The role of government Today: Public goods; government failure; taxation

Today Three mini-lectures on the role of government Public goods Sub-optimal results when privately funded Government failure Pork and political gain Taxation How much is “enough?” What should we tax?

Public goods Public goods are goods that have some degree of two characteristics Nonrival Nonexcludable Positive externalities lead to suboptimal consumption when public goods are privately purchased

Definitions Nonrival good (F/B p. 448) “A good whose consumption by one person does not diminish its availability to others” Nonexcludable good (F/B p. 448) A good that is difficult, or costly, to exclude nonpayers from consuming Pure public good (F/B p. 448) A good or service that, to a high degree, is both nonrival and nonexcludable

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Covered in earlier chapters; uses basic supply/demand theory

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Covered in Chapter 12

Categories of goods LowHigh Commons good (oxygen that you breathe) Public good (lighthouses) LowPrivate good (pens) Collective good (copyrighted books) Nonexcludable Nonrival Goods with copyright or patent protection have some level of market power

Public goods We will examine pure public goods Highly nonrival Highly nonexcludable Marginal analysis is used to find the optimal quantity Optimal quantity is where PUBLIC MB equals MC

Example Fireworks show off of a tiny coastal community 25 people live here Each person has the same private demand for fireworks P = 2 – 0.08 Q MC for fireworks is 10 Notice that if fireworks were publicly purchased, nobody would buy them (10 > 2)

Fireworks show as a public good Since one person’s enjoyment of fireworks does not take away from the enjoyment from others, PUBLIC MB is the sum of PRIVATE MBs PUBLIC MB is the vertical summation of all 25 PRIVATE MBs P = 25  (2 – 0.08 Q) = 50 – 2Q

Vertical summation Vertical summation of 25 PRIVATE MB lines produces PUBLIC MB line MC PUBLIC MB PRIVATE MB

Marginal analysis To find efficient level of fireworks, set PUBLIC MB = MC 50 – 2Q = 10 Q = 20

Summary: Public goods Public goods are goods that are nonrival and nonexcludable Private provision of public goods leads to a quantity provided that is below the optimal quantity Vertical summation of PRIVATE MBs determines PUBLIC MB Useful in determining optimal quantity of public good

Government failure Governments often fail the MB/MC test on a public scale Three methods for political gain Pork barrel legislation Price supports Rent seeking

Governments in a democracy We vote in an indirect democracy We elect people to represent us US House of Representatives US Senate Various state and local elections We elect these people with the hope that they serve our interests, especially with market failures

Pork barrel legislation Consider the US Congress 435 members of the House of Representatives Each member of the House is interested in satisfying the people living in her/his district Each member of the House may decide to try to pass legislation that is beneficial to her/his home district, even though people in other districts pay taxes to pay for the project

Pork barrel legislation Congress members in the House have 2-year terms They often act in a way to get re-elected Bringing spending projects to their home districts are usually helpful in getting re- elected

Pork barrel legislation Will other Congress members stop pork barrel practices? Not if they want their own pork policies passed When politicians agree to pass each other’s pork policies, this is known as logrolling

Price supports Another issue related to government failure involves price supports Firms try to influence politicians in order to increase profits for their businesses Proposals often have big gains to a few and small losses to many Example: Agricultural subsidies These proposals very often lead to lower efficiency

Price supports Why do price-support measures pass when efficiency is lowered? Those that lose are often unaware of the program Example: The US has had programs to keep the price of peanuts artificially high Finding out information of all governments programs is costly (Recall Ch. 13) Most voters will not find out about government programs that are not in their best interest

Rent-seeking Sometimes, a government determines a single winner for a contract Example: One firm is chosen to establish a type of beneficial technology Many firms will often spend a substantial amount of money to gain the contract These efforts are unproductive to society; this is known as rent-seeking See Example 16.6 (p. 462) for the classic example of auctioning a $20 bill

Ways to lessen government failure Campaign reform laws Restrict spending and corporate influence More informed voters Cost-benefit criteria for government spending

Summary: Government failure Governments can step in to correct market failures Governments can also make decisions that lower efficiency Pork barrel legislation Price supports Rent-seeking

Taxation Taxes are the most important source for government revenue Income Property Corporate

How much is enough? Governments can continue to charge more taxes to get more revenue, right? No: If taxes were 100%, people would have no incentive to work What is the largest amount of tax revenue that can be generated?

How much is enough? The tax- revenue relationship was popularized by Arthur Laffer Maximum tax revenue occurs at tax rate t*

What is t*? There is debate as to what t* is Most people believe that t* is substantially less than 100% This leads to the question… What should be taxed?

There are clearly situations in which the government’s actions improve overall efficiency Schools Parks National defense Roads and highways What should be taxed to limit DWL?

What should be taxed? Anything such that the DWL is less than efficiency gain from the government’s actions with the money generated Goods with inelastic demand Markets with negative externalities Goods that pollute

Summary: Taxation Taxes come from many sources The Laffer curve shows that the tax rate that maximizes tax revenue is less than 100% Some goods can be taxed such that the marginal social benefit is greater than the DWL of the tax

Lecture material finished