PP 640

1. PP 640 Unit 4 Seminar

2. Unit 4 Seminar • Natural monopolies • Public assistance • Transfer of public funds • Unit 4 assignment

3. Introduction • Some goods and services exhibit substantial economies of scale, so that costs are not minimized until the firm has a significant portion of market demand • In these cases it is more efficient to have one large firm’s produce at a lower cost than to have many small firms’ produce at a higher cost • This is a natural monopoly • Examples: Public utilities, public transportation, recreational facilities, telecommunications, etc. • Because these industries combine high start-up costs with low marginal use costs

4. Introduction continued • In such cases, it is best for a monopoly to provide the good • Problem: Monopolies usually lead to lower production, higher prices and maintained economics profits for the firms • Solution: In cases of ‘natural monopolies’, government licenses a sole producer (to capture benefits of decreasing costs) but regulates the quantity and price • → Implementing this decision is often controversial

5. The Pricing Decision • Pareto-optimal condition is the same as for any private good: • Marginal Rate of Substitution = Marginal Rate of Transformation • This can only be satisfied if firm sets • Production = Marginal Cost • Problem: At this level, Production < Average Cost, which means that firm will make negative economic profit • → Firms will not choose to produce good at this point • Solution: Government subsidizes firm to produce

6. The Pricing Decision continued • U.S. Policy - Average Cost Pricing and the Benefits-Received Principle: • U.S. governments reject the Marginal Cost pricing outlined above because financing lump-sum subsidy from ‘general revenues’ breaks the link between use and payment • Other possibilities are • Monopoly pricing • Average cost pricing • (Production = Average Cost so firm does not observe economic loss)

7. The Pricing Decision continued • Potential Tradeoffs • Marginal cost pricing results in the least efficient outcome but does not require regulation costs • Average cost pricing results in a more efficient outcome but entails regulation costs • → Governments almost universally choose average cost pricing because it appears to be fairest

8. The Investment Decision • This is not the traditional entry/exit decision in private markets • Instead, government must decide whether the good should be provided and, if it should, they must make the investment • There will be a difference based on whether we consider the: • Easy Case: Cost curves such that monopolist could break even • → Good should be provided • Hard Case: Cost curves such that monopolist could not break even without help • → Not clear good should be provided

9. The Easy Case • Goods should clearly be produced because the firm can generate enough revenue to turn a profit or break-even • The problem is that the government does not want the firm to produce to its profit-maximizing level • The possibility of breaking even does not mean that firm should be allowed to break even • Most governments handle this case by granting monopoly to firm and implementing average cost pricing

10. The Hard Case • The problem is that firms cannot earn profits so the government cannot use the potential for earning profit as a guide that the good should be provided • Is society better off with the good or with 0 units of the good? • Politicians may argue that as long as a deficit must be incurred the goal should be to minimize the deficit • → Government must sacrifice value to minimize the deficit rather than to produce at the efficient level

11. Minimize the Deficit? • In the hard case, politicians may argue that as long as a deficit must be incurred the goal should be to minimize the deficit • QMD minimizes the deficit • Qeff is the efficient level of output • → Government must sacrifice value to minimize the deficit rather than to produce at the efficient level

12. Natural Monopolies With Zero Marginal Costs • The marginal cost of providing the good to an additional consumer is essentially 0 once the start-up costs are paid • Example: Once a highway is built, it is very cheap to let one additional person drive on it • Nonexclusive Goods vs. Zero Marginal Cost Natural Monopolies • One difference is that nonexclusive goods suffer from the free-rider problem, therefore, the good must be provided by government • Zero Marginal Cost Natural Monopolies can be provided by private companies rather than government • Example: Private toll roads and bridges

13. The Efficient Pricing of Software • Computer software is an example of a global natural monopoly • → Massive costs are incurred to develop and test software but once development is completed, global distribution is virtually costless • → The optimal outcome would be to permit free downloads once the product is developed • → The problem is that this does not maximize profit • → Instead, to maximize profit, firms incur sizable costs to • print and market CDs which sell for a positive price

14. The Efficient Pricing of Software continued • Potential Solution: All-or-nothing pricing • Charge consumers a fee to get access to as much of the good as they want at no additional price per unit • Advantage: Results in efficient allocation of good • Disadvantage: Transfers entire consumer surplus to firms • Government can limit this disadvantage by controlling fees that are charged for access

15. Transfer Programs • Federal governments generally believe in two things when considering transfer payments policies, dating back to the British Poor Law of 1601 • 1. Society is willing to support the poor who cannot help themselves • 2. Society ought not to incur the cost of supporting those who are capable of helping themselves • The U.S. followed the basic tenets of the Poor Law until the Great Depression of the 1930s which forced them to enact new policies

16. Transfer Programs • The Social Security Act of 1935 • Established a two-pronged approach to poverty: • 1. Social insurance - intended to be preventive • Workers pay into system during work years (by payroll tax) and are entitled to a public pension during retirement years • - Designed to insure against the elderly entering poverty once they retire • - Administered entirely by federal government • 2. Public assistance - intended to be symptomatic i.e. addressing specific instances of need

17. The Public Choice Perspective on Public Assistance • Mainstream public sector theory believes that transfer programs result when people are sometimes ‘other-interested’ in addition to being self-interested • Public choice theory believes that individuals are always only self-interested but that sometimes helping others serves to further individual self-interest • Rawlsian Veil of Ignorance • Asks whether you would favor a program or not if you truly did not know what your future state would be • Even if you are rich today, you might not be rich tomorrow, so you might support social insurance just in case • Key difference is that public choice theory views transfer programs as a win-win situation while mainstream theory views it as a win-loss situation

18. Cash or In-Kind Assistance? continued • In-Kind Transfer Limits and Accountability • Government usually imposes limits on the amount of in-kind subsidized aid that can be received • This is necessary for some sense of cost-certainty and helps prevent re-sales of aid (i.e. black-market for food stamps)

19. Are Pareto-Optimal Redistributions Enough? • Mainstream public economic theory would say no because equity concerns are important in addition to efficiency concerns • Mainstream argues that social welfare should also be considered

20. Three Practical Issues in Designing Transfers to the Poor • Should transfers be cash or in-kind? • If transfers are in-kind, should they be decentralized? • i.e. whether transfers are managed by government (centralized) or separate entity (decentralized) • Should transfers be broad-based or targeted? • i.e. whether transfers are available to everyone (broad-based) or available only to specific individuals with specific characteristics (targeted)

21. Mainstream and Public Choice Perspectives: What Does Theory Tell Us? • Mainstream Theory holds that transfers should be: • Lump-sum with goal of equalizing social marginal utilities of income across all individuals • Centralized by government that carries out all transfers • Either cash or in-kind • Targeted to individuals (necessary to equalize social marginal utilities)

22. Mainstream and Public Choice Perspectives: What Does Theory Tell Us? continued • Public Choice Theory • Guidelines depend on nature of externality is associated with aid • If the concern is over a lack of a specific good, the subsidy should be: • Standard Pigovian • In-kind • Decentralized • If the concern is over lack of resources and entire well-being, subsidy should be • Cash • Centralized • In both cases the subsidy should be targeted at the poor • Note: There are other theories of charitable contributions that are not focused on here

23. Broad-Based Vs. Targeted Transfers • Broad-based approach is usually cheaper to administer • The Credit Income Tax • Individuals are initially given a tax credit, then for each dollar earned they owe income tax • This most broad-based approach is easy and cheaper to administer, as it is all done by IRS • Targeting Combined With an Income Tax Exemption • Most countries do not employ the most broad-based approach even though it has lowest cost • This is because they wish to target the aid to some extent • Example: Government transfers $9,000 to families in $10,000 income class and levies 15% income tax on all income above $20,000

24. Broad-Based Vs. Targeted Transfers • Similarities • $10,000 families reach $19,000 under both policies • Differences • Credit income tax has … • Much higher income tax rate (entails higher efficiency costs which may outweigh administrative savings) • To raise much more revenue to transfer the same amount to the poor • Targeted tax credit can … • Entail higher marginal tax rate for moving up in class which is a disincentive to work hard to do so

25. Negative Income Tax • Milton Friedman • 1976 Nobel Laureate • Advocated federal negative income tax • Establishes cutoff income threshold • Individuals above threshold pay taxes • Individuals below threshold receive transfers • Desirable features: • All poor receive aid, not just those eligible for SSI TANF, etc. • Level of support is the same regardless of where people live

26. Practical Issues With Targeted Transfer Programs • As mentioned above, targeted transfer programs entail high marginal tax rates • A transfer program may be defined as a success if it can satisfy three goals: • 1. Get everyone out of poverty • 2. Avoid being too costly to taxpayers • 3. Preserve incentives to work and to keep families intact • Problem: It is not possible to meet all three goals at the same time • → Some sacrifices must be made which upset some people

27. How Government Currently Apportions Aid • Cutoff level of income is determined • → Below a certain level of income receives aid, above that level of income does not • A subsidy is provided which is percentage of difference between cutoff income and actual income • Subsidies may be a disincentive to work

28. Work Incentives Under the Labor-Leisure Model • Individuals face trade-offs when deciding how many hours to work (the labor-leisure trade-off) • Additional hours of work provide income which can be used to purchase goods and services which increase utility • Additional hours of work require individuals to give up hours of leisure which decreases utility

29. The Stick Approach • Suppose X is raised to 100% and the cut-off income level is set at the poverty level • All individuals will be raised out of poverty • Program will not be too costly because total cost will be equal to poverty gap, which is not too large • Problem: No incentive at all to work because everyone is raised to poverty line. • Solution: Workfare programs • Force welfare recipients to receive education or training as condition of welfare receipt

30. The Earned Income Tax Credit • Individuals with low income receive subsidy in the form of not having to pay income tax on income below specified level • → This preserves the incentive to work because increased wage creates substitution effect out of leisure and into work

31. The Notch Problem • The notch problem: A large disincentive to work exists right around the cut-off level of income: • To offset the notch problem, government establishes multiple eligibility ranges that increase with income and offer different subsidy levels that decrease across those ranges • This helps reduce disincentive to work but does not completely eliminate it

32. Introduction Social Insurance: Social Security • The provision of social insurance is now the most important function of federal government in the US • Revenue to finance Social Security is collected through payroll tax on employers and employees • 75-year projections suggest that at, current tax rates, future revenue will be not high enough to finance current benefit levels for future generations • This is an important political issue in the US but as yet nothing has been done to change the current system

33. Introduction Social Insurance: Social Security continued • Social security is not means-tested like public assistance (majority of payments go to non-poor) • → It is designed to protect people of all income levels from suffering a large decrease in their standard of living due to events that affect earning power • → Potential events covered are retirement (Social Security), illness (Medicare), and unemployment (Unemployment Insurance)

34. Social Security Pensions: Structure • Social Security Act of 1935 established a Social Security Trust Fund overseen by a board of trustees • The program has the following features: • 1. Principle source of income to the Trust Fund is the tax on payrolls of covered employees • 2. Pension benefits are in the form of an annuity, which is payable each month from retirement to death • Spouses and dependants of the beneficiary are entitled to an annuity

35. Social Security Pensions: Modifications • The age at which a beneficiary could claim full retirement was originally set at 65 but will increase to 67 by 2012 • The system set up in 1935 was arranged so that all the money paid in by current workers was paid out to support current retirees • In 1983, President Reagan convinced Congress to build up a Trust Fund in anticipation of the coming baby boomer retirement years • Trust Fund has been accumulating surplus since 1983, funded by increase in payroll tax and retirement age

36. The Baseline Overlapping Generations Model • Economists frame their discussion of the economics of Social Security in terms of what they call an Overlapping Generations (OLG) Model consisting of two or more cohorts alive at one time (young workers and old retirees) • Models assume the following: • That individuals have identical tastes and plan their consumptions over their lifetimes • That people are not credit constrained so they can borrow and save at different points to smooth consumption over their lifetimes

37. The Baseline OLG Model continued • Under these assumptions, individuals borrow early in their careers, save in the middle, and consume from savings at the end of their lives • When a pay-as-you-go system is introduced, the first-generation retirees receive a transfer payment • In a second period, the second-generation workers retire and receive a transfer payment financed by tax on a third-generation of workers, who were not born in first period • This means that in each period, new generation of retirees receive more in transfers than they paid in taxes

38. The Baseline OLG Model continued • Under this plan … • First-generation workers gain a transfer payment • Second-generation workers gain transfer payments but lose premium and interest on taxes paid in the first-period • The same is true for all future generations • In essence then, the pay-as-you-go system represents a wealth transfer to the first-generation from all subsequent generations

39. The Baseline OLG Model continued • The OLG model therefore predicts that: • First-generation receives more income so they increase both current and future consumption • Second-generation sacrifices income so they reduce both current and future consumption • First-generation is closer to death so they have a higher marginal propensity to consume and their effect dominates (so overall consumption increases) • Increased consumption means reduced saving which implies permanent reductions in investment, capital stock, output and wages over time

40. Problems With The OLG Model • There are several reasons to believe that reduction in saving over time might not occur to degree predicted above • Bequest motive may lead to very different results • Retirees might realize that system represents a wealth transfer and might return it (plus interest rate r) to their children as a bequest • In this case, there would be no increase in consumption by initial retirees and there would be no changes in consumption among future retirees • Moral hazard might lead to earlier retirements in which case individuals will likely save more on their own • If individuals are credit-constrained they are not borrowing in the first place and payroll taxes might act as a forced savings ∴

41. Problems With The OLG Model continued • Conclusion • Individuals appear to behave differently than predictions of rational OLG model because most do not save adequately for retirement, so model might not be that accurate to begin with

42. Social Security as A Redistributional Program • Social Security is intended to be more than a straight pension program: • 1. It is intended to redistribute wealth across generations by redistributing more to lower-income people than to higher-income people • The pay-as-you-go feature redistributes a large amount of wealth across generations • Such large redistributions across generations might appeal to societies that place greater value on equality

43. Social Security as Social Insurance • The date of retirement and the length of retirement cannot be known by workers • This introduces adverse selection into the private pension market which makes it function inefficiently • Offering payments as an annuity helps reduce this problem as there is a chance that people may die early, which works in insurers favor • Annuities are underutilized in the U.S. because of the adverse selection problem • For this reason, the government steps in and provides public annuities ∴

44. Problems with Public and Private Annuities • Problems with Public Annuities • They necessarily redistribute wealth from those with low life expectancies to those with high life expectancies • Problems with Private Annuities • People might simply not understand the advantages offered by annuities and might fail to plan adequately for retirement • Private annuities do not adjust for inflation because most are not indexed • Public insurance programs are likely to be much cheaper to administer than private insurance programs

45. Social Security Reform • There have been many proposals to reform the current system to address several potential problems • The most well-known is the impending retirement of the baby boom generation • Ratio of workers to retirees was 16:1 in 1950 but will be only 2:1 by 2040 • Longer-term problems are that: • People now live longer than they did when the system originated in 1935 • Due to increasing income inequality more individuals have incomes above the payroll tax limit

46. Social Security Reform continued • Because all of these problem lead to a shortfall in the program, proposals to fix the system require altering either the revenue or the benefits streams • The magnitude of changes is not that large • It is estimated that solvency would require increased savings of 2.6% of GDP, which is about equal to the buildup in defense spending during the 1990s

47. Unit 4 Assignment • Review the Unit 2 scenario and assignment • The 10 survivors held a meeting to attempt to decide who should remain in the bunker. • Fortunately, all of the survivors were well versed in public economics and the survivors approached their situation from a perspective that the bunker dwellers would eventually end up creating an economy and that, at times, the bunker dwellers would act as a government.

48. Unit 4 Assignment • Match the public economics perspective with the survivors’ statements. • Once you have correctly matched the perspectives to the survivors’ statements, write a paper that provides a determination of which three survivors will remain in the bunker through an analysis of the theories and methodologies of political economy on the relationship between the survivors (who represent states, markets, and societies)

49. Unit 4 Assignments • Read Chapters 9-12 in the course text • Participate in the discussions • Submit your Unit 4 assignment • Please contact me with any questions!