MICROECONOMICS - Wikispacesrcclibrary.wikispaces.com/file/view/microecon_c05.pdf · The U.S. government plans to allocate $40 billion each ... Distinguish between private and public

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Chapter 5Public Spending and Public Choice

MICROECONOMICS

Professor Charles Fusi

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Introduction

The U.S. government plans to allocate $40 billion each year to firms that specialize in “clean-energy” technologies.

The government hopes that such technologies would lead to fewer emissions entering the atmosphere.

What can we learn from economics about possible ways in which the U.S. government might addressissues such as atmospheric pollution?

Lectures by Prof. Fusi

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Learning Objectives

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

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

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


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Learning Objectives (cont'd)

Analyze how Medicare affects the incentives to consume medical services

Explain why increases in government spending on public education have not been associated with improvements in measures of student performance

Discuss the central elements of the theory of public choice


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Chapter Outline

What a Price System Can and Cannot Do Correcting for Externalities The Other Economic Functions of Government The Political Functions of Government Public Spending and Transfer Programs Collective Decision Making: The Theory of Public

Choice


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What a Price System Can and Cannot Do

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

o 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


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

Market Failure

o 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)


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Correcting for Externalities

In a pure market system, economic efficiency occurs when individuals know and must bear the true opportunity cost of their actions

o In some cases, the price that someone actually pays for a resource, good, or service is higher or lower than the opportunity cost that all society pays


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Correcting for Externalities (cont'd)

Market failure: an example

o Assume

> No government regulation against pollution

> A town with clean air

> A steel mill opens and emits smoke that causes• More respiratory diseases• Dirtier clothes, houses, cars


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Market failure: an example

o 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


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Externalitieso Occur when the consequences of an economic activity

spill over to affect third parties

Third Partieso Parties who are not directly involved in a given activity or

transaction

Property Rightso Rights of an owner to use and exchange property


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Example: Space Age Litterbugs

Littering in space has created at least 18,000 objects of orbiting space junk.

After every space shuttle mission since 1981, NASA has spent about $400,000 to replace the shuttle’s debris-pitted windows.

At least once each day, scientists issue warnings of close encounters faced by orbiting commercial satellites.


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Externalities are examples of market failures

Pollution is an example of a negative externality

Inoculations generate external benefits


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Figure 5-1 External Costs and Benefits, Panel (a)


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Figure 5-1 External Costs and Benefits, Panel (b)


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Correcting for Externalities (cont’d)

Resource misallocations of externalitieso External costs—market overallocates

o External benefits—market underallocates

Government can correct negative externalitieso Special taxes (i.e. a pollution tax or “effluent fee”)

o Regulation


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How the government can correct positive externalities

o Government financing and production

o Subsidies

o Regulation


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The Other Economic Functions of Government

Providing a legal system

Promoting competition

Providing public goods

Ensuring economy-wide stability


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The Other Economic Functions of Government (cont'd)

Providing a legal system

o Enforcing contracts

o Defining and protecting property rights

o Establishing legal rules of behavior


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Promoting competition

o Market failure may occur if markets are not competitive.

> Antitrust legislation

> Monopoly power


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Antitrust Legislationo Laws that restrict the formation of monopolies and

regulate certain anticompetitive business practices

Monopolyo A firm that can determine the market price, in the

extreme case is the only seller of a good or service


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Providing public goods

o Goods to which the principle of rival consumption does not apply

o In contrast, private goods can be consumed by one individual at a time


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Principal of Rival Consumptiono Recognizes individuals are rivals in consuming private

goods

Public Goodso Can be jointly consumed by many individuals

simultaneously


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Characteristics of public goods

1. Can be used by more and more people at no additional opportunity cost

2. Difficult to charge for a public good based on consumption—the exclusion principle


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Exclusion Principleo Anyone can enjoy the benefits of a public good, even if

they have not paid for it

Free-Rider Problemo Arises when some individuals take advantage of the fact

that others will take on the burden of paying for public goods


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Ensuring economy-wide stability

o Smooth ups and downs in overall business activity

o Full Employment Act 1946

> Full employment

> Price stability

> Economic growth


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The Political Functions of Government

Government-Sponsored Goods (Merit Goods)o Goods deemed socially desirable through the political

process> Museums

Government-Inhibited Goods (Demerit Goods)o Goods deemed socially undesirable

> Illegal substances


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Why Not … classify broadband Internet access as a government-sponsored good and provide it to all U.S. residents?

One problem with government provision of broadband service to every U.S. resident is that no one knows exactly what “broadband” means.

A related problem is that the costs to taxpayers depend heavily on the broadband speed, especially for residents in rural areas.


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The Political Functions of Government (cont'd)

Income redistribution: includes progressive income tax system and transfers

o Transfer payments

> Money payments made by governments to individuals for which in return no services or goods are rendered

> Examples are Social Security old age and disability benefits and unemployment insurance benefits

o Transfers in kind

> Payments that are in the form of goods and services

> Include food stamps, subsidized public housing, medical care


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Public Spending and Transfer Programs

Government Outlays

o All federal, state and local spending

o Examples

> Defense, income security, Social Security—at the federal level

> Education, health and hospitals, public welfare—at the state level


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Figure 5-2 Total Government Outlays over Time


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Figure 5-3 Federal Government Spending Compared to State and Local Spending


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Public Spending and Transfer Programs (cont'd)

Publicly subsidized healthcare

o Medicare> Began in 1965> Pays hospital and physicians’ bills for U.S. residents over 65

with public monies> 2.9% of earnings taxed> Second biggest domestic program in existence

o Medicaid> Subsidizes people with lower incomes


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Figure 5-4 The Economic Effects of Medicare Subsidies


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Public Spending and Transfer Programs (cont’d)

To increase the quantity of medical care, the government pays a subsidy

o The price per unit paid to medical service providers increases

o The price per unit paid by consumers falls

o More medical services are consumed


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Policy Example: Seeking to Halt “Overuse” of Massachusetts Health Care

In 2006, the state of Massachusetts adopted a program analogous to Medicare for all of its residents.

Within 3 years, health care spending for a typical Massachusetts resident rose to 33 percent above the average for other U.S. residents, mainly due to the fact that the program “rewards overuse of services.”


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Economic Issues of Public Education

o State and local governments provide primary, secondary, and post-secondary education at prices well below those that would otherwise prevail in the marketplace

o Publicly subsidized, similar to government subsidized healthcare

o Education priced below market


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The Incentive Problems of Public Education

o Various measures of performance show no increase or decline in performance

o Many economists argue failure to improve relies on incentive effects

o Higher subsidies may translate to services unrelated to learning


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Example: Valuable Charter School Services—for Those Who Can Get Them

Charter schools are stated-funded schools that have the freedom to offer a variety of learning approaches.

Because many parents place higher values on the educational services of charter schools and the price of attending them is close to zero, the quantity of charter school services demanded exceeds the quantity supplied—hence the waiting lists.


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Collective Decision Making: The Theory of Public Choice

Collective Decision Making

o How voters, politicians, and other interested parties act and how these actions influence non-market decisions

Theory of Public Choice

o The study of collective decision making

o Assumes that individuals will act within the political process to maximize their individual (not collective) well-being


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Collective Decision Making: The Theory of Public Choice (cont'd)

Similarities in market and public-sector decision making

o Self-interest

o Opportunity cost

o Competition

o Similarity of individuals, but different incentive structures


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Incentive Structure

o The system of rewards and punishments individuals face with respect to their actions


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Differences between market and collective decision making

o Government goods at zero price

o Use of force

o Voting versus spending


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> Political system versus market system

• Political system run by majority rule

• Market system run by proportional rule


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Government or Political Goodso Goods (and services) provided by the public sector

Majority Ruleo Collective decision making, decisions based on more than

50%

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

blue


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> Spending of dollars can indicate intensity of want

> Votes cannot; each vote counts with the same intensity


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International Example: So Little Mail, So Little for So Many Post Offices to Do

As more people around the world transmit information via e-mail instead of physical letters and other documents, government-owned postal firms experience declines in mail volume.

Even though governments have been reducing the number of post offices they operates, they have been much slower to scale back their postal firms than if the firms were operated privately.


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You Are There: A Town Confronts a Parked Externality

In New Castle, Indiana, a resident lines some railroad tracks with dozens of yellow railcars covered with graffiti and marijuana leaves.

Those railcars are an eyesore to the community’s residents—a negative spillover from the market for rail transport services.


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The U.S. Department of Energy has announced that it would give away over $40 billion annually to businesses working on “clean technology.”

Some key recipients of the program are manufacturers of electric vehicles, such as General Motors and Ford Motor Company.

One difficulty with those vehicles is that the technology for charging vehicles’ batteries is still undeveloped.

Another difficulty is that the production of those batteries is not clean, even though those vehicles may be clean.

Issues & Applications: Uncle Sam Becomes an Investor in Clean-Energy Technology


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Summary Discussion of Learning Objectives

How market failures such as externalities might justify economic functions of government

o Market failure is a situation in which an unhindered free market allocates too many or too few resources to a specific economic activity

Private goods versus public goods and the free-rider problem

o Private goods are subject to rival consumption

o Public goods are not subject to rival consumption

o Free-riders anticipate others will pay


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Summary Discussion of Learning Objectives (cont'd)

Political functions of government that lead to its involvement in the economy

o Merit goods deemed socially desirable

o Demerit goods deemed socially undesirable

o Redistributing income

> Transfer payments

> In kind transfers


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The effect of Medicare on incentives to consume medical services

o Subsidies lead to a higher quantity of medical services consumed

o Medicare encourages people to consume medical services that are low in per-unit value relative to the cost


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Why bigger subsidies for public schools do not necessarily translate into improved student performance

o Last unit of educational services provided likely to cost more than its valuation by parents and students

o Services provided in excess of those best suited to promoting student learning


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Central elements of the theory of public choice

o Collective decision making

> Voters, politicians, other participants influence nonmarket choices

o Incentive structures

> Rewards and punishments affect provision of government goods

o Similarities and differences with market system structures

> Scarcity, competition—similarities

> Legal coercion, majority rule—differences


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MICROECONOMICS - Wikispacesrcclibrary.wikispaces.com/file/view/microecon_c05.pdf · The U.S. government plans to allocate $40 billion each ... Distinguish between private and public