Chapter 5

1. Chapter 5 Public Spending and Public Choice

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.

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 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. 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.

6. What a Price System Can and Cannot Do 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)

7. 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.

8. Correcting for Externalities 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

9. Correcting for Externalities 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

10. 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

11. Correcting for Externalities Externalities are examples of market failures. Pollution is an example of a negative externality. Inoculations generate external benefits.

12. External Costs and Benefits

13. External Costs and Benefits

14. Correcting for Externalities Resource misallocations of externalities External costs—market over allocates External benefits—market under allocates Government can correct negative externalities Special taxes (i.e. a pollution tax) Regulation

15. Correcting for Externalities How the government can correct positive externalities Government financing and production Subsidies Regulation

16. The Other Economic Functions of Government Providing a legal system Promoting competition Providing public goods Ensuring economywide stability

17. The Other Economic Functions of Government Providing a legal system Enforcing contracts Defining and protecting property rights Establishing legal rules of behavior

18. The Other Economic Functions of Government Promoting competition Market failure may occur if markets are not competitive. Antitrust legislation Monopoly power

19. 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

20. The Other Economic Functions of Government 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.

21. The Other Economic Functions of Government Principal of Rival Consumption Recognizes individuals are rivals in consuming private goods Public Goods Can be jointly consumed by many individuals simultaneously

22. The Other Economic Functions of Government 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

23. The Other Economic Functions of Government 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

24. The Other Economic Functions of Government Ensuring economywide stability Smooth ups and downs in overall business activity

25. The Political Functions of Government Merit Goods Goods deemed socially desirable through the political process Museums Demerit Goods Goods deemed socially undesirable Illegal substances

26. The Political Functions of Government Income redistribution: includes progressive income tax system and transfers

27. The Political Functions of Government 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

28. 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

29. 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

30. Figure 5-3Federal Government Spending Compared to State and Local Spending Sources: Budget of the United States government; government finances.

31. 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 Second biggest domestic program in existence Medicaid Subsidizes people with lower incomes

32. Public Spending and Transfer Programs 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.

33. 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.

34. Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It 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.

35. Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It 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?

36. Public Spending and Transfer Programs 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.

37. Public Spending and Transfer Programs Economics of public education Publicly subsidized, similar to government subsidized healthcare Education priced below market

38. Public Spending and Transfer Programs 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.

39. 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

40. Collective Decision Making: The Theory of Public Choice 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.

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

42. Collective Decision Making: The Theory of Public Choice Incentive Structure The system of rewards and punishments individuals face with respect to their actions

43. Collective Decision Making: The Theory of Public Choice 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

44. Collective Decision Making: The Theory of Public Choice Government or Political Goods Goods (and services) provided by the public sector

45. Collective Decision Making: The Theory of Public Choice Differences between market and collective decision making Voting versus spending Spending of dollars can indicate intensity of want Votes cannot; each vote counts with the same intensity

46. 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.

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

48. Issues and Applications: An Ethanol Bonanza or an Ethanol Boondoggle? Finally, some critics of ethanol subsidies argue that ethanol produced using corn actually requires more energy than the ethanol ultimately creates.

49. 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.

50. 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