Topic I: Economics and the Public Sector
Business Administration and Management
Fall 2015-2016
Departament d’Economia Pública, Economia Política i Economia Espanyola
Bibliography
2
Rosen and Gayer:
• Chapter 1
• Chapter 4
• Chapter 5
1. The Public Sector: Introduction
2. Functions of the public sector: Why does the
public sector intervene in a market economy?
i. Efficiency (public goods)
ii. Redistribution
iii. Stabilization of the economic cycle
Musgrave, (1959)
Outline
• The Soviet Union contains some of the most fertile agricultural land in the world.
• Prior to the communist revolution of 1917 Russia was the world’s largest exporter of
grain.
Collectivization of agriculture during the 1920s and 1930s was quickly followed by
dramatic declines in agricultural output. Between five and ten million Russians died
of starvation during these years with twelve to thirteen million more saved by food
donated from the Western capitalist countries.
Incentives matter!
Introduction: What if the State bans private property
What is Public Economics or Public Finance?
Part of economics that studies the intervention of the public sector in a market economy,
mainly through financial activity (i.e. public revenues and expenses).
• Public Economics: Economic decisions of the public sector and/or the reaction of
private agents to the public sector
• Public Finance: Decisions directly related to public revenues and expenditures.
Public
Economics Economics
Introduction: The Public Sector
7
(Public) Economics & Policy
8
(Public) Economics & Policy
9
Twofold approach:
1. What are the measureable effects of government programs and
interventions? (positive analysis)
2. What should the government do if we can choose optimal policy?
(normative analysis)
Closely related: Political Economy
• Why do governments behave the as they do?
(e.g. climate change)
Introduction: The Public Sector
When we do NOT need a public sector…
First Welfare Theorem
Private markets provide a Pareto efficient outcome under the following conditions:
• Private good
• No externalities
• Perfect competition 1) All firms sell an identical product
2) All firms are price takers
3) All firms have a relatively small market share
4) Buyers have complete information about the product being sold and the prices charged by each firm
5) The industry is characterized by freedom of entry and exit.
Functions of the Public Sector
• If Q<Q*, the marginal revenue exceeds the marginal cost (under-provision)
• If Q>Q*, the marginal cost exceed the marginal revenue (over-provision)
p*
Aggregate Supply
(Marginal Cost)
P
Q*
Aggregate demand
(Marginal Revenue)
Q
Functions of the Public Sector How it should be
The market maximizes the consumer’s and
producer’s surpluses
The market is not always in this equilibrium due to the existence of market failures.
• Public goods (goods that are non-rival and non-excludable)
• Externalities
• Natural Monopolies
• Information asymmetry (adverse selection and moral hazard)
Functions of the Public Sector Market Failures
Functions of the Public Sector How it should be – Private goods
• Rival: a good taken off the shelf it isn’t there for other people to consume.
• Excludable: once you buy it, you own it and can consume it as you please.
The aggregate demand for private goods is derived by summing individual
demand horizontally:
We sum private goods horizontally, because consumers cannot consume the
same units
Functions of the Public Sector How it should be – Private goods
A simple example: Fig Leaves (f)
Source: Rosen and Gayer (Chapter 4)
Functions of the Public Sector How it should be – Private goods: e.g. Fig Leaves
price=marginal cost: efficient provision
Source: Rosen and Gayer (Chapter 4)
Characteristics of public goods (e.g. national defense):
1. Non-rival consumption: The consumption of a good by an
individual doesn’t ↓ the available q for the rest of individuals. The
mg cost of a new individual that starts consuming is equal to 0.
• a good cannot be taken “off the shelf” because individuals
enjoy the same.
2. Non-excludable consumption: It is not possible to prevent the
consumption of a good by someone who is not paying for it.
• everybody can enjoy the public good.
The aggregate demand for public goods is derived by summing
individual demand vertical: We sum public goods vertically, because
consumers can consume the same units.
Functions of the Public Sector Market Failures: Public Goods
Functions of the Public Sector Market Failures: Public Goods
A simple example: Fireworks
Source: Rosen and Gayer (Chapter 4)
Functions of the Public Sector Market Failures: Public Goods
A simple example: Fireworks
EFFICIENT PROVISION
Source: Rosen and Gayer (Chapter 4)
Why are public goods a market failure?
• Inefficient market provision - unlike price, quantity is not an
effective market mechanism:
For a given quantity, individuals will not automatically self-select their
optimal price, but will instead wish to pay the lowest price possible
when they cannot be excluded from consuming the good.
If the consumption of a good is non-excludable, the market will not
provide it.
the free rider problem occurs when those who benefit from
resources, goods, or services do not pay for them, which results
in an under-provision of those goods or services.
Functions of the Public Sector Market Failures: Public Goods
Public Sector Interventions:
public provision
Functions of the Public Sector Market Failures
rival
excludable
yes no
yes private good
natural
monopoly
(e.g. cable tv)
no
common
resource
(Fishing
grounds)
public good
(national
defense)
Public goods ≠ goods provided by the public sector
• Public sector might or might not provide public goods
Goods Classification:
If the consumption of a good is non-rival but excludable, there may be
private provision, but it will be sub-optimum
Functions of the Public Sector Market Failures: Non-rival and Excludable Goods
Public Sector Interventions:
public provision?
Example: Natural Monopoly
In some industries, there are very high fixed costs associated with the starting of the activity (natural barriers to entry)
• Railways
• Energy
• Gas
• Telephony
Decreasing average costs (due to the high fixed costs)
Efficient solution: A single producer, public or private?
Functions of the Public Sector Market Failures: Natural monopolies
Monopoly
25
MR
D
Pr
Q
AC
MC
Monopoly
26
MR
D
Pr
Q
AC
MC
Qm
Pm
Monopoly
profits:
Not efficient!
In perfect competition:
Pr=MC
In Monopoly: Pr>MC
Monopoly
27
MR
D
Pr
Q
AC
MC
Qm
Pm
Q*
P*
Monopoly
28
MR
D
Pr
Q
AC
MC
Qm
Pm
Q*
P*
Loss for the
monopolist:
he is in deficit
Monopoly
29
MR
D
Pr
Q
AC
MC
Qm
Pm
Q*
P*
Qac
Pac
Possible solutions:
A. Regulation
1. price at the average cost level (still not
efficient!)
2. Taxes to finance the deficit (even more
inefficient?)
B. Incentivize competition
C. Nationalization
Externality: Utility or production of an agent depends directly on the actions of another agent
This “effect” is NOT included in the price
Defined in 2 dimensions:
Positives vs. Negatives
Production vs. Consumption
Positives / consumption
Vaccine, Education
Negatives / consumption
Tobacco, Alcohol,
Hydrocarbon
Positives / production
R&D, on-the-job training
Negatives / production
Contamination of a river,
Noise pollution
Functions of the Public Sector Market Failures: Externalities
Qm=Sub-optimal demand for the good
MC (S) Ext
MR social=D+ext
Qm Q*
€
e.g. Vaccines (positive)
Functions of the Public Sector Market Failures: Externalities
PS Intervention : Increase the consumption of the good
(subsidize vaccine)
Marginal Benefit (MB)
e.g. contamination of a river (negative)
Qm=Over-provision of the good
MC private (S)
Ext
MC social=S+ext
Qm Q*
€
Functions of the Public Sector Market Failures: Externalities
PS Intervention:
Decrease the production of the good (tax on the dumping of waste, regulation,…)
Marginal Benefit (MB)
Functions of the Public Sector Market Failures: Externalities
• IF the costs of bargaining are low
• And IF the owners can identify the source of damages and legally prevent them
An efficient solution will be achieved simply by assigning property rights without any State intervention (known as Coase Theorem)
• e.g. Animal hunting
• Lisa fishes in the river
• Bart owns a firm polluting a river: Bart creates a negative externality
Externalities are due to inability to establish property rights: why?
• If Lisa owned the river, she could tax Bart for polluting, in turn Bart will reduce his level of pollution to save money
• If Bart owned the river, he could tax Lisa for fishing, in turn Bart will reduce his level of pollution otherwise Lisa would stop fishing
Functions of the Public Sector Market Failures: Externalities
Functions of the Public Sector Market Failures: Externalities
Animal hunting: Elephant populations in Africa
• Kenya’s approach in 1977: ban hunting
Drop in elephants from 167.000 to 16.000 by 1989
• Zimbabwe in 1982: individuals owning lands get property rights to wild animals
Increase in elephants from 40.000 to 68.000 by 1995
In Kenya the cost of an elephant killed was 0 for the landowner;
In Zimbabwe the landowner had an incentive (tourists’ safari) to protect the animals.
Qm=Sub-optimal demand for the good
MC (S) Ext
MR social=D+ext
Qm Q*
€
e.g. Vaccines (positive)
Functions of the Public Sector Market Failures: Externalities
PS Intervention : Increase the consumption of the good
(subsidize vaccine)
Marginal Benefit (MB)
e.g. contamination of a river (negative)
Qm=Over-provision of the good
MC private (S)
Ext
MC social=S+ext
Qm Q*
€
Functions of the Public Sector Market Failures: Externalities
PS Intervention:
Decrease the production of the good (tax on the dumping of waste, regulation,…)
Marginal Benefit (MB)
Marginal Damage (MD)
Marginal Benefit (MB)
private MC + MD =
Marginal Social Cost
Qm Q*
€
Functions of the Public Sector Market Failures: Externalities
private MC
• Fixed amount of pollution per unit of output
Marginal Damage (MD)
Marginal Benefit (MB)
private MC + MD =
Marginal Social Cost
Qm Q*
€
Functions of the Public Sector Market Failures: Externalities
private MC
• Fixed amount of pollution per unit of output
Loss for Bart
Gain for Lisa
Functions of the Public Sector Market Failures: Externalities
• Empirical issues:
• Which pollutions do harm?
• What activities produce pollution?
• What is the value of the damage done?
• E.g. effect on houses’ prices
Marginal Damage (MD)
Marginal Benefit (MB)
private MC + MD = Marginal
Social Cost
Qm Q*
€
Functions of the Public Sector Market Failures: Externalities
private MC
• Pigouvian Tax: a tax on each unit of output in an
amount equals to the marginal damage at the efficient
output
c
d
private MC + cd
Functions of the Public Sector Market Failures: Externalities
• Compensating Lisa with the tax will be inefficient as others will decide to fish just to receive the compensation: the result is an inefficient amount of fishing in the river
• Empirically: difficult to implement in some circumstances
• E.g. tax on gasoline instead of tax of miles driven (difficult to measure in different points in time and space)
• Other solutions:
• Fees on emissions
• instead of units of output, on units of pollution
• Cap-and-Trade
• The government sells pollution permits
1. Adverse selection (example: insurance)
• In the insurance market, there are high-risk and
low-risk individuals
• If the company can’t distinguish the 2 types of individuals,
• Low-risk individuals won’t contract the insurance (too costly for them!)
• High-risk individuals will contract the insurance (but then profit <0)
Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries
Public Sector Interventions:
Public provision: public health insurance
Regulation: compulsory health insurance (everybody need to get insurance)
E.g. medical insurance
• Lisa is a very healthy girl, she is willing to pay up to 1000euro per year for
a medical insurance
• Marge is a ordinary middle age woman, she is willing to pay up to
5000euro per year for a medical insurance
• Homer is troublesome guy, he is willing to pay up to 7000euro per year
• Mr Burns is a very old sicky guy, he is willing to pay up to 10000euro per
year for a medical insurance
The insurance know the average health costs, he cannot perfectly distinguish
among sick and healthy people: (1000+5000+7000+10000)/4=5750
Only Homer and Mr Burns will buy the insurance for an average cost of
(10000+7000)/2=8500
The insurance company will lose: (2*8500)-(2*5750)=-5500
Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries
2. Moral Hazard: the insurance modifies the behavior of individuals, reducing
the effort on preventing the risk from realizing.
If individuals can affect the probability of the risk (losing a job), no one will
provide insurance for it (unemployment insurance)
Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries
Public Sector Intervention:
Public provision: e.g., public unemployment insurance
Objective:
Stabilizing the economics fluctuations by fiscal policy:
Expansive during recessions: Increase the disposable income
(increase expenditure and/or decrease taxes)
Restrictive during expansions: Decrease the disposable income
(decrease expenditure and/or increase taxes)
Automatic stabilizers:
government budget policies, particularly income taxes and welfare spending,
automatically act to dampen fluctuations in real GDP
during recessions: unemployment benefits automatically increase
during expansions: income and corporate tax revenues increase
Functions of the Public Sector Stabilization
1. The Public Sector: Introduction
2. Functions of the public sector: Why does the
public sector intervene in a market economy?
i. Efficiency (public goods)
ii. Redistribution
iii. Stabilization of the economic cycle
Musgrave, (1959)
Outline
Economic Inequality
• Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve
• Inequality Trends
• Causes of Inequality
• Effects of Inequality
Most of the content of this unit are not in the book!
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Economic Inequality
DEFINITION: Inequality studies focus on the unequal distribution
of resources among agents (e.g. individuals, countries)
Source: World Bank (various 1994-2011)
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• A curve showing the proportion of national income
earned by a given percentage of the population.
• E.g. what proportion of national income is earned by
the top 10% of the population?
Lorenz Curve
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Lorenz Curve
% of National Income
Percentage of Population
This line represents the situation if income was distributed equally.
The poorest 10% would earn 10% of national income, the poorest 30% would earn 30% of national income.
10%
10%
30%
30%
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% of National Income
Percentage of Population 30%
20%
7%
In this second example, the Lorenz curve lies further below the line of equality.
Now, the poorest 30% only earn 7% of the national income.
Lorenz Curve
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Lorenz Curve
Gini Coefficient
% o
f N
ational In
com
e
Percentage of Population
Gini Coefficient= A / (A + B)
A
B
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The Great Gatsby Curve
• The Great Gatsby Curve illustrates the connection
between concentration of wealth in one generation and
the ability of those in the next generation to move up the
economic ladder compared to their parents (economic
mobility)
• Social Mobility important source of economic growth,
innovation and political stability
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Left axis: intergenerational elasticity of income - how much a 1 percent rise in your father’s income affects your expected income -.
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Kuznets Curve
• Before Industrialization: low inequality
• First stages of Industrialization: inequality goes up
• Only some social classes benefit (productivity gap, e.g. industry
Vs agriculture)
• Later Stages of Industrialization: wealth spreads to other
social classes (e.g. rural areas)
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Kuznets Curve
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•Is it true?
Kuznets curve seems valid only for comparisons across
countries and not within countries
Economic Inequality
• Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve
• Inequality Trends
• Causes of Inequality
• Effects of Inequality
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Inequality: Perceived Vs Real
Source: Norton, M. I., & Ariely, D. (2011). Building a better America—One wealth quintile at a time. Perspectives
on Psychological Science, 6(1), 9-12.
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Inequality: Perceived Vs Real
Source: Norton, M. I., & Ariely, D. (2011). Building a better America—One wealth quintile at a time. Perspectives
on Psychological Science, 6(1), 9-12.
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Inequality Over time
Source: IMF
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Inequality Over time
Source: IMF
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Inequality Over time
Source: IMF
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Source: IMF
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A Global Perspective: Inequality
Main Points
• Inequality mostly increased in the last decades at the
country level
• Inequality slightly decreased in the last decades at the
global level
• Global Inequality is higher than inequality across countries
• Income increased mostly in some developing countries
(e.g. China) and at the very top of the income distribution
(i.e. top 1%)
• Perceived inequality is lower than real and “ideal”
inequality
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Economic Inequality
• Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve
• Inequality Trends
• Causes of Inequality
• Effects of Inequality
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Causes of Inequality
Difficult to identify clear mechanisms, however most
plausible reasons of the recent increase in inequality are
(source IMF):
• Skill-biased technical change and globalization:
increased demand for high skill jobs and decreased
demand for low skills jobs
Indeed, supply of high skill workers did not increase
sufficiently
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Causes of Inequality
• Unions’ power declined: union membership declined
and globalization reduced unions’ bargaining power
• Change in social norms: we accept more inequality
(e.g. compared to the past, we tolerate huge pay gaps)
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Capital in the 21st century
• Piketty’s point:
• In an economy where the rate of return to wealth (or
capital) is higher than the rate of economic growth,
inherited wealth will always grow faster than earned
wealth
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Capital in the 21st century
• 2 individuals, A and B
• A does not work but he owns and he gets rents
out of it = r
• B does not own anything but he works and B’s
wage depends upon economy growth rate = g
• In economic terms, r = net-of-tax rate of return on capital;
g = growth rate
• If r>g A will become richer and richer compared to B…
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Capital in the 21st century
• Piketty’s point:
• In an economy where the rate of return to wealth (or
capital) is higher than the rate of economic growth,
inherited wealth will always grow faster than earned
wealth
• Inequality goes up
• This was typical pre-industrial society
• Piketty warns we are going back to this scenario
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Economic Inequality
• Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve
• Inequality Trends
• Causes of Inequality
• Effects of Inequality
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Consequences of Inequality
• Inequality might decrease social mobility (Great Gatsby Curve)
• Efficiency Vs Equity good or bad for growth?
• Effects on social outcomes
• Political Rent Seeking
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Consequences of Inequality
GOOD:
• Providing incentives for innovation and entrepreneurship (Lazear and Rosen, 1981)
• Raising saving and investment if rich people save a higher fraction of their income (Kaldor, 1957)
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Consequences of Inequality
BAD:
• It deprives the poor of the ability to stay healthy and
accumulate human capital
• It generates political and economic instability that reduces
investment
• It impedes the social consensus required to adjust to
shocks and sustain growth
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Efficiency Vs Equality
In a nutshell…
• Good inequality increase incentives for innovation, entrepreneurship and economic growth.
• Bad inequality creates obstacles for poor people to receive education and to access credit, that impediment economic development
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Recent studies mostly argue that too high inequality can be disruptive for growth (e.g. IMF’s studies and Alesina and Rodrik, 1994)
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Consequences of Inequality
Political Rent Seeking: The Price of Inequality (Stiglitz, 2012)
• Those with power use it to insulate themselves from competitive forces by winning favourable tax treatment and government-protected market share
• E.g. decreasing taxes on top income & corporations; electoral campaign contributions; think tanks
• This might lead to the growth of populist movements…
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Consequences of Inequality
Solution: more redistributive policies?
They might have the reverse effect (decrease growth and additionally foster inequality)!
E.g. of win-win policies
• Taxes on activities with negative externalities paid mostly by the better-off (such as, perhaps, excessive risk-taking in the financial sector)
• Cash transfers aimed at encouraging better attendance at primary schools in developing countries
• Fight tax-avoidance
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