Chapter 5 Powerpoint

Chapter 5

Public Spending and Public Choice

Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-2

Introduction

The U.S. Postal Service (USPS) delivers nearly 40 percent of the world’s mail. Yet, its annual mail volume has declined by more than 20 percent since 2006.

Continuation of USPS operations is dependent on the more than $15 billion in loans provided by the federal government.

Why does government sponsor the provision of certain items, rather than allowing private firms to supply them? We will explore this question in Chapter 5.


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


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


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


Did You Know That ...

• A woman searching for scrap metal in the Eastern European nation of Georgia accidentally halted all Internet communication to Armenia?

• In shoveling below ground to find unused wires containing copper, the woman sliced through a fiber optic cable.

• In her defense, the woman claimed that she was pursuing her own self-interest by looking for scrap metal that could be sold for a profit.

• This event is an example of how the market system may cause negative spillovers for third parties.


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


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)


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


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



• 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



• 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



• Externalities are examples of market failures

• Pollution is an example of a negative externality

• Inoculations generate external benefits


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


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


Correcting for Externalities (cont’d)

• Resource misallocations of externalities– External costs—market overallocates

– External benefits—market underallocates

• Government can correct negative externalities– Special taxes (a pollution tax or “effluent fee”)

– Regulation


Example: Hungary’s Tax on Prepackaged Snacks

• The Hungarian government has determined that there are external spillovers on the nation’s health care system from the snack food market.

• The government wants to discourage production of sweets, salted snacks, and energy drinks.

• Therefore, it has imposed a tax on foods with a high content of sugar, salt, carbohydrates, or caffeine.



• How the government can correct positive externalities

– Government financing and production

– Subsidies

– Regulation


Policy Example: Stop the Presses for Subsidies!

• As newspaper readership has declined over the past decade, some government officials have argued that local newspapers provide positive externalities.

• They reason that the information provided by newspapers may save lives.

• As a consequence, some state governments provide subsidies for local newspapers.


The Other Economic Functions of Government

• Providing a legal system

• Promoting competition

• Providing public goods

• Ensuring economy-wide stability


The Other Economic Functions of Government (cont'd)

• Providing a legal system

– Enforcing contracts

– Defining and protecting property rights

– Establishing legal rules of behavior



• Promoting competition

– Market failure may occur if markets are not competitive.

• Antitrust legislation

• Monopoly power



• 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



• Providing public goods

– Goods to which the principle of rival consumption does not apply

• These are goods that may be consumed jointly by many individuals at the same time.

– In contrast, private goods can be consumed by one individual at a time



• What truly distinguishes public goods from all private goods is that the costs incurred in excluding nonpayers from consuming a public good are prohibitive

• Individuals in the private sector have little incentive to provide public goods



• 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


Example: Private Companies Look to Place Humans in Orbit – and Beyond

• Bigelow Aerospace, a private firm, has designed and tested low-cost inflatable space stations in which humans can reside.

• Another firm, Moon Express, offers a low-cost method of landing people on the moon.

• Other firms are working on the technology to get humans into orbit.



• Free-Rider Problem– Arises when some individuals take advantage of

the fact that others will take on the burden of paying for public goods

– The free-rider problem often emerges in connection with sharing the burden of international defense



• Ensuring economy-wide stability

– Smooth ups and downs in overall business activity

– Full Employment Act 1946 • Full employment

• Price stability

• Economic growth


The Political Functions of Government

• Government-Sponsored Goods– Goods deemed socially desirable through the

political process• Museums

• Government-Inhibited Goods– Goods deemed socially undesirable

• Certain psychoactive drugs


The Political Functions of Government (cont'd)

• Income redistribution: includes progressive income tax system and transfers– Transfer payments– Transfers in kind


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


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


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


Figure 5-2 Total Government Outlays over Time

Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues.


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


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

Sources: Economic Report of the President, Economic Indicators.


Figure 5-4 The Economic Effects of Medicare Subsidies


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


Policy Example: The Great Underestimates of Health Care Expenses

• In 1965, officials estimated the 1990 cost of Medicare to be $12 billion, but the actual program cost in 1990 was $110 billion.

• Similarly, the actual $45 billion cost of Medicaid in 1990 far exceeded the initial estimate of $7 billion.

• Why were the initial estimates inaccurate?

– Congress expanded the number of people eligible for both programs.

– Officials did not take into account the fact that the use of medical services would increase once these subsidies were provided.



• Health Care Subsidies Continue to Grow

– The cost of Medicare is now $550 billion per year, and unfunded guarantees of future spending exceed $25 trillion.

– In addition, the federal government pays the expenses of Medicaid, a program that provides health care for low-income citizens.

– The current cost of Medicaid is more than $400 billion per year.


What If . . . the federal government reduces out-of-pocket prices consumers pay for health care services?

• If out-of-pocket prices continue to fall, more health care services will be demanded by consumers.

• Yet, providers would require higher prices in order to expand the volume of care.

• Therefore, higher subsidies would be required, thereby raising the total government outlay.



• 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



• 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


Example: A Weak Relationship Between Spending and Schooling Results

• Alaska, New Jersey, New York, Vermont, and Washington are the states with the highest levels of per-pupil spending in public schools.

• The five lowest per-pupil spending states are Arizona, Idaho, Oklahoma, Tennessee, and Utah.

• Yet, the educational outcomes do not differ much between these two groups of states.


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


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



• Similarities in market and public-sector decision making

– Self-interest

– Opportunity cost

– Competition

– Similarity of individuals, but different incentive structures



• Incentive Structure

– The system of rewards and punishments individuals face with respect to their actions



• Differences between market and collective decision making

– Government goods at zero price

– Use of force

– Voting versus spending




– Voting versus spending

• Political system versus market system

– Political system run by majority rule

– Market system run by proportional rule



• 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




– Voting versus spending• Spending of dollars can indicate intensity of want

• Votes cannot; each vote counts with the same intensity


You Are There: The U.S. Government Ensures That an Airport is “Convenient”

• The free parking, short security lines, and spacious baggage claim areas of the Hagerstown Regional Airport in Maryland make it much more convenient than any major airport.

• But this convenience comes at an expense to U.S. taxpayers, who provide a subsidy to finance the operations of Cape Air in providing its daily flights to Baltimore.


Issues & Applications: The Government-Sponsored U.S. Postal Service

• Operating as a government-sponsored enterprise, the U.S. Postal Service (USPS) receives an implicit subsidy in the form of protection from competition.

• As mail volumes have declined, postal revenues have fallen short of operating expenses, and federally-provided loans are making up the difference.


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


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



• 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



• 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



• Central elements of the theory of public choice

– Collective decision making • Voters, politicians, other participants influence nonmarket

choices

– Incentive structures• Rewards and punishments affect provision of government

goods

– Similarities and differences with market system structures• Scarcity, competition—similarities

• Legal coercion, majority rule—differences

Date post:	14-Sep-2014
Category:	Education
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