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Chapter 5
Public Spending and Public Choice
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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.
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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
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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
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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
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Did You Know That...
• An auditor recently discovered that a New jersey public school district had been transmitting salary payments totaling $130,000 per year to the account of an employee who had been deceased for over 30 years?
• The same audit found that the public school district had paid a company $953,000 for copy equipment even though the purchase order was only for equipment valued at $55,000?
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Did You Know That… (cont’d)
• The incentives and institutional arrangements that condition the behavior of private firms and governments differ in some fundamental respects.
• One key distinction is that while firms function within the price system, a key rationale for the operations of government is to perform functions that the price system does not do well.
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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.
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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)
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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.
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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
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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
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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
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Correcting for Externalities (cont'd)
• Externalities are examples of market failures.
• Pollution is an example of a negative externality.
• Inoculations generate external benefits.
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Figure 5-1 External Costs and Benefits, Panel (a)
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Figure 5-1 External Costs and Benefits, Panel (b)
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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
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Correcting for Externalities (cont'd)
• How the government can correct positive externalities
– Government financing and production
– Subsidies
– Regulation
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The Other Economic Functions of Government
• Providing a legal system
• Promoting competition
• Providing public goods
• Ensuring economywide stability
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The Other Economic Functions of Government (cont'd)
• Providing a legal system
– Enforcing contracts
– Defining and protecting property rights
– Establishing legal rules of behavior
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The Other Economic Functions of Government (cont'd)
• Promoting competition
– Market failure may occur if markets are not competitive.• Antitrust legislation
• Monopoly power
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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
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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.
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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
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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
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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
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The Other Economic Functions of Government (cont'd)
• Ensuring economywide stability
– Smooth ups and downs in overall business activity
– Full Employment Act 1946 • Full employment
• Price stability
• Economic growth
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The Political Functions of Government
• Merit Goods– Goods deemed socially desirable through the
political process• Museums
• Demerit Goods– Goods deemed socially undesirable
• Illegal substances
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International Policy Example: China’s Government Struggles With How to regard Tobacco
• About 36% of all adults in China smoke, as compared with 21% of adults in the U.S.
• For China’s government , the good news is that it owns the nation’s cigarette manufacturing company, China National Tobacco Corporation.
• Although one measure of merit—attendance—is declining.
• Who bears the cost?
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International Policy Example: China’s Government Struggles with How to regard Tobacco (cont’d)
• The government plows earnings into a variety of activities, including constructing highways, hydroelectric dams, and railroads.
• The bad news is that all the smoking promoted in China is creating an epidemic of diseases.
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The Political Functions of Government (cont'd)
• Income redistribution: includes progressive income tax system and transfers
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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
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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
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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
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Figure 5-2 Total Government Outlays over Time
Sources: Facts and Figures on Government Finance, various issues;Economic Indicators, various issues.
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Figure 5-3 Federal Government Spending Compared to State and Local Spending
Sources: Budget of the United States government; government finances.
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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
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Figure 5-4 The Economic Effects of Medicare Subsidies
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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.
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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.
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Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It (cont'd)
• 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.
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Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It (cont'd)
• 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?
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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.
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Public Spending and Transfer Programs (cont’d)
• Economics of public education
– Publicly subsidized, similar to government subsidized healthcare
– Education priced below market
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Public Spending and Transfer Programs (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.
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E-Commerce Example: The Miniscule Payoff from Public School Internet Subsidies
• The E-Rate program of 1996 provides a subsidy to public schools for use in making classrooms Web-connected.
• The E-Rate subsidy is about $100 per pupil.
• The objective of this subsidy was to boost the breadth of students’ access to the Internet.
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E-Commerce Example: The Miniscule Payoff from Public School Internet Subsidies (cont'd)
• The effects of the E-Rate program on student performances in Texas and California found no concrete evidence of improved student performance.
• Why might the $100-per-student E-Rate subsidy provide a miniscule learning payoff for students who already have Internet access at home?
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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
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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.
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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
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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
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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
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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
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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
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Collective Decision Making: The Theory of Public Choice (cont'd)
• 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
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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.
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Issues and Applications: An Ethanol Bonanza, or an Ethanol Boondoggle? (cont'd)
• 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.
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Issues and Applications: An Ethanol Bonanza or an Ethanol Boondoggle? (cont'd)
• Finally, some critics of ethanol subsidies argue that ethanol produced using corn actually requires more energy than the ethanol ultimately creates.
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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.
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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
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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.
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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
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Summary Discussion of Learning Objectives (cont'd)
• 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