Economics of the Public Sector

The Role of Government Capitalism is associated with limited government, but

government is necessary for three reasons: Establish and maintain legal system to protect property

rights. Promote equity in the distribution of income and wealth. Correct inefficiencies that arise from markets (externalities,

public goods, and monopoly power). Public Finance/Choice is the area of economics that

studies the public sector. Incentives are different in markets versus political sphere– in

capitalism preference are revealed with purchases versus votes.

Another Look at Efficiency Efficiency in competitive markets occurs

where MB=MC. Where MB= private (max.) willingness to pay and MC= private (min.) willingness to sell.

More correctly, society will see the outcome as efficiency where marginal social benefits = marginal social costs.

Externalities drive a wedge between private and social benefits and private and social costs.

Figure 1 The Market for Aluminum

Copyright © 2004 South-Western

Quantity ofAluminum

0

Price ofAluminum

Equilibrium MB=MC

Demand(private value)

Supply(private cost)

QMARKET

Externalities Externalities are benefits (costs) received (borne) by

neither the seller or the buyer but by third parties. Private benefits + external benefits = social benefits Private costs + external costs = social costs Since external benefits and costs are not perceived

by buyers and sellers they are not captured in markets.

Therefore, markets may fail to allocate resources inefficiently.

Negative externalities Marginal social costs are greater than marginal private

costs. Pollution is a cost that may not be borne by sellers, but

it is a cost nonetheless to society. Private markets will overproduce (devote too many

resources) to the production of goods with negative externalities.

External costs and the supply curve. Missing the extra costs, markets generate an outcome

where MSC > MSB, signal that decreasing output will increase net social benefits.

Is zero pollution efficient?

Figure 2 Pollution and the Social Optimum

Copyright © 2004 South-Western

Equilibrium

Quantity ofAluminum

0

Price ofAluminum

Demand(private value)MPB=MPB

Supply(private cost)=MPC

SocialCost =MSC

QOPTIMUM

Optimum

Cost ofpollution

QMARKET

MSC

MSB

MSC

MSB

Positive externalities Marginal social benefits are greater than marginal

private benefits. Education is a benefit not only to the individual but to

society in general. Private markets will underproduce (devote too few

resources) to the production of goods with positive externalities.

External benefits and the demand curve. Missing the extra benefits, markets generate

outcomes where MSB > MSC, a signal that increasing production will increase net social benefits.

Figure 3 Education and the Social Optimum

Copyright © 2004 South-Western

Quantity ofEducation

0

Price ofEducation

Demand(private value)

Socialvalue

Supply(private cost)

QMARKET QOPTIMUM

Internalizing or Correcting Externalities

Efficiency versus who ought to modify their behavior? Moral and Ethical Codes Non-governmental organizations or Charities Integrating certain activities (bee keepers and fruit growers) Contract between parties Coase Theorem – if negotiation costs are zero, private

parties can resolve the problem of externalities. An optimal compensatory payment (bribe) = one that makes both

parties better off. Initial distribution of rights does not affect the efficient outcome, but

it does determine who will pay whom. Example of heating the apartment in Santiago

Government policies Regulation

Limits to pollution Specific technology requirements Government production Regulation and least cost solutions

Taxes and Subsidies (Pigovian) Who should pay the tax or receive the subsidy?

Tax /subsidy incidence is the same External costs, supply (demand) and the optimal tax. External benefits, demand (supply) and the optimal

subsidy.

Tradeable Pollution Permits The higher costs of avoiding pollution, i.e. the

higher the benefits from polluting, the more a firm is willing to pay.

Equivalence of Pigovian Taxes and Pollution Permits

Criticism of Economic Solutions to Taxes To live is to pollute Natural carrying capacity

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

Copyright © 2004 South-Western

Quantity ofPollution

0

Price ofPollution

Demand forpollution rights

P Pigoviantax

(a) Pigovian Tax

2. . . . which, togetherwith the demand curve,determines the quantityof pollution.

1. A Pigoviantax sets theprice ofpollution . . .

Q

Figure 4 The Equivalence of Pigovian Taxes and Pollution Permits

Copyright © 2004 South-Western

Quantity ofPollution

0

Demand forpollution rights

Q

Supply ofpollution permits

(b) Pollution Permits

Price ofPollution

2. . . . which, togetherwith the demand curve,determines the priceof pollution.

1. Pollutionpermits setthe quantityof pollution . . .

P

The Invisible Hand and Invisible Benefits and Costs Externalities are “invisible” to buyers and sellers

in markets. In some cases, government action may be needed to make them visible and ensure they are included in economic decision-making.

The efficient allocation of resources occurs where:

MSB=MSC

Public Goods and Common Resources Certain kinds of goods or services are

underproduced in markets because the market does not contain sufficient incentives to produce them in efficient amounts.

Certain kinds of resources are overused because they are owned collectively or people cannot prevent them from being used.

Classifying Different Kinds of Goods and Services

Exclusion or non-exclusion– can individuals be excluded from consuming the good or the resource. (e.g. hamburger, houses, physical examination versus fireworks, national defense, and the ocean outside of territorial waters)?

Rival or non-rival – does one person’s use of the good or resource affect another persons use. (e.g. hamburger versus lighthouse, uncongested versus congested highway)

Figure 1 Four Types of Goods

Copyright © 2004 South-Western

Rival?

Yes

Yes

• Ice-cream cones• Clothing• Congested toll roads

• Fire protection• Cable TV• Uncongested toll roads

No

Private Goods Natural Monopolies

No

Excludable?

• Fish in the ocean• The environment• Congested nontoll roads

• Tornado siren• National defense• Uncongested nontoll roads

Common Resources Public Goods

Private Good – excludable and rival (hamburger)

Public Good – not excludable and non-rival (lighthouse, warning siren)

Common Resource – rival but not excludable (ocean, old days pasture land)

Natural Monopoly – excludable but non-rival (protecting another house – MC is small)

Public Goods Examples are fireworks, national defense, basic

research, alleviating poverty) Free-rider problem – another example of revealed

preference. If people cannot be excluded, they have no little incentive to pay for the good or service).

Free-riders make it difficult for private providers to provide the optimal amount of a public good.

Voluntary exchange does not work efficiently and efficiency may be provided by government coercion.

Government Provision versus Production of Public Goods The government must perform cost-benefit

analysis to decide if it is worthwhile to provide the good and determine how much should be produced (valuing a life). Stoplights Highways – public or private, uncongested or

congested

Taxes are then imposed to provide for the good.

Tragedy of the CommonsBoston Commons – overuse of a rival

resource where individuals were not purposively not excluded.

Ocean FishingBison versus Cattle – the importance of

property rightsPricing in national parks

SummaryEfficiency and the market systemMarket failuresGovernment failures