5-2 Copyright © 2011 Pearson Education, Inc. All rights ...wps.aw.com/wps/media/objects/6779/6942092/studynotes/update_notes...Copyright © 2011 Pearson Education, Inc. All rights

Copyright ©2011 by Pearson Education, Inc.All rights reserved.

Chapter 5

Public Spending and Public Choice

5-2Copyright © 2011 Pearson Education, Inc. All rights reserved.

Introduction

Recently, the U.S. government funneled funds to General Motors to meet payrolls and to construct new plants even as the company was in the midst of bankruptcy proceedings. In addition, it worked to boost the demand for GM vehicles

In this chapter, you will learn about the rationales for and implications of the U.S. government’s financial support for GM


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 U.S. government has a roughly 30 percent ownership share in Citigroup, a New York–based banking organization that ranks among the world’s largest financial institutions?

• That same firm has utilized the government’s funds to repay debts, purchase other banks, and make profitable investments, instead of making loans to consumers and businesses


Did You Know That… (cont’d)

• The incentives and institutional arrangements that condition the behavior of private firms and governments differ in some fundamental respects

• One key distinction is that while firms function within the price system, a key rationale for the operations of government is to perform functions that the price system does not do well


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



• 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)


Example: Billboards That Catch Drivers’Eyes, Sometimes for Too Long

• Of the 500,000 billboards lining U.S. highways and city streets, approximately 2,000 are digital billboards

• Critics suggest that the bright, eye-catching digital billboards are diverting drivers’ eyes from roadways and causing accidents

• They argue that digital billboards’ bright messages distract drivers, and thereby create a negative externality by making the roads less safe for drivers, their passengers and occupants of other cars


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


Policy Example: Incentives Coax Senior Citizens from Behind the Wheel

• Many people age 85 or older continue driving even after their skills and senses falter, and so they have higher crash rates per mile traveled than all age groups except 16- and 18-year-olds

• Governments are working to make roadways safer by providing incentives for aging baby boomers to park their cars and choose alternative modes of transportation

• Many state governments are easing regulations that impede efforts by private firms to offer elderly people transportation

• Some municipal governments are providing vouchers that help cover most of the price of public transportation


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



• 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


E-Commerce Example: Is the “Nu”Internet Domain a Public Good?

• Residents in a South Pacific island nation of Niue, were to first to possess nationwide wireless Internet access

• A private company Medfield of Massachusetts provides the wireless service in exchange for the legal rights to the Internet domain name “dot-nu”

• Is the “nu” domain on the Internet a public good?


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


International Policy Example: China’s Government Struggles With How to Regard Tobacco

• About 36% of all adults in China smoke, as compared with 21% of adults in the U.S

• For China’s government , the good news is that it owns the nation’s cigarette manufacturing company, China National Tobacco Corporation

• Although one measure of merit—attendance—is declining

• Who bears the cost?


International Policy Example: China’s Government Struggles with How to Regard Tobacco (cont’d)

• The good news is that the government puts earnings into a variety of activities, including constructing highways, hydroelectric dams, and railroads

• The bad news is that all the smoking promoted in China is creating an epidemic of diseases


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: If the Government Doesn’t Pay for It, Physicians Don’t Do It

• Most professionals regard telephone and e-mail as indispensable tools for communicating with clients

• In contrast, phone consultations and e-mail contact with physicians are very rare

• Medicare pays for face-to-face visits with physicians, but not for telephone or email consultation with patients


Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It (cont'd)

• Thus, Medicare gives physicians incentives to schedule appointments with patients in their offices but provides no incentives to utilize more efficient modes of communication

• Physicians then schedule office visits with patients and avoid phone calls and e-mail communications


Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It (cont'd)

• Who pays for the fact that Medicare’s payment rules promote higher-priced, face-to-face physician-patient communications instead of lower-priced, remote communications?



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



• The Economics of Public Education

– 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


E-Commerce Example: The Miniscule Payoff from Public School Internet Subsidies

• The E-Rate program of 1996 provides a subsidy to public schools for use in making classrooms Web-connected

• The E-Rate subsidy is about $100 per pupil

• The objective of this subsidy was to boost the breadth of students’ access to the Internet


E-Commerce Example: The Miniscule Payoff from Public School Internet Subsidies (cont'd)

• The effects of the E-Rate program on student performances in Texas and California found no concrete evidence of improved student performance

• Why might the $100-per-student E-Rate subsidy provide a miniscule learning payoff for students who already have Internet access at home?


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: Why a Synonym for “Big Oil” is “Big Government”

• Politicians and pundits commonly blame “big oil”—their shorthand for private oil companies—for higher oil prices

• Today private companies such as Chevron, British Petroleum, ConocoPhillips, and ExxonMobil directly manage oil production from only 5 percent of the world’s known reserves. Governments and government-owned companies coordinate production from the remaining 95 percent of reserves

• Why might dictators in totalitarian regimes make different oil production choices than private companies would have made?


Issues and Applications: General Motors Becomes “Government Motors”

• General Motors (GM) was the largest private employer in the United States by the end of the 1970s

• Between 2007 and 2008, overall U.S. purchases of motor vehicles dropped by nearly 20 percent, but GM’s sales declined by an even larger percentage. By December 2008, company officials were in Washington, D.C., seeking government assistance


• In 2009, the company went through a government-organized bankruptcy proceeding and emerged as a company 70 percent owned by the U.S. government

• Thus, GM vehicles became a government-sponsored good whose production was subsidized by U.S. taxpayers

• In addition, Congress authorized the distribution of tax-funded vouchers worth up to $4,500 apiece to people trading in “clunkers”. GM also benefited from this consumption-subsidization program

Issues and Applications: General Motors Becomes “Government Motors” (cont’d)


• In response to continued proportional-rule “voting”by its customers not to buy as many of its products, GM announced its intention to end ties to more than 2,400 vehicle dealerships

• Later, GM discovered that its new primary owner, the U.S. government, is driven by majority-rule voting. The U.S. House of Representatives voted to require GM to reinstate dealerships

Issues and Applications: General Motors Becomes “Government Motors” (cont’d)


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

Documents

5-2 Copyright © 2011 Pearson Education, Inc. All rights ...wps.aw.com/wps/media/objects/6779/6942092/studynotes/update_notes...Copyright © 2011 Pearson Education, Inc. All rights