MicroeconomicsUnit 4

The Economics of the Public Sector

In this Unit, You will learn…

• Externalities • Public and Private Goods, Common Resources,

and Natural Monoplolies • Progressive, Regressive, and Proportional Tax

Systems

Externalities

EconomicsP R I N C I P L E S O F

N. Gregory Mankiw

Chapter 10

Introduction

• Externalities are a type of market failure where there is one or more “side effects” to a transaction.

• These side effects can either be positive or negative

• Self-interested buyers and sellers neglect these external costs or benefits of their actions, so the market outcome is not efficient.

Negative Externalities

Examples of Negative Externalities include:• The neighbor’s barking dog• Noise pollution from

construction projects• Health risk to others from

second-hand smoke• Air pollution from a factory

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The market for gasoline

$2.50

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You are all familiar with Market Supply & Demand Graphs.

Here is one for the Gas Market

Equilibrium price= $2.50Equilibrium quantity= 25 gallons

Graphing Negative Externalities

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The market for gasoline

Analysis of a Negative Externality

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Social cost

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This is the shift in Private + External Cost

• External cost is the value of the negative impact on bystanders

• Here you see the Negative externality increases total social costs

• This needs to be changed by “Internalizing the externality”

• Without this, the market is inefficient since quantity is higher than social efficient point

• In other words, the social cost of the last gallon isgreater than its value to society.

The Negative externality is the harmful effect of smog and greenhouse gas emissions

“Internalizing the Externality”

• Internalizing the externality: The altering of incentives so that people take account of the external effects of their actions

• In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs, so supply shifts left

• Imposing the tax on buyers would achieve the same outcome

Positive Externalities• Being vaccinated against

contagious diseases protects not only you, but people who visit the salad bar or produce section after you.

• R&D creates knowledge others can use.

• People going to college raise the population’s education level, which reduces crime and improves government.

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The market for Flu Shots

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Once again, the Market Supply & Demand Graph this time for flu shots.

Equilibrium price= $20Equilibrium quantity= 25 gallons

Graphing Positive Externalities

$20

A C T I V E L E A R N I N G 1 Answers

Socially optimal Q = 25 shots.

To internalize the externality, use subsidy = $10/shot.

The market for flu shots

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Social value = private value + $10 external benefit

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Q

$external benefit

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Public Goods and Common Resources

EconomicsP R I N C I P L E S O F

N. Gregory Mankiw

Chapter 11

Introduction

• We consume many goods without paying: parks, national defense, clean air & water.

• When goods have no prices, the market forces that normally allocate resources are absent.

• The private market may fail to provide the socially efficient quantity of such goods.

Important Characteristics of Goods• A good is excludable if a person can be

prevented from using it. – Excludable: fish tacos, wireless internet access– Not excludable: FM radio signals, national defense

• A good is rival in consumption if one person’s use of it diminishes others’ use. – Rival: fish tacos– Not rival:

An MP3 file of Kanye West’s latest single

The Different Kinds of GoodsPrivate goods: excludable, rival in consumption (Not much more to them)

Example: foodPublic goods: not excludable, not rival (Covered more in depth in chapter)

Example: national defenseCommon resources: rival but not excludable (Covered more in depth in chapter)

Example: fish in the oceanNatural monopolies: excludable but not rival (Same as for Private goods, not much to them)

Example: cable TV

Public Goods• Public goods are difficult for private markets to provide

because of the free-rider problem. • Free rider: a person who receives the benefit of a good but

avoids paying for it – If good is not excludable, people have incentive to be free

riders, because firms cannot prevent non-payers from consuming the good.

• Result: The good is not produced, even if buyers collectively value the good higher than the cost of providing it.

• Important Public Goods: National defense, Knowledge created through basic research, Fighting poverty

Cost-Benefit Analysis• Cost-benefit analysis: a study that compares

the costs and benefits of providing a public good

• If the benefit of a public good exceeds the cost of providing it, govt should provide the good and pay for it with a tax on people who benefit.

• Cost-benefit analyses are imprecise, so the efficient provision of public goods is more difficult than that of private goods.

Common Resources• Like public goods, common resources are not excludable.– Cannot prevent free riders from using– Little incentive for firms to provide– Role for govt: seeing that they are provided

• Additional problem with common resources:rival in consumption

• Tragedy of the Commons: A parable that illustrates why common resources get used more than is socially desirable. – The tragedy is due to an externality: one person’s use of

the resource diminishes other’s use of it.– This cost is neglected leading to over use

• Important Common Resources: Clean air and water, Congested roads, Fish, whales, and other wildlife

The Design of the Tax System

EconomicsP R I N C I P L E S O F

N. Gregory Mankiw

Chapter 12

Introduction• As stated in Ch. 10 and 11, the government can improve

market outcomes by:– Providing public goods– Regulating use of common resources– Remedying the effects of externalities

• To perform its many functions, the goverment raises revenue through taxation. Remember that: – A tax on a good reduces the market quantity

of that good.– The burden of a tax is shared between buyers and sellers

depending on the price elasticities of demand and supply.

– A tax causes a deadweight loss.

Income and Consumption taxes

• income taxes reduce the incentive to save:– If income tax rate = 25%,

8% interest rate = 6% after-tax interest rate.– The lost income compounds over time.

• Some economists advocate taxing consumption instead of income. – Would restore incentive to save.– Better for individuals’ retirement income security

and long-run economic growth

Marginal and Average Tax Rates

• Average tax rate– total taxes paid divided by total income– measures the sacrifice a taxpayer makes

• Marginal tax rate– the extra taxes paid on an additional dollar of

income– measures the incentive effects of taxes

on work effort, saving, etc.

Lump Sum Taxes• A lump-sum tax is the same for every person

Example: lump-sum tax = $4000/person• A lump-sum tax is the most efficient tax: – Causes no deadweight loss: Does not distort

incentives.– Minimal administrative burden: No need to hire

accountants, keep track of receipts, etc. • But they are perceived as unfair:– In dollar terms, the poor pay as much as the rich.– Relative to income (as a percentage), the poor pay

much more than the rich.

Principles with Taxes• Benefits principle: the idea that people should pay taxes

based on the benefits they receive from government services– Tries to make public goods similar to private goods – the

more you use, the more you pay• Ability-to-pay principle: the idea that taxes should be levied

on a person according to how well that person can shoulder the burden– Suggests that all taxpayers should make an “equal

sacrifice” that depends not just on the tax payment, but on the person’s income and other circumstances

– Called Vertical equity: the idea that taxpayers with a greater ability to pay taxes should pay larger amounts

Tradeoff of Efficiency and Equity• There are two types of equity:• Vertical equity: the idea that taxpayers with a

greater ability to pay taxes should pay larger amounts• Horizontal equity: the idea that taxpayers with

similar abilities to pay taxes should pay the same amount– Problem: Difficult to agree on what factors,

besides income, determine ability to pay.• The tradeoff of efficiency and equity leads

governments to try and find the pest possible tax system

Three Tax Systems• Proportional tax:

Taxpayers pay the same fraction of income, regardless of income

• Regressive tax: High-income taxpayers pay a smaller fraction of their income than low-income taxpayers

• Progressive tax: High-income taxpayers pay a larger fraction of their income than low-income taxpayers

Flat TaxesFlat tax: a tax system under which the marginal tax rate is the same for all taxpayers– Typically, income above a certain threshold is taxed at a

constant rate– The higher the threshold, the more progressive

the tax– Radically reduces administrative burden– Not popular with

• people who benefit from the complexity of the current system (accountants, lobbyists)

• people who can’t imagine life without their favorite deduction/loophole

– Used in some central/eastern European countries

End Of Unit 4

“Government's view of the economy could be summed up in a few short phrases: If it moves, tax

it. If it keeps moving, regulate it. And if it stops moving, subsidise it” Ronald Reagan (America’s

40th US President (1981- 89), 1911-2004)