Seminar Unit 1 - “Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.” - - Ronald Reagan, 40 th President of the United States

Unit 1 Seminar 1. Public Sector Theory 2. Market Failures 3. Welfare Economics Fundamental Theorems

Three Normative Aspects of Public Sector Economics 1. Public expenditure theory  What government expenditures do we expect, and why?  How should government carry out its desired functions? 2. Theory of taxation  What principles should guide design of government tax policy 3. Theory of fiscal federalism

Fiscal Federalism Refers to multi-tiered system of government Questions Which tiers should provide which government functions? How do people sort themselves across tiers? Federal - 1 State - 50 Local - 89,000+

What are the Legitimate Economic Functions of a Government? Depends on chosen economic system… Least individual freedom Most individual freedom Centrally Planned Socialism: Government owns all resources and makes all important economic decisions Decentralized Capitalist Economy: Limited government; individuals and firms make all important economic decisions

Where do Current Economies Fall? Least individual freedom Most individual freedom China Often referred to as “communist” economy 52.8 % free according to Heritage Foundation’s Index of Economic Freedom (126th freest in world) United States Often referred to as ‘capitalist’ economy Gov’t spending 30% of GDP 80.6% free in 2008 according to Heritage Foundation’s Index of Economic Freedom (5th freest in world)  Modern economies all lie well within bounds

What Economic Functions Should Government Provide? Should honor consumer and producer sovereignty (humanism) Gov’t should intervene in cases of market failure Functions that government cannot perform at all or performs sufficiently badly to merit gov’t intervention The correct definition of market failure is the main issue over which Liberals and Conservatives disagree Both sides do agree that gov’t should not intervene in markets that are functioning well

Two Goals of Economies 1: EFFICIENCY Efficiency is mainly a positive concept Economists measure efficiency as Pareto Optimality Definition: An economy-wide allocation of resources is efficient if in order to increase one person’s utility at least one other person’s utility must be decreased Example An allocation in which I have everything and you have nothing is an ‘efficient’ allocation (Pareto Optimal)  The only way to make you better off is to take some away from me

Two Goals of Economies 2: EQUITY (FAIRNESS) Equity is mainly a normative concept End-results equity Asks whether outcomes are fair.  For example: Is it fair that over half of income in U.S. goes to 20% of households? If not, what should be done to correct it? Process equity Asks whether rules determining process are fair, regardless of allocation.  For example: Do children of wealthy families start with an advantage due to their family’s wealth? If so, then what should be done to level the playing field?

How Should Government Carry Out Its Desired Functions? In general, government should act as agent for individuals  Implies that elected officials do not make decisions on own behalf  Ignores that elected officials are individuals interested in their own personal welfare

Public Choice Theory (1) Credited to James Buchanan (Nobel Laureate 1986) Believed individuals self-interested in both private and public economic affairs Gov’t just another venue through which to pursue economic self-interest Buchanan’s Public Choice Theory adds political content to concept of individual decision-making  Argues that gov’t is efficient only if it establishes rules that allow people to get what they want from gov’t

Public Choice Theory (2) Therefore, what would be an efficient (Pareto Optimal) decision rule? Unanimity: only way to make at least one person better off without making anyone worse off  Problem: Unanimity is impractical As number of citizens increases what are chances anything passes?  Solution: Buchanan argues that unanimity should only be required when gov’t first agrees on its decision- making process After that all decisions can be made by different rule (i.e. majority rule)

How do Mainstream and Public Choice Theories Compare? Similarities: Both argue that democracy is process that is most consistent with decentralized market economy that honors consumer sovereignty Differences: Public choiceMainstream Adds political contentIgnores political content wherever possible Focuses on processFocuses on outcomes Assumes narrow self- interest in private and public affairs Assumes narrow self- interest in private affairs only

Pros and Cons of Public Choice Theory More desirable aspectsLess desirable aspects Better able to explain and predict actual gov’t behavior Has a thin normative base which makes correct decisions on gov’t intervention in cases of market failure difficult to determine Focuses more on process than outcomes Belief in self-interest in all aspects of life appealing to economists Ignores possibility that individuals have sense of community

And Finally… Recent experiments (Behavioral Economics) suggest that individual behavior is often more consistent with Mainstream view  Individuals appear more self-interested in market experiments than in public good experiments

Market Failures - How do markets fail? - What activities should government be involved in? To answer these questions, we must consider … - Structure of individual product and factor markets - Nature of individual preferences and production technologies

The Market Assumptions Best market structure → Perfect competition (1) Many, many consumers and firms (2) Homogenous product (3) Perfect information for buyers and sellers (4) Free entry and exit in Long-run

The First and Second Fundamental Theorems of Welfare Economics First Fundamental Theorem of Welfare Economics -If all technical assumptions hold, a perfectly competitive market generates an efficient allocation of resources Implications 1. Full Pareto optimality holds in terms of people 2. No other system can do better in terms of efficiency

The First and Second Fundamental Theorems of Welfare Economics continued Second Fundamental Theorem of Welfare Economics - If all technical assumptions hold, a perfectly competitive economy can generates any of the feasible efficient allocations of resources with a suitable distribution of initial resources

The First and Second Fundamental Theorems of Welfare Economics continued - Adam Smith ( ) – One of the first modern economic thinkers - Published the An Inquiry into the Nature and Causes of the Wealth of Nations in Observed that the market economy functions as if guided by ‘invisible hand’ to generate proper allocation of resources

The First and Second Fundamental Theorems of Welfare Economics continued Combined Implication of the Theorems -Markets are simple (1) Markets are decentralized (2) Markets are anonymous (3) Market rules are entirely self-serving -Yet markets are potentially very powerful - According to the two fundamental theorems of Welfare Economics, perfectly competitive markets can provide economically efficient outcomes -Experience suggests that most markets work exceedingly well

The First and Second Fundamental Theorems of Welfare Economics continued - Theory suggests potential power of markets, but … do markets always function well? - Musgrave (1959) focuses on three separate branches of public economics to address this question - 1. Distribution branch - Addresses failures to achieve end-results or process equity 2.Allocation branch - Addresses failures to achieve Pareto Optimal outcomes 3.Stabilization branch - Addresses failures in macroeconomic policy (mainly left to macro courses)

PARETO OPTIMALITY Paretian System  Two fundamental components of Paretian value system  1. Individual preferences count  2. Prevailing income distribution is desireable

PARETO OPTIMALITY Pareto Criterion  Purpose  Pareto criterion is a technique for comparing or ranking alternative states of the economy  Definition of Pareto Criterion  If it is possible to make at least one person better off in moving from state A to state B without making anyone else worse off, state B is ranked higher by society than state B

PARETO OPTIMALITY Pareto Criterion  Pareto Improvement A movement from state A to state B  Pareto Criterion vs.Unanimity Pareto criterion allows indifference by some individuals (some not made worse off)

PARETO OPTIMALITY Pareto Optimum  A state of the economy from which it is impossible to make one person better off without making another person worse off.  If society finds itself in a position from which there is no Pareto improvement, then there is a Pareto optimum  If economy is not in Pareto optimum, some inefficiency in the economy

PARETO OPTIMALITY Weak Pareto Criterion  Everyone is made better off. Strong Pareto Criterion  Some people are made better off, while noone is made worse off. Pareto criterion breaks down if even one individual is made worse off.

PARETO OPTIMALITY Graphically Utility Person B Utility Person A Set of Pareto improvements Pareto-inefficient starting point Utility Possibility Curve Corresponds to all possible combinations of utility for individuals A and B for given production possiblity frontier

PARETO OPTIMALITY AND INCOME DISTRIBUTION Pareto optimality gives an efficient resource allocation and maximum social welfare for a given income distribution If change existing income distribution, then new Pareto optimum Hence, many Pareto optimum may exist associated with different factor endowments (incoome distributions)

PARETO OPTIMALITY AND INCOME DISTRIBUTION Implies cannot solve problem of efficiency and income distribution in two stages by: 1. First, Pareto-efficient resource allocation 2. Optimum distribution No solution by Pareto criterion

LIMITATIONS TO PARETO CRITERION 1. Breaks down if single individual made worse off 2. Many alternatives simply not comparable  Alternative Pareto optimum (corresponding to different income distributions) not Pareto comparable  Pareto criterion does not allow choosing between alternative income distributions 3. Favors status quo 4. Not all first-best Pareto-optimal choices are superior to some second-best (Pareto- inefficient) choices  Second-best may have superior income distribution

Violations of the Technical Assumptions There are several potential reasons that markets fail in allocation … 1. Externalities - Consumption by individual or production by firm that affects utility function or production function of at least one other individual or firm - Can be positive (utility increasing) or negative (cost increasing) - Examples: Positive - education, urban renewal, public health, R&D, etc; Negative - air pollution, noise pollution, etc.

Violations of the Technical Assumptions continued - Problem: Additional utility (cost) is not recognized by market which leads to under- production (over-production) - Solution: Government intervenes in market by taxes, subsidies, and/or regulation to create more efficient outcome

Violations of the Technical Assumptions continued Nonexclusive (Public) goods - A good for which, once someone buys, it everyone is able to enjoy the full amount of the services provided by the good - Examples: national defense, highways, parks, pools, golf clubs, etc. - Problem: If you can consume a good whether you pay for it or not, you have no incentive to contribute to production (the free-rider problem) which results in under-production - Solution: Government provides more efficient level of production which is financed through collection of taxes

Violations of the Market Assumptions 1. Property Rights and Enforceable Contracts - Problem: If property rights are not protected (i.e. I can steal what you produce) there is no incentive to undertake economic activity - Solution: Government regulation and enforcement 2. Decreasing Costs/Economies of Scale - Goods for which the average cost of production decreases as quantity produced increases over a large scale - Example: Public utilities, public transportation, telecomms, etc. - Problem: Efficient production results with one (or few) large firms. - Such a market has incentive to act as monopoly which results in under-production - Solution: Government grants monopoly and regulates production to get more efficient outcome

Violations of the Market Assumptions continued Private/Asymmetric Information: - One party in a two-party transaction possesses more information than the other - Problem: Party possessing more information can take advantage of other party which results in inefficient outcome - Solution: Government creates oversight bodies that regulate functioning of such markets (e.g. FDA, FTC, etc.) to create more efficient outcome

Stabilization Conclusion - Problems in allocation branch usually require government intervention to make markets operate more efficiently

Government Response to Market Failure in the U.S. - Government addresses different concerns at different levels (→ Fiscal Federalism) At federal level Government provides: - National defense → (~20% of spending in U.S. in 2006) - Social insurance → (~40% of spending in U.S. in 2006) - Public Assistance → (~15% of spending in U.S. in 2006) - Federal regulating agencies - Grants-in-aid to states and localities

Government Response to Market Failure in the U.S. continued At state and local level Government provides: - Public education → (~15% of spending in U.S. in 2006) - Transportation funds → (~6% of spending in U.S. in 2006) - Public Welfare → (~25% of spending in U.S. in 2006) - etc.