Chapter 5Chapter 5

Public Spending Public Spending and Public Choiceand Public Choice

Three areas of concentrationThree areas of concentration

1. Explain how market failures, such as externalities, might justify economic functions of government

2. Distinguish between private and public goods and explain the nature of the free-rider problem

3. Describe the political functions of government that entail its involvement in the economy

What is Market Failure?What is Market Failure?• When the market produces more or

less than the ideal optimal good or service. OR the wrong mix of input is given for output…..

• Brings about externalities and public goods.

When the market fails… it is When the market fails… it is a double edge sworda double edge sword

Market Fails if not optimal mix.* Optimal Mix of Output…… “Most desirable combination of output attainable with existing resources, technology and social values.”

Market Failure *“An imperfection in the market mechanism that prevents optimal outcomes.”

Market FailureMarket FailureIs this evident in today’s market?Is this evident in today’s market?

*market moves resources from one industry to another. (price directs resources) (demand responds) (price moves the resources then to another demand choice) (at this point (competition begins to prevail to level the prices)

P

Q

P

Q

D1D2

What a Price System Can What a Price System Can and Cannot Doand Cannot Do

• In its most ideal form, a price system allows resources to move from lower-valued to higher-valued uses through voluntary exchange.

– Economic efficiency arises when all mutually advantageous trades have taken place.

• There are, however, situations when a price system does not generate the desired results.

What a Price System Can What a Price System Can and Cannot Do (cont'd)and Cannot Do (cont'd)

• Market Failure

– A situation in which the unrestrained market economy leads to too few or too many resources going to a specific economic activity• Prevents economic efficiency and individual

freedom

• Is addressed by public policy (government)

In real words?In real words?Not enough public parks… Not enough care for environment…Not enough welfare…Not enough healthcare…Too much separation between top 10%

income earners and median income earners…

Not adequate security within our borders….

Too many immigrants….

Socially Optimal Amount (Output)Socially Optimal Amount (Output)

Sometimes, the socially optimal amount is referred to as the efficient amount.

Correcting for Externalities Correcting for Externalities (cont'd)(cont'd)

• Market failure: an example

– Market failure occurs• Steel mill does not pay for the clean air

• Costs of production have “spilled over” to the residents (third parties)

• Lower production cost– More steel is produced than would otherwise be

the case

Market failure = (forces of S & D not leading us to BEST point on ppc… Who decides what is defined as BEST?

Enter…. Government intervention!Did you hear the words tax and

subsidy?

Will they perform magic?

Correcting for ExternalitiesCorrecting for Externalities• Externalities

– Occur when the consequences of an economic activity spill over to affect third parties

• Third Parties

– Parties who are not directly involved in a given activity or transaction

• Property Rights

– Rights of an owner to use and exchange property

Correcting for Externalities Correcting for Externalities (cont'd)(cont'd)

• Externalities are examples of market failures.

• Pollution is an example of a negative externality.

• Inoculations generate external benefits.

Correcting for ExternalitiesCorrecting for Externalities• Resource misallocations of

externalities

– External costs—market overallocates

– External benefits—market underallocates

• Government can correct negative externalities

– Special taxes (i.e. a pollution tax or “effluent fee”)

– Regulation

Correcting for Externalities Correcting for Externalities (cont'd)(cont'd)

• How the government can correct positive externalities

– Government financing and production

– Subsidies

– Regulation

There are two main types of economic instruments used in There are two main types of economic instruments used in environmental policy, both of which aim to provide an environmental policy, both of which aim to provide an

incentive to use resources sustainably: incentive to use resources sustainably:

• Price-based measures use charges, taxes and subsidies to persuade polluters to reduce their discharges.

• Rights-based measures "create rights to use environmental resources, or to pollute the environment, up to a pre-determined limit, and allowing these rights to be traded"

Other Economic Functions Other Economic Functions of Governmentof Government

• Providing a legal system

• Promoting competition

• Providing public goods

• Ensuring economy wide stability

The Other Economic The Other Economic Functions of Government Functions of Government

(cont'd)(cont'd)• Providing a legal system

– Enforcing contracts

– Defining and protecting property rights

– Establishing legal rules of behavior

The Other Economic Functions The Other Economic Functions of Government (cont'd)of Government (cont'd)

• Promoting competition

– Market failure may occur if markets are not competitive.• Antitrust legislation

• Monopoly power

The Other Economic Functions The Other Economic Functions of Governmentof Government

• Antitrust Legislation– Laws that restrict the formation of

monopolies and regulate certain anticompetitive business practices

• Monopoly– A firm that can determine the market

price, in the extreme case is the only seller of a good or service

The Public The Public Sector:Government’s role. Sector:Government’s role. Questions to ponder:

• What is Public Sector?• When do markets fail?• Should government step in?• Can people “ride free” in public

sector?

• Governments Enter the Market to assure:

1. Public Goods2. Externalities (positive or

elimination of negative)3. Market power4. Equity

Two concepts to rememberTwo concepts to remember

• Public goods… can be equally consumed by all… no restrictions

Skateboarding in the park… Terrorists… can also go to the park… Illegal immigrants can go to school…

• Private goods… consumption by one person excludes consumption by another..

( my doughnut… my car… etc)

But, if mix of output gets totally But, if mix of output gets totally out of whack…. Government takes out of whack…. Government takes

overover..

TranslationTranslationIf government and/or the consumer was

not acting as a watchdog…. Would corporations be diligent about utilizing the proper mix of resources…If they are, can they compete? Telecommunications Industry?

Does that always mean regulation increased?

Could it mean that consumer sovereignty switches to another desire… BUT… what about things like energy… would we really know if the provider was efficient?

Methods to Reduce PollutionMethods to Reduce PollutionGovernment sets pollution standardsMarket environmentalism –

Government allocates pollution permits and then allows them to be bought and sold

Government Allocates Pollution Government Allocates Pollution Permits (allows market to operate)Permits (allows market to operate)Agreement that a certain area can handle

“acceptable” amt of pollution.The amount is quantified, then parceled

into permits that “polluters” bid for in auction.

Can buy and sell pollution rights among companies bidding.

Allows some companies to pollute more than others… ones that are really “good” sometimes get perks like tax benefits… others have opportunity to pass on to their consumers (TXU)

Federal Government Federal Government Spending Compared to State Spending Compared to State

and Local Spendingand Local Spending

Sources: Budget of the United States government; government finances.

Government reallocates resources if 1) market produces “wrong” amount of certain g&S and 2) market fails to allocate resources to some g&s that are in best interest of society.

What are externalities? “costs or benefits of a market activity borne by a third party.”

Spillovers…an action when one individual or group harms the property of others without their consent.

Examples of spilloversExamples of spilloversThrowing trash in someone’s back

yardBurning ties in the alleyPlaying your stereo loudly at 3:00

a.m. Businesses dumping wastes, sludge

into riversPeople trashing the beach or

highway.Electric Companies burning

phosphorous fuels

Spillover Examples that perpetrate on Spillover Examples that perpetrate on others others

Calling police when loud party of teenagers next door (actions of teens imposing unwanted cost on neighbor)

Living in downstairs apartment.. Having upstairs neighbors doing Tai Bo when they get off work at 4:00 a.m.

Calling the city when a neighbor doesn’t keep his yard mowed on regular basis.

Externalities can be positive or Externalities can be positive or negativenegative

Homeowners keep lawns immaculate (benefits the neighborhood)

Scientific study for polio vaccine (others benefit beyond scientists’ recognition)

Education……. How would this be a benefit?

How can spillovers be corrected?How can spillovers be corrected?

Most obvious way is Legislation.1. To prohibit2. To heavily tax the specific product and

manufacturer. Tax would be derived to allow for off-setting the clean-up cost. (Super Fund is example)

3. Subsidize both consumers or producers 4. ***Tax incentives… if reduction of

pollution and compliance adhered to, taxes reduced.

A Corrective Tax Gone A Corrective Tax Gone WrongWrong

Government may miscalculate external costs and impose a tax that moves the supply curve from S1 to S3 instead of from S1 to S2. As a result, the output level will be farther away from the socially optimal output than before the “corrective” tax was applied.Q3 is farther away from Q2 than Q1 is from Q2.

Public Spending and Public Spending and Transfer Programs Transfer Programs

• Publicly subsidized healthcare

– Medicare• Began in 1965• Pays hospital and physicians’ bills for U.S.

residents over 65 with public monies• 2.9% of earnings taxed/ no cap• Second biggest domestic program in existence

– Medicaid• Subsidizes people with lower incomes

The Economic Effects of The Economic Effects of Medicare SubsidiesMedicare Subsidies

Subsidy M = customers pay Pd for quantity QmProviders receive price Ps for supply the good.

Collective Decision Making: The Collective Decision Making: The Theory of Public Choice Theory of Public Choice

• Government or Political Goods

– Goods (and services) provided by the public sector

• Majority Rule

– Collective decision making, decisions based on more than 50%

– Proportional Rule

– If 10% of “dollar votes” cast for blue cars, 10% of output is blue

Equity Equity or perhaps better stated or perhaps better stated as as InequityInequity.(ensuring market .(ensuring market

economy)economy)1)Inadequate income (redistribute to have-

nots) 2) Merit goods (everyone entitled to some

minimum of food,clothing, shelter) In-kind transfers in food stamps, housing vouchers, health clinics)

3)Social Security and unemployment compensation protect people’s economic security by providing money when they retire or are unable to work.

Opportunity cost… if government provides health care, private sector cannot compete. Government “crowds” out the private .

**** Remember, the largest opportunity cost of an item supplied by government is the best alternative use that could have been made of the resources required to provide that good.