ppt05 - wps.aw.comwps.aw.com/wps/media/objects/6779/6942092/studynotes/notes05.pdf · actions. – In some cases ... • Demerit Goods – Goods deemed socially undesirable • Illegal

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 5

Public Spending and Public Choice


5-2

Introduction

Many feel that ethanol-based motor fuel offers a win-win situation: less reliance on gasoline derived largely from foreign oil and reduced carbon pollution from auto emissions.

The U.S. government agrees—to the tune of more than $8 billion in annual government subsidies for ethanol production.


5-3

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


5-6

Did You Know That...

• An auditor recently discovered that a New jersey public school district had been transmitting salary payments totaling $130,000 per year to the account of an employee who had been deceased for over 30 years?

• The same audit found that the public school district had paid a company $953,000 for copy equipment even though the purchase order was only for equipment valued at $55,000?


5-7

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.


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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.


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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)


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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.

– 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.


5-11

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


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• 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


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• 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


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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)


5-16

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


5-17

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


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• How the government can correct positive externalities

– Government financing and production

– Subsidies

– Regulation


5-19

The Other Economic Functions of Government

• Providing a legal system

• Promoting competition

• Providing public goods

• Ensuring economywide stability


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The Other Economic Functions of Government (cont'd)

• Providing a legal system

– Enforcing contracts

– Defining and protecting property rights

– Establishing legal rules of behavior


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• Promoting competition

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

• Monopoly power


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• 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


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• 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.


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

private goods

• Public Goods– 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 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


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• 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 Goods– Goods deemed socially desirable through the

political process• Museums

• Demerit Goods– Goods deemed socially undesirable

• Illegal substances


5-29

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?


5-30

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

• The government plows 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.


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The Political Functions of Government (cont'd)

• Income redistribution: includes progressive income tax system and transfers


5-32

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


5-33

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


5-34

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


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Figure 5-2 Total Government Outlays over Time

Sources: Facts and Figures on Government Finance, various issues;Economic Indicators, various issues.


5-36

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

Sources: Budget of the United States government; government finances.


5-37

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


5-38

Figure 5-4 The Economic Effects of Medicare Subsidies


5-39

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.


5-40

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.


5-41

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.


5-42

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?


5-43


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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• Economics of public education

– Publicly subsidized, similar to government subsidized healthcare

– Education priced below market


5-45


• 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.


5-46

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.


5-47

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?


5-48

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


5-49

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.


5-50


• Similarities in market and public-sector decision making

– Self-interest

– Opportunity cost

– Competition

– Similarity of individuals, but different incentive structures


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• Incentive Structure

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


5-52


• Differences between market and collective decision making

– Government goods at zero price

– Use of force

– Voting versus spending


5-53



– Voting versus spending

• Political system versus market system

– Political system» Run by majority rule

– Market system» Run by proportional rule


5-54


• 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


5-55



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

• Votes cannot; each vote counts with the same intensity


5-56

Issues and Applications: An Ethanol Bonanza, or an Ethanol Boondoggle?

• From the U.S. government’s point of view, the use of gasoline as a motor fuel presents two problems.

• Many reserves are located in the politically unstable Middle East and air pollution.

• The key ingredients for ethanol are homegrown and less pollution is created.


5-57

Issues and Applications: An Ethanol Bonanza, or an Ethanol Boondoggle? (cont'd)

• The government has designated ethanol as a merit good and provides a subsidy to ethanol producers of just over $1 per gallon.

• Paradoxically, the cost of producing ethanol is very high relative to the benefits.

• Gasoline consumption would drop by no more than 20% and decreases in pollution would be minor.


5-58

Issues and Applications: An Ethanol Bonanza or an Ethanol Boondoggle? (cont'd)

• Finally, some critics of ethanol subsidies argue that ethanol produced using corn actually requires more energy than the ethanol ultimately creates.


5-59

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.


5-60

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


5-61


• 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.


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• 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 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

ppt05 - wps.aw.comwps.aw.com/wps/media/objects/6779/6942092/studynotes/notes05.pdf · actions. – In some cases ... • Demerit Goods – Goods deemed socially undesirable • Illegal