The Public Sector Chapter 4

Introduction The market can determine WHAT goods to produce, HOW, and for WHOM. Market outcomes may not necessarily be most desirable.

Introduction Government intervention may be needed to ensure better answers.

Introduction The key questions addressed by this chapter are: Under what circumstances do markets fail? How can government intervention help? How much government intervention is desirable?

Market Failure Our goal is to produce the optimal mix of output. An optimal mix of output is the most desirable combination of output attainable with existing resources, technology and social values.

Market Failure Ideally, the market mechanism leads to an optimal mix of output. The market mechanism uses market prices and sales to signal desired outputs (or resource allocations).

Market Failure Changes in market prices direct resources from one industry to another. The economy moves along the perimeter of the production-possibilities curve.

Market Failure The market mechanism may produce a mix of output that is different from the one society desires. This is called market failure. Market failure establishes a basis for government intervention.

Market Failure Market failure occurs when an imperfection in the market mechanism prevents optimal outcomes. The forces of supply and demand do not lead us to the best point on the production-possibilities curve.

Market Failure Production possibilities All Other Goods (units per time period) Computers (units per time period) Production possibilities X (Optimal mix) M (Market mix)

Causes of Market Failure The four specific sources of market failure are: Public goods Externalities Market power Equity

Public Goods A private good is a good or service whose consumption by one person excludes consumption by others. An example of a private good is a donut. When one person consumes a donut, the process of consumption excludes others from consuming that same donut.

Joint Consumption A public good is a good or service whose consumption by one person does not exclude consumption by others. An example of a public good is national defense. One person’s consumption of national defense does not preclude others from consuming the same amount of national defense.

The Free-Rider Dilemma The communal nature of public goods may cause consumers to try for a free ride. A free rider is an individual who reaps direct benefits from someone else’s purchase (consumption) of a public good.

The Free-Rider Dilemma Consumers will not demand the public good hoping that someone else will purchase it. They get the benefit(s) of the good or service without paying for it(them).

Underproduction of Public Goods If public goods were marketed like private goods, everyone would wait for someone else to pay. The result might be a total lack of public services.

Underproduction of Public Goods The market tends to underproduce public goods and overproduce private goods. If we want more public goods, we need a non-market force — government intervention — to get them.

Underproduction of Public Goods (Market mix) A (Optimal mix) PUBLIC GOODS Production possibilities R S V W PRIVATE GOODS

Externalities Externalities are the costs (or benefits) of a market activity borne by a third party. The difference between the social and private costs (benefits) of a market activity.

Externalities Whenever externalities are present, the preferences expressed in the marketplace will not be a complete measure of a good’s value to society.

Externalities The market will underproduce goods that yield external benefits and overproduce those that generate external costs.

External Costs The market responds to consumer demand, not externalities.

External Costs Social demand equals market demand plus externalities. The externality is subtracted if it is an external cost.

External Costs The optimal production mix is where the social demand curve intersects the supply curve.

Externalities Quantity of Cigarettes Price Market supply Market demand Social demand EM qM External cost per pack EO qO

External Benefits Externalities can also be beneficial. An example is the students education. Not only does it benefit the student and the school, but it also benefits society through research or having better informed citizens.

External Benefits If a product yields external benefits, the social demand is greater than the market demand.

External Benefits and Costs When externalities are present, the market mechanism will not get us the optimal mix of output. To get that optimal mix, we need government intervention.

Market Power The market may fail when the response to price signals is flawed, rather than the signals themselves.

Restricted Supply When a firm has market power it has the ability to alter the market price of a good or service.

Restricted Supply Market power gives a producer the ability to maximize profits rather than produce the optimal mix of output.

Restricted Supply Monopoly is the most severe form of market power. A monopoly is a firm that produces the entire market supply of a particular good or service.

Antitrust Policy Government intervention is necessary to prevent or dismantle concentrations of market power.

Antitrust Policy Government follows an antitrust policy when it intervenes to alter market structure or prevent abuse of market power.

Natural Monopoly A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply.

Natural Monopoly The government may have to regulate the behavior of a natural monopoly to ensure that consumers get the benefits of its cost efficiency.

Inequity The distribution of goods and services generated by the marketplace is not necessarily “fair.”

Taxes and Transfers Taxes and transfer payments are the principal tools for transferring money from those who have “too much” to those who have “too little.”

Taxes and Transfers Transfer payments are made to individuals for which no current goods or services are exchanged, like Social Security, welfare, unemployment benefits.

Merit Goods The government is called upon to distribute merit goods when the market does not provide enough. A merit good is a good or service society deems everyone is entitled to some minimal quantity of.

Macro Instability The micro failures of the marketplace imply that we are at the wrong point on the production-possibilities curve or inequitably distributing the output produced.

Macro Instability The goal of macro intervention is to foster economic growth. Get us on the production possibilities curve (full employment). Avoid inflation (price stability). Increase our capacity to produce (growth).

Macro Instability Unemployment is the inability of labor-force participants to find jobs. Inflation is an increase in the average level of prices of goods and services.

Growth of Government The potential micro and macro failures of the marketplace provide specific justifications for government intervention.

Federal Growth The increasing responsibilities of the federal government have greatly increased its size.

Federal Growth The federal government employed 350,000 people and spent only $650 million in 1902. Today, the federal government employs 4,000,000 and spends $2 trillion a year.

Direct Expenditure Although the absolute size of government has grown, the relative size of government has declined slightly since World War II.

Income Transfers Virtually all of the recent growth in federal expenditure has come from increased income transfers, not purchases of goods and services.

Government Growth 50 45 40 35 30 25 20 15 10 5 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 2000 Percentage of National Output State and local purchases Federal purchases Total government purchases

State and Local Growth Prior to World War II, state and local spending on goods and services dominated public-sector spending.

State and Local Growth During World War II the share of total output going to state and local governments shrank dramatically.

State and Local Growth In the mid-1960s, state and local government spending caught up with federal spending.

State and Local Growth Since then, the share has increased. Today, state and local governments buy much more output than the federal government and employ four times as many people.

State and Local Spending 31% 21% 17% 4% 7% 10% State Spending 43% 8% 17% 11% 10% 6% 5% Local Spending Public safety Transportation Health Welfare Environment Education Miscellaneous

Taxation The opportunity costs of public spending are not always apparent. Opportunity cost is the most desired goods or services that are foregone in order to obtain something else.

Taxation The primary function of taxes is to transfer command over resources (purchasing power) from the private sector to the public sector.

Federal Taxes The personal income tax, social security taxes, corporate taxes, and excise taxes are the most important taxes collected by the federal government.

Income Taxes The Sixteenth Amendment to the U.S. Constitution (1915) granted the federal government authority to collect income taxes. It is now the largest single source of government revenue.

Income Taxes The federal income tax is designed to be progressive. A progressive tax is one in which tax rates rise as incomes rise.

Social Security Taxes The social security tax is the second major source of federal revenue. Workers transfer part of their earnings to retired workers by making “contributions” to Social Security.

Social Security Taxes The social security tax is proportional up to a certain income ceiling and is regressive after that. Proportional tax – a tax that levies the same rate on every dollar of income. Regressive tax – a tax system in which tax rates fall as income rises.

Corporate Taxes The federal government taxes the profits of corporations as well as consumer incomes.

Excise Taxes Excise taxes are imposed on certain goods and services – examples include liquor, gasoline, cigarettes, and telephone service. Excise taxes discourage production and consumption of these goods.

Federal Taxes Excise taxes 3% Corporate Customs duties 1% income Social Security taxes 32% Individual income tax 50% Corporate income 10% Other 8% Excise taxes 3% Customs duties 1% Estate and gift taxes 1% Miscellaneous 3%

State and Local Revenues Taxes, federal aid, and user charges are the major sources of revenues for state and local governments.

Taxes Cities depend heavily on property taxes while states rely heavily on sales taxes. State and local taxes tend to be regressive.

State and Local Tax Sources STATE TAX SOURCES Corporate 6% Property 2% Other 9% Income 35% Sales 48% LOCAL TAX SOURCES Other 6% Sales 15% Income 6% Property 73%

Federal Aid State and local governments also receive revenue from the federal government. Most of this revenue is in the form of categorical grants.

Federal Aid Categorical grants are federal grants to state and local governments for specific expenditure purposes. Examples of categorical grants include employment programs, Medicaid, schools, and highways.

User Charges Another major source of state and local revenues consists of user charges. A user charge is a fee paid for the use of a public-sector good or service.

User Charges Examples of user charges include college tuition, library fees, etc.

Big Lotteries’ Real Losers Lotteries are a regressive source of government revenue. Poor people spend a larger percentage of their income on lottery tickets than do rich people.

Government Failure Some government intervention in the marketplace is clearly desirable. Governments, like markets, can fail.

Government Failure Government failure occurs when government intervention fails to improve economic outcomes.

Perceptions of Waste Government waste implies that the public sector isn’t producing as many services as it could with the sources at its disposal. With such inefficiency, we are producing inside our production-possibilities curve.

Opportunity Cost The issue of government waste encompasses questions of efficiency and opportunity cost.

Opportunity Cost Efficiency—Are we getting as much service as we could from the resources we allocate to the government? Opportunity Cost—Are we giving up too many private-sector goods in order to get those services?

Opportunity Cost Everything the government does entails an opportunity cost. We must consider not only what governments do, but also what we give up to allow them to do it.

Cost-Benefit Analysis Additional public-sector activity is desirable only if the benefits from that activity exceed its opportunity costs.

Valuation Problems The value of (benefits) of public services must be estimated because they don’t have (reliable) market prices.

Ballot-Box Economics Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them.

Ballot-Box Economics We do not know what the real demand for public goods is, and votes alone do not reflect the intensity of individual demands.

Public Choice Theory Government officials may pursue their own agendas over public interest. The theory of public choice emphasizes the role of self-interest in public policy.

Public Choice Theory Public choice is a theory of public-sector behavior emphasizing rational self-interest of decision-makers and voters.

Public Choice Theory A central tenet of public-choice theory is that bureaucrats are just as selfish (utility maximizing) as everyone else.

Downsizing Government The Great Depression of the 1930s and World War II stimulated a significant expansion of the role of government in the economy.

Deficit Financing The federal government kept growing during the Reagan years using borrowed money.

Military Cutbacks The federal share of total output declined during the 1990s as military spending declined.

Nonmilitary Downsizing The increasing skepticism about government intervention has prompted a worldwide downsizing of the public sector. The downsizing has been most dramatic in the former communist nations lie the Soviet Union.

The Public Sector End of Chapter 4