The Economics of Government

Study Questions

1. What is the role of government to insure public goods are available to society?

2. What is the role of government when dealing with a negative externality?

3. What is the role of government when dealing with a positive externality?

4. List four activities where government acts as the agent for society.

Study Questions

5. Contrast a progressive tax system with a regressive tax system.

6. What is the function of a transfer payment? 7. Relate the government budget to the national

debt. 8. Contrast decision making in the voting booth

with decision making in the market place.

Study Questions

9. Contrast running a bureaucracy with running a business.

10. How does government define the poverty line?

11. Describe the conflict between the two economic goals of equity and efficiency.

Roles of Government

Agent of society.make society function smoothly and efficientlypass laws to govern our conductadjudicate and resolve conflictprovide assistance to needy society membersprovide or arrange for goods and servicesconsumes goods and services

Public goods

private good: rival in consumptionexclusionary

public good:non-rival in consumptionnon-exclusionary

Public goods

Free rider problem:Once produced, a public good can be used by

everybody “for free”Therefore, nobody will pay for a public goodFirms see nobody who will pay, so they do not

produce the public good

Public goods

Solution:government becomes the buyer firms produce the good and get paid by

governmentpeople use the good “for free”government collects taxes or fees to fund the

purchase

What is Market Failure?

When the market produces more or less than the ideal optimal good or service. OR the wrong mix of input is given for output…..

Brings about externalities and public goods.

When the market fails… it is a double edge swordMarket Fails if not optimal mix.

* Optimal Mix of Output…… “Most desirable combination of output attainable with existing resources, technology and social values.”

Market Failure

*“An imperfection in the market mechanism that prevents optimal outcomes.”

Market FailureIs this evident in today’s market?*market moves resources from one industry to

another. (price directs resources) (demand responds) (price moves the resources then to another demand choice) (at this point (competition begins to prevail to level the prices)

Changes in market prices directs resourcesP

Q

P

Q

D1

D2

How do you know if optimal mix is met?

Optimal mix of ANY GOOD or SERVICE =MB = MC(Marginal benefit = Marginal Cost)If the cost exceeds the benefit… the failure

occurs. If benefit exceeds the cost, then market is functioning according to other factors (price, demand, etc.)

Plano City Council issues “no smoking” in restaurants, bars, or outside bars on patios.

What is the marginal private cost to Sports Bar?

What is the external cost to Plano?

What is the social cost? C > B?

Think!

If the Plano allows restaurants and bars to allow smoking… what is the accelerated health cost or hazard? (is there any?)

If Plano does not allow smoking in restaurants, etc, will businesses be able to make a profit? Will the sports bar still have the draw for watching f-ball?

What is a Social Cost?

The cost to society resulting from a negative externality or wrong mix of output of resources. Too much secondary smoke in a restaurant.

Is there a socially optimal amount of output?The amount that adjusts the benefits (external and private) with the costs (external and private)

Externalities

A cost or benefit arising from an activity that falls on a third party (someone other than the producer or the consumer)Third party cost? Negative externalityThird party benefit? Positive externality

Negative externality

Example: pollutionProducer keeps costs low by dumping waste

into a riverPeople living along the river suffer a cost as

they live in a degraded environment Society adds this externalized cost to the

private costs of buyer and seller

The Negative Externality CaseBecause of a negative externality, marginal social costs (MSC) are greater than marginal private costs (MPC)The market output is greater than the socially optimal output. The market is said to fail in that it overproduces the good.

Negative externality

Social costs = private costs + external (third party) costs.Society says these goods are:

over consumed over produced

External costs are not included in market decision making.

Government intervenes.

Negative externality

Government can: force the producer to internalize the cost.prohibit the producer from making the

product. reward the producer for reducing the external

cost.

Examples of spillovers

Throwing trash in someone’s back yard Living downstairs from a Tai Bo person Playing your stereo loudly at 3:00 a.m. Businesses dumping wastes, sludge into

rivers People trashing the beach or highway. Electric Companies burning phosphorous

fuels

Positive externality

Social benefits = private benefits + external (third party) benefits.Society says these goods are:

under consumed under produced

External benefits are not included in market decision making.

Government intervenes.

In real words?Not enough public parks…

Not enough care for environment…

Not enough welfare…

Too much separation between top 10% income earners and median income earners…

Not adequate security within our borders….

Too many immigrants….

But, if mix of output gets totally out of whack…. Government takes over.

Translation

If government and/or the consumer was not acting as a watchdog…. Would corporations be diligent about utilizing the proper mix of resources…If they are, can they compete? …. NOW..

Telecommunications Industry?

Does that always mean regulation increased?

Could it mean that consumer sovereignty switches to another desire… BUT… what about things like energy… would we really know if the provider was efficient?

Positive externality

Government can:subsidize the producer to produce moresubsidize the consumer by offering the good

at a very low pricecoerce the consumer by mandating the use of

the good

Establish Rules of Conduct

Government provides and enforces a level within which an economy can operate. law of contracts fraud lawsprotection of property rights

Property rights

If protected:people work hard, earn more, and accumulate

property to obtain a better standard of living.enables those in poverty to move upward and

create a prosperous middle class. If not protected:

incentive to work and accumulate is removed. those in poverty are doomed to stay there.

Taxes

Government earns nothing and produces no wealth.

Taxes provide an income stream for government.Taxes are paid by income earners.Taxes transfer the earner’s purchasing power

to the government.Government becomes the buyer.

3 Kinds of Taxes

Progressive

Regressive

Proportional

The primary function of taxes is to transfer command over resources (purchasing power) from the private sector to the public sector.

Types of Taxes Progressive = tax rate increases as the tax

base increases Proportional = tax rate remains the same

regardless of the base Regressive= tax rate decreases as the

base increases. (often cited as unfair because it places heaviest burden on the least able to pay ---sales tax--- social security tax.)

What is your preference?

1% $380,354

5% $159,619

10% $113,018

25% $66,532

50% $32,879

Kiplinger report 2009Income earners (family 4)

Transfer payments

A payment from the government that a person or institution receives because he or it is entitled to it by law.There is no requirement for the recipient to do

or to provide anything in return.Government redistributes some of the

taxpayer’s income to provide a social safety net.

Special interest groups

Not all transfer payments go to low income earners. Special interest groups petition government for

special favors: handouts, subsidies, favoritism in government contracts, and tax breaks.

Lobbying for these favors can impact decision making by members of Congress and by bureaucrats.

Government budgeting

Most state and local government agencies must operate with a balanced budget:Revenues must equal spending.

The Federal government usually does not have a balanced budget:Deficit: Revenues less than spending.Surplus: Revenues greater than spending.

Budget deficits and the national debt Federal budget is usually in deficit.

Increased spending is politically palatable. Increased taxes are not politically palatable.To finance the deficit, the US Treasury

Department must borrow by offering government securities to the public.

This added borrowing increases the national debt.

Problems with deficit spending

“Crowding out” When the government needs to borrow, it taps into

the same funds pool used by consumers and businesses to borrow.

More for government? Less for the private sector.

Interest payments Government must pay interest to all debt holders. More debt? More interest payments must be funded

by taxes.

The tax burden

Ideally, high income earners should pay more taxes than middle- or low-income earners.

In reality, high-income earners lobby for special tax breaks and hire accountants and lawyers to help them avoid paying high taxes. Middle- and low-income earners can’t do this; they

simply pay their taxes. In our system, middle-income earners end up paying

most of the taxes.

Decision making in government

Each government decision maker uses his own value system to do cost-benefit analysis.

In government, however, the benefits and costs do not accrue to the decision maker, but to other groups.

The decision maker cannot properly evaluate the costs and benefits as well as an individual would for himself.

Decision making in government

Benefits accrued by one group will be offset by costs accrued by another group.

Special interest groups will lobby the government decision maker with incentives and penalties, which influence the decision making.

Voting booth vs. Market

Voting booth: vote for the candidate that

satisfies you the most get the winner (who was

preferred by the majority), who might not have been your preference

Market: vote for the product that

satisfies you the most get that product (no matter

what the majority of customers prefer)

markets are more democratic than voting booths

Bureaucracy

A business firm has a profit motive. produce a customer

satisfying product (otherwise, the customer will choose a rival’s product)

constantly strive to keep costs low

the measure of success is to increase profits

A bureaucracy has no profit motive. customers have no

alternative to choose from. the measure of success is

to increase the bureaucracy’s budget (increase costs)

Figure 5-1. Profit-Seeking Firms and Bureaucratic Agencies

size of firm/agency

cost per unit

idealsizedfirm/agency

Economies of scale:ATC decrease as sizeincreases

Economies of scale:ATC increase as sizeincreases

profit-seeking firmsoperate here

bureaucraticagenciesoperate here

Income distribution

Income is earned.Produce goods in high demand; earn a high

income.Produce goods in low demand; earn a low

income.Produce nothing; earn nothing.

Income is distributed unequally in America (and in all other countries of the world).

Unequal Income Distribution

Reasons why: education level intact vs. broken family structure work ethic talents and skills availability age and experience health willingness to take risks or endure hardship discrimination in hiring luck (be in the right place at the right time)

For 2008, the poverty threshold for a single person under age 65 was an income of $11,201, or less than $1,000 a month.

For a family of four, the threshold was $21,834.

For a family of six, $28,769.

Recession just completed finds 40 million in U.S. living in poverty.

Poverty 2008 statistics

Redistribution through public sector will reduce the size of the economic pie:

Weakens the link between productive activity and reward (taxes increased reduce individual reward for hard work-less productive.

As public policy redistributes large share of income,more resources flow into increasing it

Economics of Transfer Payments

Higher taxes to finance redistribution will induce taxpayers to focus less on income producing activities and more on income shelters *higher incomes have greater opportunity here

When leakages flow in taxes rather than in savings (money is unproductive)

Money that is productive generates more capital

More capital generates more jobs. More jobs generates more income.

Economics of Transfer

The government is called upon to distribute merit goods when the market does not provide enough.

A merit good is a good or service society deems everyone is entitled to some minimal quantity . Public goods have two particular characteristics. They are:

1. Non-excludable - once the goods are provided, it is not possible to exclude people from using them even if they haven't paid. This allows 'free-riders' to consume the good without paying.

2. Non-rival - this means that consumption of the goods by one person does not diminish the amount available for the next

Merit Goods

Taxes paid today go to pay benefits for people drawing today.

Do you think there is a “special fund” where the SS dollars go???

70% of SS goes to retirees - avg monthly benefit of $898.20

15% to disabled workers and familiesMay, 2003- avg benefit for disabled workers

was $837.7015% goes to widows, widowers, and families

– avg check of $850.80By 2030-twice as many older Americans 35

million to 70 million. Now there are 3.4 workers for every beneficiary… by 2030 there will be just 2.1 workers for each beneficiary.

More Grim Statistics Concerning SS

Equality vs. Efficiency

These goals are in conflict. Unequal incomes generate a highly efficient,

productive society with the highest standard of living.

Requiring equal incomes destroys incentive to work hard, to improve oneself, or to seek better opportunity. Society is less efficient, less productive, and has a lower standard of living.

Virtually all of the recent growth in federal expenditure has come from increased income transfers, not purchases of goods and services.

Why is the U.S. Economy owing billions of dollars?“If you subsidize something you get more of it.”

Dr. Milton Friedman, Free to Choose

Question is:

What kind of an economy do we Joe Q’s want?

The primary function of taxes is to transfer command over resources (purchasing power) from the private sector to the public sector.

Why from private to public? Why not the other way around?

So, it all gets back to Joe Q Citizen… Taxes paid to government.

Government failure occurs when government intervention fails to improve economic outcomes.

Government waste implies that the public sector isn’t producing as many services as it could with the sources at its disposal.

With such inefficiency, we are producing inside our production-possibilities curve.

Opportunity costThe issue of government waste encompasses

questions of efficiency and opportunity cost.

Perceptions of Waste

FY09 Budget Priorities