Topic I: Economics and the Public Sector

Business Administration and Management

Fall 2015-2016

Departament d’Economia Pública, Economia Política i Economia Espanyola

Bibliography

Rosen and Gayer:

• Chapter 1

• Chapter 4

• Chapter 5

1. The Public Sector: Introduction

2. Functions of the public sector: Why does the

public sector intervene in a market economy?

i. Efficiency (public goods)

ii. Redistribution

iii. Stabilization of the economic cycle

Musgrave, (1959)

Outline

• The Soviet Union contains some of the most fertile agricultural land in the world.

• Prior to the communist revolution of 1917 Russia was the world’s largest exporter of

grain.

Collectivization of agriculture during the 1920s and 1930s was quickly followed by

dramatic declines in agricultural output. Between five and ten million Russians died

of starvation during these years with twelve to thirteen million more saved by food

donated from the Western capitalist countries.

Incentives matter!

Introduction: What if the State bans private property

What is Public Economics or Public Finance?

Part of economics that studies the intervention of the public sector in a market economy,

mainly through financial activity (i.e. public revenues and expenses).

• Public Economics: Economic decisions of the public sector and/or the reaction of

private agents to the public sector

• Public Finance: Decisions directly related to public revenues and expenditures.

Public

Economics Economics

Introduction: The Public Sector

(Public) Economics & Policy

Twofold approach:

1. What are the measureable effects of government programs and

interventions? (positive analysis)

2. What should the government do if we can choose optimal policy?

(normative analysis)

Closely related: Political Economy

• Why do governments behave the as they do?

(e.g. climate change)

Introduction: The Public Sector

When we do NOT need a public sector…

First Welfare Theorem

Private markets provide a Pareto efficient outcome under the following conditions:

• Private good

• No externalities

• Perfect competition 1) All firms sell an identical product

2) All firms are price takers

3) All firms have a relatively small market share

4) Buyers have complete information about the product being sold and the prices charged by each firm

5) The industry is characterized by freedom of entry and exit.

Functions of the Public Sector

• If Q<Q*, the marginal revenue exceeds the marginal cost (under-provision)

• If Q>Q*, the marginal cost exceed the marginal revenue (over-provision)

Aggregate Supply

(Marginal Cost)

Aggregate demand

(Marginal Revenue)

Functions of the Public Sector How it should be

The market maximizes the consumer’s and

producer’s surpluses

The market is not always in this equilibrium due to the existence of market failures.

• Public goods (goods that are non-rival and non-excludable)

• Externalities

• Natural Monopolies

• Information asymmetry (adverse selection and moral hazard)

Functions of the Public Sector Market Failures

Functions of the Public Sector How it should be – Private goods

• Rival: a good taken off the shelf it isn’t there for other people to consume.

• Excludable: once you buy it, you own it and can consume it as you please.

The aggregate demand for private goods is derived by summing individual

demand horizontally:

We sum private goods horizontally, because consumers cannot consume the

same units

Functions of the Public Sector How it should be – Private goods

A simple example: Fig Leaves (f)

Source: Rosen and Gayer (Chapter 4)

Functions of the Public Sector How it should be – Private goods: e.g. Fig Leaves

price=marginal cost: efficient provision

Characteristics of public goods (e.g. national defense):

1. Non-rival consumption: The consumption of a good by an

individual doesn’t ↓ the available q for the rest of individuals. The

mg cost of a new individual that starts consuming is equal to 0.

• a good cannot be taken “off the shelf” because individuals

enjoy the same.

2. Non-excludable consumption: It is not possible to prevent the

consumption of a good by someone who is not paying for it.

• everybody can enjoy the public good.

The aggregate demand for public goods is derived by summing

individual demand vertical: We sum public goods vertically, because

consumers can consume the same units.

Functions of the Public Sector Market Failures: Public Goods

A simple example: Fireworks

EFFICIENT PROVISION

Why are public goods a market failure?

• Inefficient market provision - unlike price, quantity is not an

effective market mechanism:

For a given quantity, individuals will not automatically self-select their

optimal price, but will instead wish to pay the lowest price possible

when they cannot be excluded from consuming the good.

If the consumption of a good is non-excludable, the market will not

provide it.

the free rider problem occurs when those who benefit from

resources, goods, or services do not pay for them, which results

in an under-provision of those goods or services.

Public Sector Interventions:

public provision

Functions of the Public Sector Market Failures

excludable

yes no

yes private good

natural

monopoly

(e.g. cable tv)

common

resource

(Fishing

grounds)

public good

(national

defense)

Public goods ≠ goods provided by the public sector

• Public sector might or might not provide public goods

Goods Classification:

If the consumption of a good is non-rival but excludable, there may be

private provision, but it will be sub-optimum

Functions of the Public Sector Market Failures: Non-rival and Excludable Goods

public provision?

Example: Natural Monopoly

In some industries, there are very high fixed costs associated with the starting of the activity (natural barriers to entry)

• Railways

• Energy

• Gas

• Telephony

Decreasing average costs (due to the high fixed costs)

Efficient solution: A single producer, public or private?

Functions of the Public Sector Market Failures: Natural monopolies

Monopoly

profits:

Not efficient!

In perfect competition:

In Monopoly: Pr>MC

Monopoly

Loss for the

monopolist:

he is in deficit

Monopoly

Possible solutions:

A. Regulation

1. price at the average cost level (still not

efficient!)

2. Taxes to finance the deficit (even more

inefficient?)

B. Incentivize competition

C. Nationalization

Externality: Utility or production of an agent depends directly on the actions of another agent

This “effect” is NOT included in the price

Defined in 2 dimensions:

Positives vs. Negatives

Production vs. Consumption

Positives / consumption

Vaccine, Education

Negatives / consumption

Tobacco, Alcohol,

Hydrocarbon

Positives / production

R&D, on-the-job training

Negatives / production

Contamination of a river,

Noise pollution

Functions of the Public Sector Market Failures: Externalities

Qm=Sub-optimal demand for the good

MC (S) Ext

MR social=D+ext

e.g. Vaccines (positive)

PS Intervention : Increase the consumption of the good

(subsidize vaccine)

Marginal Benefit (MB)

e.g. contamination of a river (negative)

Qm=Over-provision of the good

MC private (S)

MC social=S+ext

PS Intervention:

Decrease the production of the good (tax on the dumping of waste, regulation,…)

• IF the costs of bargaining are low

• And IF the owners can identify the source of damages and legally prevent them

An efficient solution will be achieved simply by assigning property rights without any State intervention (known as Coase Theorem)

• e.g. Animal hunting

• Lisa fishes in the river

• Bart owns a firm polluting a river: Bart creates a negative externality

Externalities are due to inability to establish property rights: why?

• If Lisa owned the river, she could tax Bart for polluting, in turn Bart will reduce his level of pollution to save money

• If Bart owned the river, he could tax Lisa for fishing, in turn Bart will reduce his level of pollution otherwise Lisa would stop fishing

Animal hunting: Elephant populations in Africa

• Kenya’s approach in 1977: ban hunting

Drop in elephants from 167.000 to 16.000 by 1989

• Zimbabwe in 1982: individuals owning lands get property rights to wild animals

Increase in elephants from 40.000 to 68.000 by 1995

In Kenya the cost of an elephant killed was 0 for the landowner;

In Zimbabwe the landowner had an incentive (tourists’ safari) to protect the animals.

Qm=Sub-optimal demand for the good

MC (S) Ext

MR social=D+ext

e.g. Vaccines (positive)

PS Intervention : Increase the consumption of the good

(subsidize vaccine)

e.g. contamination of a river (negative)

Qm=Over-provision of the good

MC private (S)

MC social=S+ext

PS Intervention:

Decrease the production of the good (tax on the dumping of waste, regulation,…)

Marginal Damage (MD)

private MC + MD =

Marginal Social Cost

private MC

• Fixed amount of pollution per unit of output

private MC + MD =

Marginal Social Cost

private MC

• Fixed amount of pollution per unit of output

Loss for Bart

Gain for Lisa

• Empirical issues:

• Which pollutions do harm?

• What activities produce pollution?

• What is the value of the damage done?

• E.g. effect on houses’ prices

private MC + MD = Marginal

Social Cost

private MC

• Pigouvian Tax: a tax on each unit of output in an

amount equals to the marginal damage at the efficient

output

private MC + cd

• Compensating Lisa with the tax will be inefficient as others will decide to fish just to receive the compensation: the result is an inefficient amount of fishing in the river

• Empirically: difficult to implement in some circumstances

• E.g. tax on gasoline instead of tax of miles driven (difficult to measure in different points in time and space)

• Other solutions:

• Fees on emissions

• instead of units of output, on units of pollution

• Cap-and-Trade

• The government sells pollution permits

1. Adverse selection (example: insurance)

• In the insurance market, there are high-risk and

low-risk individuals

• If the company can’t distinguish the 2 types of individuals,

• Low-risk individuals won’t contract the insurance (too costly for them!)

• High-risk individuals will contract the insurance (but then profit <0)

Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries

Public provision: public health insurance

Regulation: compulsory health insurance (everybody need to get insurance)

E.g. medical insurance

• Lisa is a very healthy girl, she is willing to pay up to 1000euro per year for

a medical insurance

• Marge is a ordinary middle age woman, she is willing to pay up to

5000euro per year for a medical insurance

• Homer is troublesome guy, he is willing to pay up to 7000euro per year

• Mr Burns is a very old sicky guy, he is willing to pay up to 10000euro per

year for a medical insurance

The insurance know the average health costs, he cannot perfectly distinguish

among sick and healthy people: (1000+5000+7000+10000)/4=5750

Only Homer and Mr Burns will buy the insurance for an average cost of

(10000+7000)/2=8500

The insurance company will lose: (2*8500)-(2*5750)=-5500

2. Moral Hazard: the insurance modifies the behavior of individuals, reducing

the effort on preventing the risk from realizing.

If individuals can affect the probability of the risk (losing a job), no one will

provide insurance for it (unemployment insurance)

Public Sector Intervention:

Public provision: e.g., public unemployment insurance

Objective:

Stabilizing the economics fluctuations by fiscal policy:

Expansive during recessions: Increase the disposable income

(increase expenditure and/or decrease taxes)

Restrictive during expansions: Decrease the disposable income

(decrease expenditure and/or increase taxes)

Automatic stabilizers:

government budget policies, particularly income taxes and welfare spending,

automatically act to dampen fluctuations in real GDP

during recessions: unemployment benefits automatically increase

during expansions: income and corporate tax revenues increase

Functions of the Public Sector Stabilization

1. The Public Sector: Introduction

2. Functions of the public sector: Why does the

public sector intervene in a market economy?

i. Efficiency (public goods)

ii. Redistribution

iii. Stabilization of the economic cycle

Musgrave, (1959)

Outline

Economic Inequality

• Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve

• Inequality Trends

• Causes of Inequality

• Effects of Inequality

Most of the content of this unit are not in the book!

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Economic Inequality

DEFINITION: Inequality studies focus on the unequal distribution

of resources among agents (e.g. individuals, countries)

Source: World Bank (various 1994-2011)

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• A curve showing the proportion of national income

earned by a given percentage of the population.

• E.g. what proportion of national income is earned by

the top 10% of the population?

Lorenz Curve

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Lorenz Curve

% of National Income

Percentage of Population

This line represents the situation if income was distributed equally.

The poorest 10% would earn 10% of national income, the poorest 30% would earn 30% of national income.

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% of National Income

Percentage of Population 30%

In this second example, the Lorenz curve lies further below the line of equality.

Now, the poorest 30% only earn 7% of the national income.

Lorenz Curve

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Lorenz Curve

Gini Coefficient

ational In

Percentage of Population

Gini Coefficient= A / (A + B)

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The Great Gatsby Curve

• The Great Gatsby Curve illustrates the connection

between concentration of wealth in one generation and

the ability of those in the next generation to move up the

economic ladder compared to their parents (economic

mobility)

• Social Mobility important source of economic growth,

innovation and political stability

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Left axis: intergenerational elasticity of income - how much a 1 percent rise in your father’s income affects your expected income -.

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Kuznets Curve

• Before Industrialization: low inequality

• First stages of Industrialization: inequality goes up

• Only some social classes benefit (productivity gap, e.g. industry

Vs agriculture)

• Later Stages of Industrialization: wealth spreads to other

social classes (e.g. rural areas)

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Kuznets Curve

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•Is it true?

Kuznets curve seems valid only for comparisons across

countries and not within countries

Economic Inequality

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Inequality: Perceived Vs Real

Source: Norton, M. I., & Ariely, D. (2011). Building a better America—One wealth quintile at a time. Perspectives

on Psychological Science, 6(1), 9-12.

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Inequality: Perceived Vs Real

Source: Norton, M. I., & Ariely, D. (2011). Building a better America—One wealth quintile at a time. Perspectives

on Psychological Science, 6(1), 9-12.

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Inequality Over time

Source: IMF

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Source: IMF

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Source: IMF

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Source: IMF

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A Global Perspective: Inequality

Main Points

• Inequality mostly increased in the last decades at the

country level

• Inequality slightly decreased in the last decades at the

global level

• Global Inequality is higher than inequality across countries

• Income increased mostly in some developing countries

(e.g. China) and at the very top of the income distribution

(i.e. top 1%)

• Perceived inequality is lower than real and “ideal”

inequality

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Economic Inequality

26-11-2014 67

Causes of Inequality

Difficult to identify clear mechanisms, however most

plausible reasons of the recent increase in inequality are

(source IMF):

• Skill-biased technical change and globalization:

increased demand for high skill jobs and decreased

demand for low skills jobs

Indeed, supply of high skill workers did not increase

sufficiently

26-11-2014 68

Causes of Inequality

• Unions’ power declined: union membership declined

and globalization reduced unions’ bargaining power

• Change in social norms: we accept more inequality

(e.g. compared to the past, we tolerate huge pay gaps)

26-11-2014 69

Capital in the 21st century

• Piketty’s point:

• In an economy where the rate of return to wealth (or

capital) is higher than the rate of economic growth,

inherited wealth will always grow faster than earned

wealth

26-11-2014 70

• 2 individuals, A and B

• A does not work but he owns and he gets rents

out of it = r

• B does not own anything but he works and B’s

wage depends upon economy growth rate = g

• In economic terms, r = net-of-tax rate of return on capital;

g = growth rate

• If r>g A will become richer and richer compared to B…

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• Piketty’s point:

• In an economy where the rate of return to wealth (or

capital) is higher than the rate of economic growth,

inherited wealth will always grow faster than earned

wealth

• Inequality goes up

• This was typical pre-industrial society

• Piketty warns we are going back to this scenario

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Economic Inequality

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Consequences of Inequality

• Inequality might decrease social mobility (Great Gatsby Curve)

• Efficiency Vs Equity good or bad for growth?

• Effects on social outcomes

• Political Rent Seeking

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• Providing incentives for innovation and entrepreneurship (Lazear and Rosen, 1981)

• Raising saving and investment if rich people save a higher fraction of their income (Kaldor, 1957)

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• It deprives the poor of the ability to stay healthy and

accumulate human capital

• It generates political and economic instability that reduces

investment

• It impedes the social consensus required to adjust to

shocks and sustain growth

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Efficiency Vs Equality

In a nutshell…

• Good inequality increase incentives for innovation, entrepreneurship and economic growth.

• Bad inequality creates obstacles for poor people to receive education and to access credit, that impediment economic development

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Recent studies mostly argue that too high inequality can be disruptive for growth (e.g. IMF’s studies and Alesina and Rodrik, 1994)

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Political Rent Seeking: The Price of Inequality (Stiglitz, 2012)

• Those with power use it to insulate themselves from competitive forces by winning favourable tax treatment and government-protected market share

• E.g. decreasing taxes on top income & corporations; electoral campaign contributions; think tanks

• This might lead to the growth of populist movements…

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Solution: more redistributive policies?

They might have the reverse effect (decrease growth and additionally foster inequality)!

E.g. of win-win policies

• Taxes on activities with negative externalities paid mostly by the better-off (such as, perhaps, excessive risk-taking in the financial sector)

• Cash transfers aimed at encouraging better attendance at primary schools in developing countries

• Fight tax-avoidance

26-11-2014 81

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