ECONOMIC ROLES OF GOVERNMENT IN A MARKET ECONOMY

Under Ideal Market Conditions

• Almost no role as long as society only cares about efficiency• Define and enforce private property rights• Outcome will be efficient

• That state of the world in which all opportunities to make someone better off without making anyone worse off are exhausted

• Efficiency means not wasting resources• all resources allocated so that no more of one type of good can be

produced without having to produce less of another type of good.• This concept of production efficiency can be illustrated with a Production

Possibilities Curve

Consumption Goods

Cap

ital G

oods

0

Efficient

Inefficient

Production Possibilities Curve

• More generally, we can illustrate efficiency with Supply/Demand• efficiency means maximizing society’s net benefits from

producing/consuming• supply curve reflects society’s marginal cost of producing a good (MSC)• demand curve reflects society’s marginal benefit of consuming a good

(MSB)• society’s net benefits are maximized where MSC=MSB

S = MSC

D = MSB

Qe

0

$

ApplesQ1 Q2

At Q1 MSB>MSCso society can gainthis much extra net

benefit

At Q2 MSB<MSCso society can gainthis much extra netbenefit

Efficiency in Perfect Markets

In the Real World

• Conditions are not ideal• market failures

• externalities• public goods• monopolies

• business cycle• recessions• economic booms

• Society cares about more than efficiency• cares about economic fairness

• whatever that is!• wants to impose certain paternalistic requirements on consumption

• merit/demerit goods

The Roles of Government

• Allocation• correcting market failures• merit/demerit goods

• Redistribution• redistributive tax structure• redistribution in cash and in kind

• Stabilization• fiscal policy• monetary policy

Allocation

•Correcting market failure•externalities•public goods•monopolies•merit and demerit goods

Externalities

• Negative externality• costs not accounted for by economic decision maker

• Positive externality• benefits not accounted for by economic decision maker

• Externalities (both + and -) in production and consumption

• Causes divergence between market supply and MSC or market demand and MSB• Thus, market equilibrium not efficient

• that is, the market fails to achieve an efficient state• society stands to gain from government correction of the market failure

• Happens because of failure to define a property right• Air pollution

• lack of private property right to the atmosphere• factory uses the atmosphere as an input for which it does not pay• society incurs a cost not accounted for by the factory• too much of good produced

D=MSB

S

MSC$

Q0

External cost

QmarketQeff

A

B

CABC = welfare loss triangle = net social gain from reducing output to Qeff

overproduction

Negative Externality From Pollution

• Education• students receive private benefits from education• others receive benefit of associating with educated person• student cannot capture this public benefit

• i.e., lacks property right needed to charge for this service to others• causes too little education to be consumed

Q0

$

D

MSB

S=MSC

Qmarket Qeff

A

B

C

= welfare loss triangle= net social gain from increasing output to Qeff

ABC

Positive Externality From Education

Externality Policies

•Pollution• Pigouvian taxes

• tax factory • shifts S up to MSC• how to measure value of pollution/amount of tax• not common

• gas tax• tax the product

• works in short run but no incentive to find less polluting technology• tax the pollutant

• better long run incentives

• command and control• require pollution reducing capital, clean fuels, etc.

• e.g., stack scrubbers• lacks long run incentive to find better technology• same rules for all firms regardless of costs• easier to administer and politically more acceptable

• past reluctance to adopt market-based solutions like taxes

• pollution rights• 1990 Clean Air Act

• radical market-based departure from traditional reliance on standards• power generating firms issued rights to pollute

• these rights were for a level of pollution much lower than then-current levels• these rights are auctioned on the Chicago Board of Trade

• firms able to reduce pollution at lower cost than the price of a pollution right will sell• firms for which the cost of pollution reduction is higher will buy

•more pollution reduction by allowing firms that can reduce at lowest cost to reduce the most•incentive to find new ways to produce power with less pollution•anyone can buy, including environmental groups•want to rid the Earth of a ton of S02 each year? It’ll cost you about $200!

Public Goods

• an apple is a PRIVATE good• national defense is a PUBLIC good• What distinguishes private goods from public goods?

• private goods are EXCLUDABLE• public goods are NONEXCLUDABLE

• an apple is a private good because a consumer who does not pay the price can be excluded from consuming it

• no one can be excluded from consuming public goods -- can anyone not be protected?

• private goods are RIVAL in consumption• public goods are NONRIVAL in consumption

• if I eat an apple, you cannot• when I consume national defense, it’s still there for you to consume

• therefore, it costs nothing to provide to additional consumers• therefore, the efficient price is zero

• since no one can be excluded from consuming a public good, and since the efficient price is zero, the private sector would ordinarily not be able to provide it

• WARNING! A good is public or private because of these characteristics, not because the government provides it or doesn’t• governments provide all sorts of things, including private goods

• e.g., electricity, steel• private sector sometimes finds ways to provide public goods

• e.g., TV broadcasting

• Government provides public goods at zero price• Funding out of general budget

• we pay taxes based on income, consumption, etc., not on the amount of public goods we consume• for example, a household earning $100,000 pays more tax than a household earning

$10,000 but both consume the same national defense

• Quantity determined through political process

Mixed Goods

• Mixed goods have characteristics of both private and public goods• sometimes characteristics depend on circumstances

• highways are nonrival as long as few drivers are on them but become rival with congestion

• sometimes a nonexcludable good becomes excludable when technology changes• city streets

Monopoly

• Perfectly competitive firms produce efficient output• efficient output where P=MC

• Monopolies restrict output and drive up price• monopoly output not efficient because P>MC• society suffers a welfare loss

$

Q0

D

MC

MR

QM Qeff

Monopoly

PM

Peff

PM = monopoly pricePeff = efficient price

QM = monopoly quantityQeff = efficient price

Monopolywelfare loss

Two Types of Monopoly

• Artificial• requires some kind of barrier to entry

• legislated barrier, sole access to input, etc.• Microsoft???

• What is Microsoft’s barrier to entry?

• Natural• very high fixed costs must be spread over whole market

• breaking up makes no sense as it would raise average fixed costs that would be passed on to consumers

Monopoly Policy

• Artificial• break up

• prohibit collusion• U.S. anti-trust law

• Natural• two possibilities

• regulate to force firm to act as if it were a perfectly competitive firm• the usual response to natural monopoly in U.S.

• state provision• the usual response everywhere else

Merit and Demerit Goods

• Goods provision of which society wants to encourage (in the case of merit goods) or discourage• merit

• education• housing• health care

• demerit• tobacco• alcohol

• Various subsidies and taxes used to encourage or discourage consumption• housing allowances• sin taxes on tobacco and alcohol

• Direct provision• Medicaid

Redistribution

• Society cares about equity or fairness as well as efficiency• Thus a role of government is to create a more fair distribution than

the market produces• distribution of income• distribution of opportunity

• education• health

What is Fair?

• We know what an efficient allocation is• We have no idea what a fair distribution is

• equal income for all?

• Redistribution creates inefficiency• distorts returns to productivity• drives wedge between cost and value

Mechanisms to Redistribute

• Via the tax structure• progressive taxation• negative income tax

• Transfers• cash• in-kind

Progressive Taxation

• A progressive tax makes the after-tax (disposable) income more equal• Burden of tax rises as income rises

• as income rises, proportion of income paid as tax rises• in U.S., Federal Personal Income Tax

• A proportional tax has no redistributive effect• as income rises, proportion paid as tax stays the same

• in U.S., property taxes more or less proportional

• A regressive tax makes after-tax income less equal• as income rises, proportion paid as tax falls

• in U.S., Social Security tax, sales taxes

• In U.S., overall tax structure is proportional• progressivity of the Personal Income Tax is offset by regressivity of sales

and Social Security taxation

Redistributive Effect of U.S. Tax Structure

Negative Income Tax• Proposed from time to time

• a variant of NIT is used in U.S.

• Cash assistance through income tax• Structure of a negative income tax

• define income guarantee (IG)• define rate at which transfer phased out (t)• if transfer is T,earned income is IE, and disposable income is ID,

T = IG - t IE

ID = IE + T

• For example, suppose IG = $10,000 t = 0.5

then…

IE T ID

$0 $10,000 $10,000$1,000 $9,500 $10,500$2,000 $9,000 $11,000$5,000 $7,500 $12,500$10,000 $5,000 $15,000$15,000 $2,500 $17,500$20,000 $0 $20,000

Illustration of NIT

•Note that the higher IG or the lower t, the higher the income getting transfers•we can calculate break-even income, the income

at which T reaches $0: IB = IG/t

• for our example:

IB = $10,000/0.5 = $20,000

Transfers

Taxes

45o

IB

IG

0

Dis

posa

ble

Inco

me

Earned Income (IE)

Negative Income Tax

NIT Advantages/Disadvantages

• Advantages• simple and straightforward

• would be administered through income tax• could replace myriad of cash and in-kind programs

• Disadvantages• either t has to be high or IG low or NIT gets to be very expensive

Earned Income Tax Credit

• Like an NIT but only for workers• takes the form of a tax credit on Personal Income Tax that increases tax

refund

• Credits depend on income, children, and other factors affecting living expenses

• Major form of income support for the poor in U.S.• As of 1996, maximum credit was 40% of first $8,900

• max credit therefore $3,560

• Max credit earned until $11,650 and then phased out at rate of 21.06%• Dollar amounts indexed to inflation after 1996

45o

0

ID

IE

Earned Income Tax Credit

$8,900 $11,650 $28,450

$12,460

$15,219

$28,450

Transfers

Taxes

Transfers to the Poor (Welfare)

• Two major forms of cash transfers to the poor funded by Federal government• Temporary Assistance to Needy Families (TANF)• Supplemental Security Income (SSI)

• States also have general assistance programs for singles or childless couples

• Several in-kind transfers• Medicaid• food stamps• housing assistance• other

• employment and training• social services

• child care, rehabilitation, legal aid, etc.• energy assistance

Temporary Assistance to Needy Families (TANF)

• State administered• Federal government makes block grants to states to fund TANF

• block grant set amount that increases each year for inflation only• if a state spends less it can keep difference• if it spends more, it has to fund difference

• incentive for states to get poor off welfare

• Key elements of TANF• recipients must eventually work, be seeking work, or be in training or

school• recipient who has children over the age of five and who declines an offer of work

arranged by caseworker loses benefits• recipients lose benefits after two years without work

• only those with children under one year of age exempt• states receive grants to support child care so parents can work

• maximum lifetime benefit of five years• states may waive above requirements for disabled and others unable to

work• no more than 20% of caseload

•teen mothers on TANF required to live at home with responsible adult and attend school•unmarried mothers who do not help establish paternity lose 25% of benefits• funds available to help enforce child-support

laws• states that reduce out-of-wedlock births the

most receive bonus from Federal government

• Each state responsible for establishing its own rules within Federal requirements• Florida cuts payments for additional children born to those on TANF• Massachusetts limits support for two years in any five-year period• Wisconsin exempts virtually no one from work requirement• Mississippi has very low benefits and urges churches and charities to play

greater role

TANF Is New

• Result of major welfare reform enacted in 1996• For article from Economist magazine on consequences of the

reform, go to: http://www.economist.com/world/na/displayStory.cfm?Story_ID=751378

Supplemental Security Income

• Federally administered• Provides assistance to the poor who are aged, blind, or disabled• States can supplement SSI

Medicaid

• Health care for the poor under 65• Jointly funded by Federal governments and states• Eligibility determined by states

• generally eligible if on TANF or SSI

• Medical services billed directly to state• states determine reimbursement rates

• Most expensive of all programs of assistance to the poor• 6.35% of all Federal spending in 1997

• $105 billion• projected to rise to $243 billion by 2006

• 24 million recipients

Food Stamps

• Federally funded and state administered• Recipients receive coupons that can be redeemed for food and

related items• Varies with income and household size

Housing Assistance

• Subsidized housing for the poor• Public housing at low rents that vary by income• Subsidies for private housing

Federal Expenditures, 1997

% Total FederalProgram Amount Spending

SSI $27B 1.63TANF 20 1.21EITC 20 1.21

All cash 67 4.05

% Total FederalProgram Amount Spending

Medicaid $105B 6.35Food stamps 26 1.57Social services 7 0.42Child nutrition 9 0.54

All in-kind $147B 8.89

Cash versus In-Kind Transfers

• More than twice as much spending in-kind than cash• although most of in-kind is Medicaid

• Why not just give cash to spend as they like?• equivalent cash would make them better off than in-kind from THEIR

perspective• but donors are better off dictating consumption to the poor

Minimum Wage

• Federal legislation requiring firms to pay workers no less than a minimum wage• currently $5.15 per hour

• Purpose to assure workers receive a “living wage”• Makes low-skilled workers less employable

WE

WMin

0Labor

Wage

LELMin LS

DL

SLIncreased unemployment

II

Effects of Minimum Wage

I III

I: Better off - working at higher wageII: Worse off - unemployedIII: Want to work at higher wage but cannot find work

Distribution of Income in U.S.

• 11.8% lived in poverty in 1999 • poverty defined as income equal to three times that needed to buy an

adequate diet• arbitrary definition but gives us a benchmark to make annual comparisons

• Percent poor fell steeply from 1960 (22.2%) to 1973 (11.2%), rose to new high in 1983 (15.2%) and fell to 13.8% in 1995, 12.7% in 1998, and 11.8% in 1999

• Ratio of rich to poor has risen steadily, however• In 1947 ratio of richest fifth to poorest fifth of households was 8.6• In 1997 ratio was 13.7

Percent Share Money Income

Lowest HighestYear Fifth Fifth Ratio1947 5.0 43.0 8.61967 4.0 43.8 11.01977 4.3 43.7 10.21987 3.8 46.7 12.31997 3.6 49.4 13.71999 3.6 49.4 13.7

Lorenz Curves

• Graphical representation of distribution of income• Table shows distribution by quintiles for 1968 and 1992

• We can plot these data to construct a Lorenz Curve

• The diagonal represents perfect equality• The more unequal, the more bowed out from the diagonal• Good way to visualize, but not good when quantification needed

Gini Coefficient

Households ranked by income

Perc

ent i

ncom

e

0%

100%

100%

A

B

Gini Coefficient =Area A

(Area A+Area B)

Lorenz Curve

•Gini coefficient takes value of zero with perfect equality and 1 with perfect inequality•Gini coefficient makes it easy to plot distribution of income over time, as in the following graph

•Increasing equality until late ’60s followed by increasing inequality•Table and graphs on Lorenz curve and Gini coefficient from

Social Security

•Several programs all funded through payroll taxes• government-provided pension• what most think of by the term “Social Security”

• disability payments• health care for the elderly• unemployment compensation

•The most expensive of all government programs in U.S.• surpassed national defense in 1993

Social Security Retirement• Pensions funded by payroll taxes of 7.65% paid by both employees

and employers on first $72,600 of wages (in 1999)• self-employed pay 15.3%• maximum wage base indexed to inflation

• Basic pension available at retirement at age 65• retirement at 62 with reduced pension available

• Essentially a “pay-as-you-go” system

•private retirement systems are fully funded• contributions build a fund from which

earnings pay benefits

•Social Security not fully funded•benefits paid from taxes collected• essentially a transfer from workers to retirees• because of baby-boom tax revenues exceed

pension payments so a fund is building up currently•will reach its max sometime during the next

twenty years as baby-boomers retire• fund will then shrink until it is gone unless tax

rates go up, retirement age is increased, or some other adjustment is made

• Pension amount a function of past earnings, age, marital status, number of dependents, etc.• must have paid Social Security taxes for at least forty quarters to qualify

• Pensions also paid to dependent spouses over 65 at one-half the worker’s pension• widows/widowers get what the spouse would have gotten

• Strong redistributional element• gross replacement rate (ratio of benefits to pre-retirement wages) falls as

pre-retirement income rises• worker earning 45% of average wage earnings would have a GRR of almost 60%• average wage earner a little over 40%• worker earning at the maximum wage tax base around 25%

• Social Security pensions are tax-free • average wage earner’s 40% GRR is more like 50% on an after-tax basis

• Incentive effects• obvious disincentive to work past 65

• many opt to retire at 62 when Social Security becomes available at a reduced rate• savings and capital formation

• reduces need to save for retirement• disincentive to work past 65 increases need to save for retirement

• net effect may be a wash

Health Insurance For The Elderly

• Two parts• Part A is hospitalization insurance for the elderly

• Financed by 2.9% tax on all wages paid by both employers and employees• covers only medically necessary care in hospitals and is subject to a

deductible

• Part B is voluntary medical insurance available at highly subsidized rates• premiums cover only about a fourth of costs• subject to deductible of 20% and maximum payments for each medical

procedure

• Medicare spending amounts to over 11% of total federal spending or 2.4% of GDP

Unemployment Compensation

• Income support for workers temporarily out of work• temporarily laid off• lost job through fault not of their own

• does not cover loss of job through misconduct• does not cover work loss due to labor disputes

• worker must be full-time and have worked a minimum time to qualify for benefits

• Funded by Federal tax on payrolls• first $7,000 of wages• tax levied on employer only• tax rate varies by each firm’s employment record

• firms that lay off workers frequently pay higher taxes

• Each state levies own tax to supplement Federal fund• base and rates vary by state• base always equal to or greater than Federal base

• Benefits vary widely by state• high of about two-thirds of lost wages plus dependent allowance• average only about 35%

• has been declining in recent years

• Benefits normally last only for a maximum of 26 weeks• Benefits extended 13 weeks in recessions• Congress may extend even further• Average worker uses only 8 weeks

• Incentive effects• availability of unemployment compensation makes the period of

unemployment easier to take• both negative and positive effects

• reduces incentive to look for a job• increases unemployment rate

• one study estimates that a ten percentage point increase in replacement rate increases unemployment by 1.5 weeks

• allows worker to extend job search• potentially more fruitful job search