Chapter 5wps.aw.com/wps/media/objects/3847/3940260/studynotes/notes05.pdf · • Demerit Goods Goods deemed ... Figure 5-2 Total Government Outlays over Time ... actions influence

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Chapter 5

Public Spending and Public Choice

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 5-2

Introduction

Why have shortages existed in markets for vaccines?

Why might the government have a role in trying to correct this situation?


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


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 collects more than $1 trillion annually in income taxes?

• Local, state, and federal governments raise more than $1 trillion in other taxes?

• Government takes care of some of the functions that the price system does not?

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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.

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.

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Correcting for Externalities (cont'd)

• Market failure: an example

AssumeNo government regulation against pollution

A town with clean air

A steel mill opens and emits smoke that causes

More respiratory diseasesDirtier clothes, houses, cars



• Market failure: an example

Market failure occursSteel mill does not pay for the clean air

Costs of production have “spilled over” to the residents (third parties)

Lower production costMore steel is produced than would otherwise be the case



• ExternalitiesOccur when the consequences of an economic activity spill over to affect third parties

• Third PartiesParties who are not directly involved in a given activity or transaction

• Property RightsRights of an owner to use and exchange property

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• 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 (a)

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External Costs and Benefits

• Resource misallocations of externalitiesExternal costs—market overallocates

External benefits—market underallocates

• Government can correct negative externalities

Special taxes

Regulation


External Costs and Benefits (cont'd)

• Effluent Fee

A pollution tax


External Costs and Benefits (cont'd)

• How the government can correct positive externalities

Government financing and production

Subsidies

Regulation

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The Other Economic Functions of Government

• Providing a legal system

• Promoting competition

• Providing public goods

• Ensuring economywide 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

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• Antitrust LegislationLaws that restrict the formation of monopolies and regulate certain anticompetitive business practices

• MonopolyA 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 ConsumptionRecognizes individuals are rivals in consuming private goods

• Public GoodsCan be jointly consumed by many individuals simultaneously

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• Characteristics of public goods1.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 PrincipleAnyone can enjoy the benefits of a public good, even if they have not paid for it.

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



• Ensuring economywide stability

Smooth ups and downs in overall business activity

Full Employment Act 1946 Full employment

Price stability

Economic growth

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The Political Functions of Government

• Merit GoodsGoods deemed socially desirable through the political process

Museums

• Demerit GoodsGoods deemed socially undesirable

Illegal substances


Policy Example: Civic Centers Grow as Exhibition Attendance Declines

• More than 50 new government-funded civic centers are under construction in the United States.

• Although one measure of merit—attendance—is declining.

• Who bears the cost?


The Political Functions of Government (cont'd)

• Income redistribution: includes progressive income tax system and transfers

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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

ExamplesDefense, 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


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


Public Spending and Transfer Programs (cont'd)

• Publicly subsidized healthcareMedicare

Began in 1965Pays hospital and physicians’ bills for U.S. residents over 65 with public monies2.9% of earnings taxedSecond biggest domestic program in existence

MedicaidSubsidizes people with lower incomes

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Figure 5-4 The Economic Effects of Medicare Subsidies


The Economic Effects of Medicare Subsidies

• 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: Is the Medicare Program on the Fast Track to Bankruptcy?

• Medicare spending is growing much faster than employer and employee contributions.

• If both Medicare and federal tax collections continue to grow at present rates until 2050, Medicare will account for half of all federal tax collections.

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Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd)

• Because of the growth in program spending, Medicare will lack financial resources to cover promised benefits by 2019 or sooner.

• Congress will have to increase taxes or cut benefits or both.


Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd)

• How do increasing life expectancies contribute to Medicare’s funding difficulties?


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.

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Economic Issues of Public Education (cont'd)

• Economics of public education

Publicly subsidized, similar to government subsidized healthcare

Education priced below market


Economic Issues of Public Education (cont'd)

• 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.


Policy Example: What Have Public Schools Done with Subsidies?

• Public school enrollments have increased 40% since 1960.

• Inflation-adjusted spending per student has increased 200%.

• Teachers have increased by 60%.

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Policy Example: What Have Public Schools Done with Subsidies? (cont'd)

• Overall, number of non-teaching staff increased 500%.

• As predicted by the basic economics of subsidies, schools have allocated funds to activities contributing little to student learning.


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

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• 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

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Voting versus spendingPolitical system versus market system

Political system♦ Run by majority rule

Market system♦ Run by proportional rule



• Government or Political GoodsGoods (and services) provided by the public sector

• Majority RuleCollective decision making, decisions based on more than 50%

• Proportional RuleIf 10% of “dollar votes” cast for blue cars, 10% of output is blue




Voting versus spendingSpending of dollars can indicate intensity of want

Votes cannot; each vote counts with the same intensity

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Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain?

• Every fall, millions of U.S. residents stand in line for their flu shots.

• During the mid-2000s, shortages of flu vaccines developed.

• Flu vaccines were not the only vaccines difficult to obtain.


Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain? (cont'd)• Why are vaccine shortages occurring?

Paradoxically, because inoculations provide external benefits

The scenarioU.S. government purchases vaccinesManufacturers required to sell at discount, so receive lower pricesProduction is scaled backShortages occur


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.

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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 paymentsIn 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

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• Central elements of the theory of public choice Collective decision making

Voters, politicians, other participants influence nonmarket choices.

Incentive structuresRewards and punishments affect provision of government goods.

Similarities and differences with market system structuresScarcity, competition—similarities Legal coercion, majority rule—differences

End of Chapter 5Public Spending and Public Choice

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Chapter 5wps.aw.com/wps/media/objects/3847/3940260/studynotes/notes05.pdf · • Demerit Goods Goods deemed ... Figure 5-2 Total Government Outlays over Time ... actions influence