Chapter 5 Public Spending and Public Choice Introduction

Chapter 5 Public Spending and Public Choice

Introduction Why have shortages existed in markets for vaccines? Why might the government have a role in trying to correct this situation? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 2

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 3

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 theory of public choice Copyright © 2008 Pearson Addison Wesley. All rights reserved. 4

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: Theory of Public Choice Copyright © 2008 Pearson Addison Wesley. All rights reserved. 5

Did You Know That. . . • The U. S. government collects more than $1 trillion annually in income taxes? • Local, state, and federal governments raise more than $1 trillion in other taxes? • Government takes care of some of the functions that the price system does not? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 6

What a Price System Can and Cannot Do • In its most ideal form, a price system allows resources to move from lowervalued 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 7

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 Ø Prevents economic efficiency and individual freedom Ø Is addressed by public policy (government) Copyright © 2008 Pearson Addison Wesley. All rights reserved. 8

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 9

Correcting for Externalities (cont'd) • Market failure: an example § Assume Ø No ØA government regulation against pollution town with clean air ØA steel mill opens and emits smoke that causes q More respiratory diseases q Dirtier clothes, houses, cars Copyright © 2008 Pearson Addison Wesley. All rights reserved. 10

Correcting for Externalities (cont'd) • Market failure: an example § Market failure occurs Ø Steel mill does not pay for the clean air Ø Costs of production have “spilled over” to the residents (third parties) Ø Lower q production cost More steel is produced than would otherwise be the case Copyright © 2008 Pearson Addison Wesley. All rights reserved. 11

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 12

Correcting for Externalities (cont'd) • Externalities are examples of market failures. • Pollution is an example of a negative externality. • Inoculations generate external benefits. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 13

Figure 5 -1 External Costs and Benefits, Panel (a) Copyright © 2008 Pearson Addison

External Costs and Benefits • Resource misallocations of externalities § External costs—market overallocates § External benefits—market underallocates • Government can correct negative externalities § Special taxes § Regulation Copyright © 2008 Pearson Addison Wesley. All rights reserved. 16

External Costs and Benefits (cont'd) • Effluent Fee § A pollution tax Copyright ©

External Costs and Benefits (cont'd) • How the government can correct positive externalities § Government financing and production § Subsidies § Regulation Copyright © 2008 Pearson Addison Wesley. All rights reserved. 18

The Other Economic Functions of Government • Providing a legal system • Promoting competition • Providing public goods • Ensuring economywide stability Copyright © 2008 Pearson Addison Wesley. All rights reserved. 19

The Other Economic Functions of Government (cont'd) • Providing a legal system § Enforcing contracts § Defining and protecting property rights § Establishing legal rules of behavior Copyright © 2008 Pearson Addison Wesley. All rights reserved. 20

The Other Economic Functions of Government (cont'd) • Promoting competition § Market failure may occur if markets are not competitive. Ø Antitrust legislation Ø Monopoly power Copyright © 2008 Pearson Addison Wesley. All rights reserved. 21

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 22

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 23

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24

The Other Economic Functions of Government (cont'd) • Characteristics of public goods 1. Can be used by more and more people at no additional opportunity cost 2. Difficult to charge for a public good based on consumption—the exclusion principle Copyright © 2008 Pearson Addison Wesley. All rights reserved. 25

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 26

The Other Economic Functions of Government (cont'd) • Ensuring economywide stability § Smooth ups and downs in overall business activity § Full Employment Act 1946 Ø Full employment Ø Price stability Ø Economic growth Copyright © 2008 Pearson Addison Wesley. All rights reserved. 27

The Political Functions of Government • Merit Goods § Goods deemed socially desirable through the political process Ø Museums • Demerit Goods § Goods deemed socially undesirable Ø Illegal substances Copyright © 2008 Pearson Addison Wesley. All rights reserved. 28

Policy Example: Civic Centers Grow as Exhibition Attendance Declines • More than 50 new government-funded civic centers are under construction in the United States. • Although one measure of merit— attendance—is declining. • Who bears the cost? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 29

The Political Functions of Government (cont'd) • Income redistribution: includes progressive income tax system

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 31

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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 32

Public Spending and Transfer Programs • Government Outlays § All federal, state and local spending § Examples Ø Defense, income security, Social Security—at the federal level Ø Education, health and hospitals, public welfare —at the state level Copyright © 2008 Pearson Addison Wesley. All rights reserved. 33

Figure 5 -2 Total Government Outlays over Time Copyright © 2008 Pearson Addison Wesley.

Figure 5 -3 Federal Government Spending Compared to State and Local Spending Copyright ©

Public Spending and Transfer Programs (cont'd) • Publicly subsidized healthcare § Medicare Ø Began in 1965 Ø Pays hospital and physicians’ bills for U. S. residents over 65 with public monies Ø 2. 9% of earnings taxed Ø Second biggest domestic program in existence § Medicaid Ø Subsidizes people with lower incomes Copyright © 2008 Pearson Addison Wesley. All rights reserved. 36

Figure 5 -4 The Economic Effects of Medicare Subsidies Copyright © 2008 Pearson Addison

The Economic Effects of Medicare Subsidies • 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 38

Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? • Medicare spending is growing much faster than employer and employee contributions. • If both Medicare and federal tax collections continue to grow at present rates until 2050, Medicare will account for half of all federal tax collections. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 39

Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd) • Because of the growth in program spending, Medicare will lack financial resources to cover promised benefits by 2019 or sooner. • Congress will have to increase taxes or cut benefits or both. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 40

Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd) • How do increasing life expectancies contribute to Medicare’s funding difficulties? Copyright © 2008 Pearson Addison Wesley. All rights reserved. 41

Economic Issues of Public Education • State and local governments provide primary, secondary, and postsecondary education at prices well below those that would otherwise prevail in the marketplace. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 42

Economic Issues of Public Education (cont'd) • Economics of public education § Publicly subsidized, similar to government subsidized healthcare § Education priced below market Copyright © 2008 Pearson Addison Wesley. All rights reserved. 43

Economic Issues of Public Education (cont'd) • 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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 44

Policy Example: What Have Public Schools Done with Subsidies? • Public school enrollments have increased 40% since 1960. • Inflation-adjusted spending per student has increased 200%. • Teachers have increased by 60%. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 45

Policy Example: What Have Public Schools Done with Subsidies? (cont'd) • Overall, number of non-teaching staff increased 500%. • As predicted by the basic economics of subsidies, schools have allocated funds to activities contributing little to student learning. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 46

Collective Decision Making: Theory of Public Choice • Collective Decision Making § How voters, politicians, and other interested parties act and how these actions influence non-market decisions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 47

Collective Decision Making: Theory of Public Choice (cont'd) • Theory of Public Choice §

Collective Decision Making: 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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 49

Collective Decision Making: Theory of Public Choice (cont'd) • Incentive Structure § The system of rewards and punishments individuals face with respect to their actions Copyright © 2008 Pearson Addison Wesley. All rights reserved. 50

Collective Decision Making: Theory of Public Choice (cont'd) • Differences between market and collective decision making § Government goods at zero price § Use of force § Voting versus spending Copyright © 2008 Pearson Addison Wesley. All rights reserved. 51

Collective Decision Making: Theory of Public Choice (cont'd) • Differences between market and collective decision making § Voting versus spending Ø Political q system versus market system Political system Run by majority rule q Market system Run by proportional rule Copyright © 2008 Pearson Addison Wesley. All rights reserved. 52

Collective Decision Making: 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 Copyright © 2008 Pearson Addison Wesley. All rights reserved. 53

Collective Decision Making: Theory of Public Choice (cont'd) • Differences between market and collective decision making § Voting versus spending Ø Spending of dollars can indicate intensity of want Ø Votes cannot; each vote counts with the same intensity Copyright © 2008 Pearson Addison Wesley. All rights reserved. 54

Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain? • Every fall, millions of U. S. residents stand in line for their flu shots. • During the mid-2000 s, shortages of flu vaccines developed. • Flu vaccines were not the only vaccines difficult to obtain. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 55

Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain? (cont'd) • Why are vaccine shortages occurring? § Paradoxically, because inoculations provide external benefits § The scenario Ø U. S. government purchases vaccines Ø Manufacturers required to sell at discount, so receive lower prices Ø Production is scaled back Ø Shortages occur Copyright © 2008 Pearson Addison Wesley. All rights reserved. 56

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. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 57

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 Ø Transfer Ø In payments kind transfers Copyright © 2008 Pearson Addison Wesley. All rights reserved. 58

Summary Discussion of Learning Objectives (cont'd) • The effect of Medicare on incentives to consume medical services § Subsidies lead to a higher quantity of medical services consumed. § Medicare encourages people to consume medical services that are low in per-unit value relative to the cost. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 59

Summary Discussion of Learning Objectives (cont'd) • Why bigger subsidies for public schools do not necessarily translate into improved student performance § Last unit of educational services provided likely to cost more than its valuation by parents and students § Services provided in excess of those best suited to promoting student learning Copyright © 2008 Pearson Addison Wesley. All rights reserved. 60

Summary Discussion of Learning Objectives (cont'd) • Central elements of theory of public choice § Collective decision making Ø Voters, politicians, other participants influence nonmarket choices. § Incentive structures Ø Rewards and punishments affect provision of government goods. § Similarities and differences with market system structures Ø Scarcity, competition—similarities Ø Legal coercion, majority rule—differences Copyright © 2008 Pearson Addison Wesley. All rights reserved. 61

End of Chapter 5 Public Spending and Public Choice