Why and How Should State and Local Governments Intervene in the Economy?

1. Why and How Should State and Local Governments Intervene in the Economy? MGMT 932 Local Public Economics and Business Strategy Session 2: March 30, 2006 Professor Therese McGuire These slides are for exclusive use in MGMT 932 at the Kellogg School of Management, Northwestern University. No other use is allowed without permission of Professor Therese McGuire.

2. Review of useful tools and concepts from microeconomics • Consumer choice using indifference curves and budget constraints. • Two-good world – CDs and books. • Indifference curves – constant utility contours. • Downward sloping. • Cannot cross. • Fill the NE quadrant. • Reflect unlimited wants. • Slope is marginal rate of substitution (MRS). • Some funky indifference curves. • Budget constraint – delineates the feasible set. • Income and prices are all you need. • Prices determine the slope -- -Px/Py • Income determines the placement relative to the origin. • Optimal choice determined by tangency of indifference curve and the budget constraint. • Why does this characterize the optional choice? • Illustrate derivation of demand curve for CDs.

3. Policy Analysis Using Consumer Choice Theory • A price subsidy versus an equally costly voucher. • Two goods – CDs and books. • Policy decision to encourage reading. • Subsidize the purchase price of books. • Give a voucher for purchase of books. • Which policy results in a greater increase in the number of books purchased? • Which policy makes the consumer better off? • A voucher versus an equally costly cash grant. • Alternative depiction – expenditures on the axes. • Two categories of expenditures – housing and all other goods. • Policy decision to assist people in obtaining housing. • Give a rent voucher. • Give a cash grant. • Which policy results in a greater increase in expenditures on housing? • Which policy makes the consumer better off?

4. Consumer and Producer Surplus • Take a given market equilibrium where supply and demand cross. • Characterized by equilibrium price and quantity, P1 and Q1 • Area under the demand curve represents total willingness to pay for Q1 • Area under the supply curve represents total costs of production of Q1 • Supply curve reflects marginal costs; attribute fixed costs to the first unit produced. • Consumer surplus – difference between the amount willing to pay and the amount actually paid for the good. • Value consumers place on the good above and beyond the price they have to pay. • Area under the demand curve and above the price line. • Producer surplus – difference between the amount received and that required to induce provision of the good. • Revenues received in excess of costs of production (value/profits to producers). • Area under the price line and above the supply curve. • Efficient allocation is the allocation that maximizes the sum of CS + PS • Efficient allocation maximizes the value to society of this market.

5. First Theorem of Welfare Economics • A competitive market equilibrium is Pareto optimal (efficient) if: • Regular (convex) consumer preferences, • Convex production – no increasing returns to scale, • Exclusion is possible, • No externalities, • No public goods, • No uncertainty (perfect information), • Adequate number of agents (no market power), For a given set of endowments. • Even if all of the above conditions are met, the equilibrium allocation may not be fair. • With redistributive lump-sum taxation, can have efficiency and a fair distribution. • With other forms of redistributive taxation, tradeoff between equity and efficiency.

6. Why does the theorem hold?Because firms and consumers are price takers. • In a perfectly competitive market, firms and consumers are price takers. • MRSxy = Px/Py (due to tangency of indifference curve and budget line at the optimal bundle chosen by the consumer) • MCx = Px (due to profit maximizing choice under perfect competition) • MCy = Py (ditto) • Together imply MRSxy = MCx/MCy = MRTxy Thus, because consumers and producers face the same set of prices, the rate at which consumers are willing to trade x for y is exactly equal to the rate at which producers are able to convert x for y. If this condition does not hold, trades are available that can make some people better off without harming others. • This is very powerful stuff. • No resources are wasted or misallocated (directed toward lower value goods). • The size of the economic pie – and the valuation of that pie by society – is maximized. • If we care about economic well being and standards of living, we should care about efficiency.

7. What goes wrong?The market fails. • The conditions needed for the theorem to hold are stringent. • Suppose we do not have an adequate number of agents. Suppose we have a monopoly market. • Monopolist is a price setter, not a price taker. • Monopolist chooses the level of output at with MR = MC; not P = MC. • The MRS is no longer equal to the MRT. • Advantageous trades are left on the table. Society loses. • By how much does society lose? • The loss to society is the loss in CS and PS. • Deadweight loss (DWL): the consumer and producer surplus lost to society by a change in output from the efficient level of output. • Policy response? • Break up the monopoly. • Regulate the monopoly. • Bottom line: • Markets first. Why? Efficient allocation of resources. • Governments second. Why? Markets fail.

8. Public Goods and Externalities • From the perspective of state and local government, the two most important market failures are public goods and externalities. • We will also see state and local government intervention for redistribution. • Public goods. • Distinct from publicly provided goods. • Nature of the good is characterized by: • Non-rival consumption. • Examples: lighthouse, theatrical production, street light. • Non-excludability. • Examples: park, national defense, city streets. • Key characteristic for why the private market fails is non-excludability. Why? • Non-excludability leads to the “free rider” problem. • Example: Community of 100 people that wants to build a street light costing $100. • Each person values the street light more than $1. • Entrepreneur sees the value to the community far exceeds $100. • Entrepreneur goes door to door seeking donations. How much do you contribute? • If left to the private market, too little of a public good is provided.

9. Policy Responses to Public Goods • Public provision. • Coerce people into contributing through taxation. • Subsidize the consumption/production of the good. • How important is the free-riding phenomenon in practice? • Empirical literature (mostly experimental) finds that people voluntarily contribute 40-60 percent of their true valuations. • Why do some people contribute? “warm glow”: care about giving itself. • In sum, private provision of public goods leads to under-provision, but: • May not be too bad if people care about giving. • Prevalence of public goods may not be great. • Public intervention may be worse than the private market outcome. • Weak incentives for cost containment. • Weak incentives to provide high quality service.

10. Public Goods and Externalities (continued) • Externalities: When the actions of one individual affect the welfare of another individual in a way that is outside of the market mechanism. • Positive externality. • The most common justification for public intervention. • Definition: private benefits are less than social (societal) benefits. • Leads to under-production/under-consumption of the good (similar to public goods). • Graphically/mathematically… • MPB marginal private benefit is the value to consumer of another unit. • MEB marginal external benefit to others outside the market of another unit. • MSB = MPB + MEB • Private market optimum/equilibrium: MPB = MC • Social optimum: MSB = MC • Policy response: Internalize the externality. • Pigouvian subsidy equal to the marginal external benefit at the social optimum. • Examples • R&D subsidies – What is the externality? What are the subsidies? • Subsidies to home ownership – What is the externality? What are the subsidies? • Subsidies to higher education – What is the externality? What are the subsidies?

11. Public Goods and Externalities (continued) • Negative externality. • Definition: private costs are less than social (societal) costs. • Leads to over-production/over-consumption of the good. • Graphically/mathematically… • MPC marginal private cost is the cost to the firm of another unit. • MD marginal damage is the marginal damage (costs) imposed on others outside the market of another unit. • MSC = MPC + MD • Private market optimum/equilibrium: MPC = MB (Price) • Social optimum: MSC = MB • Policy response: Internalize the externality. • Pigouvian tax equal to the marginal damage at the social optimum. • Regulation – government limits the amount of the offending production. • Create a market – tradeable permits to pollute, for example. • Redefine property rights – Coase Theorem implies no government intervention. • Two things to keep in mind: • Typically it is not optimal to reduce the activity causing the externality to zero. Why not? • There is a big advantage to Pigouvian taxes: they raise revenues!

12. Are state and local government interventions aimed at markets characterized by public goods and externalities? • Few of the goods and services provided by state and local governments are public goods. What gives? • Aspects of publicness (positive externalities). • Equity concerns. • Inertia or tradition. • Not every decision is an economic one. Political decisions need not be economically rationale. • Many of the negative externalities generated in our economy are not contained within local or state borders. • The problems “spillover” to other jurisdictions. • The solutions must come from a higher level of government.

13. Example for discussion: Zoning • Definition: The division of a community into districts or zones in which certain activities are prohibited and others are permitted. • Can we justify government intrusion into real estate development?

14. Preview of Topics for Week 2 • Principles of taxation. • Equity. • Efficiency. • Simplicity. • The big three taxes. • Individual income tax. • General sales tax. • Property tax. • Side bar on the corporate income tax. • Fiscal shenanigans at the state level. • The fiscal crisis that began in 2001. • State revenues and expenditures over the business cycle.