Public Spending and Public Choice

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Chapter 5

• Public Spending and Public Choice

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Three areas of concentration

• Explain how market failures, such as
  externalities, might justify economic functions
  of government
• 2. Distinguish between private and public goods
  and explain the nature of the free-rider problem
• 3. Describe the political functions of government
  that entail its involvement in the economy

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When the market fails it is a double edge sword

• Market 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.

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Market FailureIs this evident in todays 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)

P
P
D1
D2
Q
Q
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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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In real words?

• Not enough public parks
• Not enough care for environment
• Not enough welfare
• Not enough healthcare
• Too much separation between top 10 income
  earners and median income earners
• Not adequate security within our borders.
• Too many immigrants.

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Specific Example

• Hypothetical
• No government regulation exists.
• Steel producing plant moves into the
  neighborhood.
• Production of steel emits dirt, smut, unhealthy
  air throughout the neighborhood.
• This is an externality the spillover is the
  dirty air borne by the citizens.
• Who pays for this cost? Citizens- company making
  a profit on steel.

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Socially Optimal Amount (Output)

• Sometimes, the socially optimal amount is
  referred to as the efficient amount.

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Correcting for Externalities (cont'd)

• 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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Figure 5-1 External Costs and Benefits, Panel (a)
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• Market failure (forces of S D not leading us
  to BEST point on ppc Who decides what is defined
  as BEST?
• Enter. Government intervention!
• Did you hear the words tax and subsidy?
• Will they perform magic?

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Correcting for Externalities

• 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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Correcting for Externalities (cont'd)

• 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 (b)
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Correcting for Externalities

• Resource misallocations of externalities
• External costsmarket overallocates
• External benefitsmarket underallocates
• Government can correct negative externalities
• Special taxes (i.e. a pollution tax or effluent
  fee)
• Regulation

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Correcting for Externalities (cont'd)

• How the government can correct positive
  externalities
• Government financing and production
• Subsidies
• Regulation

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There are two main types of economic instruments
used in environmental policy, both of which aim
to provide an incentive to use resources
sustainably

• Price-based measures use charges, taxes and
  subsidies to persuade polluters to reduce their
  discharges.
• Rights-based measures "create rights to use
  environmental resources, or to pollute the
  environment, up to a pre-determined limit, and
  allowing these rights to be traded"

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Other Economic Functions of Government

• Providing a legal system
• Promoting competition
• Providing public goods
• Ensuring economy wide 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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The Other Economic Functions of Government
(cont'd)

• Promoting competition
• Market failure may occur if markets are not
  competitive.
• Antitrust legislation
• Monopoly power

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The Other Economic Functions of Government

• 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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The Public SectorGovernments role.

• Questions to ponder
• What is Public Sector?
• When do markets fail?
• Should government step in?
• Can people ride free in public sector?

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• Governments Enter the Market to assure
• 1. Public Goods
• 2. Externalities (positive or elimination of
  negative)
• 3. Market power
• 4. Equity

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Two concepts to remember

• Public goods can be equally consumed by all no
  restrictions
• Skateboarding in the park Terrorists can also
  go to the park Illegal immigrants can go to
  school
• Private goods consumption by one person excludes
  consumption by another..
• ( my doughnut my car etc)

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

• If government and/or the consumer was not acting
  as a watchdog. Would corporations be diligent
  about utilizing the proper mix of resourcesIf
  they are, can they compete?
• 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? What about government-driven choices?

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Methods to Reduce Pollution

• Government sets pollution standards
• Market environmentalism Government allocates
  pollution permits and then allows them to be
  bought and sold

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Government Allocates Pollution Permits (allows
market to operate)

• Agreement that a certain area can handle
  acceptable amt of pollution.
• The amount is quantified, then parceled into
  permits that polluters bid for in auction.
• Can buy and sell pollution rights among companies
  bidding.
• Allows some companies to pollute more than
  others ones that are really good sometimes get
  perks like tax benefits others have opportunity
  to pass on to their consumers (TXU)

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• Government reallocates resources if 1) market
  produces wrong amount of certain gS and 2)
  market fails to allocate resources to some gs
  that are in best interest of society.
• What are externalities? costs or benefits of a
  market activity borne by a third party.
• Spilloversan action when one individual or group
  harms the property of others without their
  consent.

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Examples of spillovers

• Throwing trash in someones back yard
• Burning ties in the alley
• Playing your stereo loudly at 300 a.m.
• Businesses dumping wastes, sludge into rivers
• People trashing the beach or highway.
• Electric Companies burning phosphorous fuels

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Spillover Examples that perpetrate on others

• Calling police when loud party of teenagers next
  door (actions of teens imposing unwanted cost on
  neighbor)
• Living in downstairs apartment.. Having upstairs
  neighbors doing Tai Bo when they get off work at
  400 a.m.
• Calling the city when a neighbor doesnt keep his
  yard mowed on regular basis.

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Externalities can be positive or negative

• Homeowners keep lawns immaculate (benefits the
  neighborhood)
• Scientific study for polio vaccine (others
  benefit beyond scientists recognition)
• Education. How would this be a benefit?

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How can spillovers be corrected?

• Most obvious way is Legislation.
• To prohibit
• To heavily tax the specific product and
  manufacturer. Tax would be derived to allow for
  off-setting the clean-up cost. (Super Fund is
  example)
• Subsidize both consumers or producers
• Tax incentives if reduction of pollution and
  compliance adhered to, taxes reduced.

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A Corrective Tax Gone Wrong

• Government may miscalculate external costs and
  impose a tax that moves the supply curve from S1
  to S3 instead of from S1 to S2.
• As a result, the output level will be farther
  away from the socially optimal output than before
  the corrective tax was applied.
• Q3 is farther away from Q2 than Q1 is from Q2.

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Federal Government Spending Compared to State
and Local Spending
Sources Budget of the United States government
government finances.
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2008 FY category Tax Policy Center
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2008 FY- Tax Policy Center
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Public Spending and Transfer Programs

• 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/ no cap
• Second biggest domestic program in existence
• Medicaid
• Subsidizes people with lower incomes

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The Economic Effects of Medicare Subsidies
Subsidy M customers pay Pd for quantity
Qm Providers receive price Ps for supply the
good.
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Collective Decision Making The Theory of Public
Choice

• 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

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Equity or perhaps better stated as
Inequity.(ensuring market economy)

• 1)Inadequate income (redistribute to have-nots)
• 2) Merit goods (everyone entitled to some minimum
  of food,clothing, shelter) In-kind transfers in
  food stamps, housing vouchers, health clinics)
• 3)Social Security and unemployment compensation
  protect peoples economic security by providing
  money when they retire or are unable to work.

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• Opportunity cost if government provides health
  care, private sector cannot compete. Government
  crowds out the private .
• Remember, the largest opportunity cost of an
  item supplied by government is the best
  alternative use that could have been made of the
  resources required to provide that good.

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We are at a crossroads-Which path should the
U.S. take?

• Free Markets?
• Private markets?
• Government Regulated Markets?
• Government Driven Markets?
• Government Run Markets?

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Thats All Folks!