Chapter 5

1. Chapter 5 Public Spending and Public Choice

2. Introduction The U.S. government plans to allocate $40 billion each year to firms that specialize in “clean-energy” technologies. The government hopes that such technologies would lead to fewer emissions entering the atmosphere. What can we learn from economics about possible ways in which the U.S. government might address issues such as atmospheric pollution?

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

4. 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

5. 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

6. Did You Know That ... The French Mediterranean island of Corsica has about 10,000 stray cattle and pigs? Most of the stray animals are abandoned by farmers after the elimination of agricultural subsidies from the French government make it too costly to keep maintain them in fenced lots. They constitute a spillover effect onto third parties caused by the failure of Corsican farmers to take into account the full costs of their actions.

7. 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

8. 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)

9. 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

10. 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

11. 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

12. Correcting for Externalities (cont'd) 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

13. Example: Space Age Litterbugs Littering in space has created at least 18,000 objects of orbiting space junk. After every space shuttle mission since 1981, NASA has spent about $400,000 to replace the shuttle’s debris-pitted windows. At least once each day, scientists issue warnings of close encounters faced by orbiting commercial satellites.

14. Correcting for Externalities (cont'd) Externalities are examples of market failures Pollution is an example of a negative externality Inoculations generate external benefits

15. Figure 5-1External Costs and Benefits, Panel (a)

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

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

18. Correcting for Externalities (cont'd) How the government can correct positive externalities Government financing and production Subsidies Regulation

19. The Other Economic Functions of Government Providing a legal system Promoting competition Providing public goods Ensuring economy-wide stability

20. The Other Economic Functions of Government (cont'd) Providing a legal system Enforcing contracts Defining and protecting property rights Establishing legal rules of behavior

21. The Other Economic Functions of Government (cont'd) Promoting competition Market failure may occur if markets are not competitive. Antitrust legislation Monopoly power

22. The Other Economic Functions of Government (cont'd) 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

23. The Other Economic Functions of Government (cont'd) 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

24. The Other Economic Functions of Government (cont'd) Principal of Rival Consumption Recognizes individuals are rivals in consuming private goods Public Goods Can be jointly consumed by many individuals simultaneously

25. The Other Economic Functions of Government (cont'd) Characteristics of public goods Can be used by more and more people at no additional opportunity cost Difficult to charge for a public good based on consumption—the exclusion principle

26. Example: Countdown to Private Production of Space Travel Increasingly more private firms, such as Armadillo Aerospace, Blue Origin, and Virgin Galactic, provide space-travel services in suborbital ships that orbit around the earth. These space ships have a limited number of seats, so that the services are not a public good and they are subject to the principle of rival consumption.

27. The Other Economic Functions of Government (cont'd) 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

28. The Other Economic Functions of Government (cont'd) Ensuring economy-wide stability Smooth ups and downs in overall business activity Full Employment Act 1946 Full employment Price stability Economic growth

29. 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

30. Why Not … classify broadband Internet access as a government-sponsored good and provide it to all U.S. residents? One problem with government provision of broadband service to every U.S. resident is that no one knows exactly what “broadband” means. A related problem is that the costs to taxpayers depend heavily on the broadband speed, especially for residents in rural areas.

31. The Political Functions of Government (cont'd) Income redistribution: includes progressive income tax system and transfers Transfer payments Transfers in kind

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

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

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

35. Figure 5-2 Total Government Outlays over Time

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

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

38. Figure 5-4 The Economic Effects of Medicare Subsidies

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

40. Policy Example: Seeking to Halt “Overuse” of Massachusetts Health Care In 2006, the state of Massachusetts adopted a program analogous to Medicare for all of its residents. Within 3 years, health care spending for a typical Massachusetts resident rose to 33 percent above the average for other U.S. residents, mainly due to the fact that the program “rewards overuse of services.”

41. Public Spending and Transfer Programs (cont’d) 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 Publicly subsidized, similar to government subsidized healthcare Education priced below market

42. Public Spending and Transfer Programs (cont’d) 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

43. Example: Valuable Charter School Services—for Those Who Can Get Them Charter schools are stated-funded schools that have the freedom to offer a variety of learning approaches. Because many parents place higher values on the educational services of charter schools and the price of attending them is close to zero, the quantity of charter school services demanded exceeds the quantity supplied—hence the waiting lists.

44. 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

45. 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

46. Collective Decision Making: The Theory of Public Choice (cont'd) Similarities in market and public-sector decision making Self-interest Opportunity cost Competition Similarity of individuals, but different incentive structures

47. Collective Decision Making: The Theory of Public Choice (cont'd) Incentive Structure The system of rewards and punishments individuals face with respect to their actions

48. Collective Decision Making: The Theory of Public Choice (cont'd) Differences between market and collective decision making Government goods at zero price Use of force Voting versus spending

49. Collective Decision Making: The Theory of Public Choice (cont'd) Differences between market and collective decision making Voting versus spending Political system versus market system Political system run by majority rule Market system run by proportional rule

50. Collective Decision Making: The Theory of Public Choice (cont'd) 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