Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 5 Public Spending and Public Choice

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 5

Public Spending and Public Choice

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 5-2

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?


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


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


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


Did You Know That ...

• The French Mediterranean island of Corsica has about 10,000 stray cattle and pigs?

• Most of the stray animals are abandoned by farmers after the elimination of agricultural subsidies from the French government make it too costly to keep maintain them in fenced lots.

• They constitute a spillover effect onto third parties caused by the failure of Corsican farmers to take into account the full costs of their actions.


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– 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 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)


Correcting for Externalities

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

– 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


Correcting for Externalities (cont'd)

• Market failure: an example

– 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



• 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



• 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


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.



• Externalities are examples of market failures

• Pollution is an example of a negative externality

• Inoculations generate external benefits


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


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


Correcting for Externalities (cont’d)

• 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



• How the government can correct positive externalities

– Government financing and production

– Subsidies

– Regulation


The Other Economic Functions of Government

• Providing a legal system

• Promoting competition

• Providing public goods

• Ensuring economy-wide stability


The Other Economic Functions of Government (cont'd)

• Providing a legal system

– Enforcing contracts

– Defining and protecting property rights

– Establishing legal rules of behavior



• Promoting competition

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

• Monopoly power



• 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



• Providing public goods

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

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



• Principal of Rival Consumption– Recognizes individuals are rivals in consuming private goods

• Public Goods– Can be jointly consumed by many individuals simultaneously



• 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


Example: Countdown to Private Production of Space Travel

• Increasingly more private firms, such as Armadillo Aerospace, Blue Origin, and Virgin Galactic, provide space-travel services in suborbital ships that orbit around the earth.

• These space ships have a limited number of seats, so that the services are not a public good and they are subject to the principle of rival consumption.



• Exclusion Principle– Anyone can enjoy the benefits of a public good, even if they have not paid for it

• Free-Rider Problem– Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods



• Ensuring economy-wide stability

– Smooth ups and downs in overall business activity

– Full Employment Act 1946 • Full employment

• Price stability

• Economic growth


The Political Functions of Government

• Government-Sponsored Goods (Merit Goods)– Goods deemed socially desirable through the political process• Museums

• Government-Inhibited Goods (Demerit Goods)– Goods deemed socially undesirable

• Illegal substances


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.


The Political Functions of Government (cont'd)

• Income redistribution: includes progressive income tax system and transfers– Transfer payments– Transfers in kind


The Political Functions of Government (cont'd)

• 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


The Political Functions of Government

• Transfers in Kind

– Payments that are in the form of goods and services

– Include food stamps, subsidized public housing, medical care


Public Spending and Transfer Programs

• Government Outlays

– All federal, state and local spending

– Examples• Defense, income security, Social Security—at the federal level

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


Figure 5-2 Total Government Outlays over Time


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


Public Spending and Transfer Programs (cont'd)

• 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• Second biggest domestic program in existence

– Medicaid• Subsidizes people with lower incomes


Figure 5-4 The Economic Effects of Medicare Subsidies


Public Spending and Transfer Programs (cont’d)

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

– The price per unit paid to medical service providers increases

– The price per unit paid by consumers falls

– More medical services are consumed


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.”



• Economic Issues of Public Education

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

– Publicly subsidized, similar to government subsidized healthcare

– Education priced below market



• The Incentive Problems of Public Education

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

– Many economists argue failure to improve relies on incentive effects

– Higher subsidies may translate to services unrelated to learning


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.


Collective Decision Making: The Theory of Public Choice

• Collective Decision Making

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


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

• Theory of Public Choice

– The study of collective decision making

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



• Similarities in market and public-sector decision making

– Self-interest

– Opportunity cost

– Competition

– Similarity of individuals, but different incentive structures



• Incentive Structure

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



• Differences between market and collective decision making

– Government goods at zero price

– Use of force

– Voting versus spending




– Voting versus spending

• Political system versus market system

– Political system run by majority rule

– Market system run by proportional rule



• 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




– Voting versus spending• Spending of dollars can indicate intensity of want

• Votes cannot; each vote counts with the same intensity


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.


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.


• 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


Summary Discussion of Learning Objectives

• How market failures such as externalities might justify economic functions of government– 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– Private goods are subject to rival consumption

– Public goods are not subject to rival consumption

– Free-riders anticipate others will pay


Summary Discussion of Learning Objectives (cont'd)

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

– Merit goods deemed socially desirable

– Demerit goods deemed socially undesirable

– Redistributing income • Transfer payments

• In kind transfers



• The effect of Medicare on incentives to consume medical services

– Subsidies lead to a higher quantity of medical services consumed

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



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

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

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



• Central elements of the theory of public choice

– Collective decision making • Voters, politicians, other participants influence nonmarket choices

– Incentive structures• Rewards and punishments affect provision of government goods

– Similarities and differences with market system structures• Scarcity, competition—similarities

• Legal coercion, majority rule—differences

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Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 5 Public Spending and Public Choice