Markets Versus Governments

We provide a simple framework for comparing market allocations with government-regulated allocations. Governments can collect information about individuals’types and enforce transfers across individuals. Markets (without signi…cant government intervention) have to rely on transactions that are ex post bene…cial for individuals. Consequently, governments achieve better risk sharing and consumption smoothing than markets. However, politicians in charge of collective decisions can use the centralized information and the enforcement power of government for their own bene…ts. This leads to political economy distortions and rents for politicians, making government-operated allocation mechanisms potentially worse than markets. We provide conditions under which it is ex ante bene…cial for the society to tolerate the political economy distortions in exchange for the improvement in risk sharing. For example, more e¤ective controls on politicians or higher discount factors of politicians make governments more attractive relative to markets. Moreover, when markets cannot engage in self-enforcing risk-sharing arrangements and income e¤ects are limited, greater risk aversion and greater uncertainty make governments more attractive relative to markets. Nevertheless, we also show theoretically and numerically that the e¤ect of risk aversion on the desirability of markets may be non-monotonic. In particular, when markets can support self-enforcing risk-sharing arrangements, a high degree of risk aversion improves the extent of risk sharing in markets and makes governments less necessary. The same pattern may also arise because of “income e¤ects” on labor supply. Consequently, the welfare gains of governments relative to markets may have an inverse U-shape as a function of the degree of risk aversion of individuals. Keywords: governments, markets, mechanisms, political economy, risk sharing. JEL Classi…cation: H11, H21, E61, P16. This paper builds on and signi…cantly extends Section 8 of our earlier working paper “Markets Versus Governments: Political Economy of Mechanisms”NBER Working Paper No. 12224, April 2006. This paper is prepared for the Carnegie-Rochester Conference Series on Public Policy. We thank Georgy Egorov, Oleg Itskhoki, and Alp Simsek for excellent research assistance and Stefania Albanesi for comments. All three authors gratefully acknowledge …nancial support from the National Science Foundation.