, once established, protects payers and non-payers alike. And one person’s enjoyment of national defense is not decreased by an immigrant who enters the country and enjoys it also. In other words, once the nation is defended, it doesn’t cost more to protect 200 million citizens as 100 million.

By comparison, a merchant selling apples is selling a private good, because he can exclude non-paying customers from consuming his apples. And every bite of an apple that a paying customer eats is one less bite available to others.

As it turns out, private markets cannot provide most public goods. The reason is the free-rider problem. Suppose private companies, not government, supplied our national defense. Customers would pay these companies to defend the nation, and their decision to buy the protection would be voluntary, otherwise it would not be a free market. Unfortunately, many citizens could decide to take a free ride, enjoying national defense for free while others pay for it. But if everyone took advantage of this, no one would pay for national defense at all.

Public goods are best provided by public institutions like government. The government requires citizens to pay for the good by law; citizens then become forced riders, or compelled taxpayers. This "coercion" is justified because the majority of voters prefer it to the alternative, which is defeat and enslavement by the Hitlers and Stalins of the world.

Examples of public goods include environmental protection, public parks, law and order, standardizing weights and measures, a common education, a common language, public health, printing and controlling a national currency, and more. Examples of public goods provided by private merchants include fireworks displays and street musician performances — although getting paid for these services by all who enjoy them is impossible.

Imagine a land with no law and order. Everyone would be free to commit violence and aggression without worrying about police retaliation. Greed would spur individuals to rob, cheat and steal at every opportunity. Jealous lovers could kill with impunity. Nothing could stop your neighbor from driving you off your land and taking your property, except your own use of defensive force.

In such anarchy, only the fittest and luckiest would survive. But even after these survivors won their first battles, they would only find themselves in a new round of conflict, this time against proven and battle-tested survivors. The price of continual war isn’t worth it, even to the survivors. Society avoids this bleak scenario by agreeing to cooperate for survival, or at least limiting the competition to fairer and less harmful methods. This more stable and peaceful approach makes everyone richer in the long run.

But cooperation requires rules that everyone lives by. Unfortunately, private markets cannot provide such law and order. Take, for example, the law against murder. How could the market enforce such a law? With government, the answer is simple: the police enforce it. But how would the free market provide police protection? Some libertarians have proposed imaginative solutions, like having private police agencies compete on the free market. You might subscribe to Joe’s Security Forces, and I might subscribe to Bill's Police Agency. But suppose one day I steal your car. You could call your police agency to come and arrest me. But I could claim the car is rightfully mine, thanks to a bad business deal between us, and call my own police agency to defend against your theft of my property. The result is tribal warfare. What’s worse, the richest citizens would be able to afford the largest private armies, and use them to acquire yet more riches, which in turn would fund yet larger armies. Libertarian scholars have attempted to save their idea with even more imaginative arguments, but the exercise only proves the unworkability of the idea, and the vast majority of scholars reject the whole approach.

The folly of this exercise becomes even more apparent when you consider how the free market would provide the law itself. Again, some libertarians propose private legislative companies competing on the free market. By paying a legislative company a few hundred dollars a year, you could buy whatever slate of laws you would like to live by. Unfortunately, two people might claim sole ownership of the same property, and point to their different slate of laws awarding them ownership. In that case, the law is of no help in identifying the true owner, and the two parties are left to negotiate. These negotiations would occur under conditions of anarchy, and the side with the most power, influence or police force would win the negotiations. This would be a society of power politics, where might makes right.

True law and order can only be provided by a single entity covering the entire group in question. That is, law and order is a natural monopoly. A single private company can’t run this natural monopoly for two reasons. First, it would have no competition, unlike government, which could restore competition through voting. In other words, governments are democracies, but private companies are dictatorships, and if only one company provides law and order, you might as well have a monarchy. Second, true law and order is also a public good, much like national defense, but one that offers protection against internal enemies instead of external ones. Free riders could enjoy the benefit of the private company’s law and order without paying for it. Having democratic government provide law and order is the only way to solve these problems.

When most people think of "law and order," they generally think of police officers fighting street crime. However, the most important laws in society are actually the laws that set up our social, property and business systems.

For example, business laws protect us against fraud, false advertising, breach of contract, copyright infringement, embezzlement, insider trading, monopolistic abuse, unfair market manipulations and hundreds of other ills that would occur under true anarchy. Without business laws, the market could not even operate. For example, if we did not have copyright laws discouraging people from pirating all their software, computer programmers could not even make a profit, and would have no incentive to produce.

Property laws protect us against theft, invasions of privacy, trespassing, pollution, vandalism, and disputes over property boundaries and ownership. Without these laws, we would have no stable system of private property.

Social laws guarantee our freedom of speech, religion, press, ballot box, due process, and equal rights. Without these laws, we would not live in a free society, but in tyranny.

Again, the free market could not provide these public goods without suffering from free riders and tribal warfare. This leads to an important conclusion: the public sector creates the rules that the private sector needs to operate.

Another irreplaceable role of government is providing national infrastructure, which includes roads, electricity, telecommunications, postal systems, and other large-scale underpinnings of the national economy. Historically, private enterprise has been unable to afford building national infrastructure. Only government has the pockets deep enough to fund such huge projects. Almost always, these projects lay dormant or underdeveloped until the government takes them up, and then progress is rapid.

Nor would we want private companies so large that they could provide national infrastructure; any company that large would surely be a monopoly, for competitors of equal size would be a waste of the nation's resources.

The classic example is road building. Private companies tried building toll roads and turnpikes in the early 1800s, but the projects were not viable. Most companies lost money in the long run, and only a few made slim profits. As a result, America’s road system languished. But a dramatic boost in road building came with Eisenhower's Federal Aid Highway Act of 1956, which authorized the creation of over 40,000 miles of interstate highway. These highways expanded, interconnected and accelerated the U.S. economy, with profound results. They allowed the middle class to migrate from the cities to the suburbs, with an enormous increase in privacy and quality of life. They also breathed new life into commerce.

Another reason why governments are better at road building is eminent domain. This is the power to build roads where they are logically needed, by compelling land owners to sell their property at fair market values. Critics protest the coercive nature of eminent domain, but consider the alternative. If private road-building companies asked landowners to sell their property voluntarily, roads would either not be built at all, or they would zigzag crazily across the map.

Why? Because some property owners would not sell their land at any price, for reasons of sentimentality, convenience, stubbornness, or misjudgment. Others would jack up their price tenfold or a hundredfold, knowing how keenly, say, two cities would like to connect to each other. Some libertarians argue that such a high asking price would reflect the true value of the land between the two cities, if they were willing to pay it. But the problem with that argument is that if every individual landowner asked an astronomical sum, the total costs of the project would skyrocket. The costs might easily exceed the budget of the road-building company. And they would certainly make tolls skyrocket, reducing the potential economic benefit and activity between the two cities, and diverting it instead to the former landowners who do not produce anything more for their windfall. So eminent domain makes society richer in the long run.

Highways are but one example of how publicly funded infrastructure has increased commerce. Others include:

Settling the West: The U.S. government played a primary role in settling the West. It conducted massive land purchases like the Louisiana Purchase ($15 million), the Texas/California purchase ($25 million), and others. It then gave the land to American settlers for a song, thanks to the Homestead Act and other giveaways. Conquest, where it occurred, was done primarily by the U.S. Army, not gun-toting pioneers. The government also subsidized the Wells Fargo postal routes, agricultural colleges, rural electrification, telegraph wiring, road-building, irrigation, dam-building, farm subsidies, and farm foreclosure loans.

Funding Railroads: In the late 19th century, the government gave away 131 million acres in federal land grants, at enormous cost to itself, to railroad companies to build their railroads. Four of the five transcontinental railroads were built this way. To help them, Congress authorized loans of $16,000 to $48,000 per mile of railroad (depending on the terrain).

Rural Electrification: In 1935, only 13 percent of all farms had electricity, because utility companies found it unprofitable to wire the countryside for service. Roosevelt's Rural Electrification Administration began correcting this market failure; by 1970, more than 95 percent of all farms would have electricity.

U.S. Mail: Many people think that the privately owned UPS, which delivered 3 billion pieces of mail in 1997, is America’s postal success story. But this figure pales in comparison to the U.S. Postal Service, which delivered 190 billion pieces of mail that same year. The U.S. Postal Service also achieves a 91 percent on-time delivery rate charging among the lowest rates in the industrialized world. No private organization could hope to match these numbers. It is also interesting to note that the privately-funded Pony Express was a financial failure that lasted only a few years. The government subsidized the Wells Fargo Company, which succeeded delivering mail to California for rest of the 19th century.

The Internet: In the 1960s, the government created ARPANET, which was used and developed by the Defense Department, public universities and other research organizations. In 1985, the National Science Foundation created various supercomputing centers around the country, linking the five largest together to start the modern Internet we know today.

NASA: Thanks to America’s space program, today we have a fleet of satellites that conduct global telecommunications, weather observation and warning, ozone and global warming studies, intelligence missions, high-resolution and high-accuracy mapping, as well as detection of forest fires, oil spills, El Nino events, natural disasters and earth-threatening asteroids. Space exploration was so inherently difficult that it took decades and hundreds of billions of dollars before the practical benefits became possible. Private companies could not have possibly afforded such investment, or waited so long until it bore fruit.

The Treasury and Federal Reserve System: The Treasury prints the very money the economy runs on. And using Keynesian policies to expand or contract the money supply, the Fed has completely eliminated economic depressions in the last six decades.

Federal Emergency Management Agency: Today FEMA has won widespread praise for its response to natural disasters like earthquakes, hurricanes, floods and tornadoes. No private business could wait the long intervals between disasters like FEMA does, or bring relief to entire cities or states.

Human Genome Project: The government provides the money and the organization for this 20-year project, which will give medical science a road map of the human genetic code. Researchers have already found genes that contribute to 50 diseases.

Centers for Disease Control and Prevention: This legendary American organization, popularized by the movie Outbreak, isolates and wipes out entire plagues and diseases that strike anywhere in the world. "The CDC," says Dr. James Le Duc of the World Health Organization, "is the only ballgame in town."

Mass education: This is probably the most remarkable example where the government overcame a market failure. Prior to the 1840s, the vast majority of Americans were illiterate. What few schools existed were private schools that educated boys only from the richest families. However, during the 19^th century, the government began funding mass education at both the elementary and high school level. Between 1900 and 1996, the percentage of teenagers who graduated from high school mushroomed from 6 to 85 percent. The government also began issuing grants and loans for college education, and college enrollees aged 18 to 24 mushroomed from 2 to 60 percent. In essence, the government is responsible for the educated workforce that causes today’s economy to excel.

Finally, government is useful for correcting market failures. Economists define market failure as "an imperfection in the price system that prevents the efficient allocation of resources." There are many types of market failure; here are the definitions of the most important ones:

Asymmetric Information: This is any difference in information and expertise between two negotiating parties. For example, in the used-car market, the seller's information is based on sales that he conducts every day, but the buyer's information is based on a purchase he conducts only a few times in his lifetime. The resulting exchange is likely to be unfair or one-sided.

Adverse Selection: This is any unfair exchange based on asymmetric information.

Externality: Also called the spillover effect. This occurs when someone other than the buyer shares the costs or benefits of the product. The classic example is pollution. Factories can either treat pollution, which costs money, or dump it for free into the air or water. If they dump it, then not only are customers paying a price for the product, but local citizens too, in the form of higher mortality and disease rates, less fertile land, environmental catastrophes, etc. Sometimes the spillover effect is both positive and negative. An airport benefits its flying customers, but it also subjects the local neighborhood to various externalities. Positive ones include increased local business; negative ones include noise pollution.

Imperfect competition: This is any situation where a monopoly or oligopoly controls the market for a certain product. The lack of competition raises prices, lowers quality, slows down innovation and exploits customers.

Path dependency: This is the tendency to stick to a certain path, trend, technology, method or location, even after more promising alternatives appear. The most commonly cited — and now disputed — example is the QWERTY typewriter keyboard. This 19th century system placed the most commonly used letters far apart on the keyboard, purposely slowing down typing to avoid key jamming. Of course, today's electronic keyboards do not suffer from jamming, and a better system, DSK, cuts down on typing time by 10 percent. Unfortunately, society is committed to the old system, because it is too costly to retrain all typists and retool all keyboard production everywhere. Conservatives have raised objections to the QWERTY example, but path dependency has been found in thousands of other places in the economy as well. Examples include the English vs. the metric system, steam vs. gas engines, water-cooled vs. gas-cooled nuclear reactors, and the centralization of entire industries in a single city, like auto production in Detroit, or aircraft production in Seattle, or movie-making in Hollywood.

Failure to provide public goods: As outlined above, free markets cannot provide most public goods, or goods that are non-exclusive and non-rival. Attempts to do so result in a free-rider problem, where consumers may enjoy the good without paying.

Because markets are the cause of market failures, it follows that markets cannot correct them. But they are solvable by government. For example, governments can educate consumers, regulate polluters, break up monopolies, subsidize retraining, retooling or relocating programs, and provide public goods like national defense.

Once you consider all the goods and services that only government can provide (or provide well), it should become clear that government plays an extensive, beneficial and irreplaceable role in society. Conservatives and libertarians who wish to scale back government would only create more problems than they solve.

Markets do have their advantages over government, depending on the type of goods and services offered. Markets are better at handling most private goods. Why? It is a truism that democracy only works when the people are educated. Voters would be overwhelmed trying to educate themselves on the best prices for bicycle parts, the best safety features for surgery or what 32 flavors an ice cream store should sell. It is easy to see that a lot of ignorant votes would be cast in a system where voters attempted to run every aspect of the economy. In a free market, customers can become experts only on the things they want to buy, and then vote with their dollars.

Under the current (and imperfect) system, markets also have other advantages of specificity. First, elections take place only once every two or four years, so consumer choice mechanisms are much weaker in government. (This could be solved by holding more frequent elections, initiatives and referendums.) Also, markets allow people to vote for very specific things — like Ben & Jerry's ice cream over Haagen Daz. In an election, people vote on generalities — like a politician's overall record, which may include disagreeable as well as agreeable policies. (This, too, could be resolved by allowing voters to vote on more specific issues and offices.)

In the final analysis, the correct ratio of government to market has a logical answer, based on the above considerations. We'll explore more of these considerations in greater detail throughout this FAQ.

Return to Overview