Chapter 5: The Public Sector and Public Choice ECON 152 – PRINCIPLES OF MICROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

2 What a Price System Can and Cannot Do A perfectly competitive price system can allocate resources efficiently through the interaction of markets. Market Failure  A situation in which an unrestrained market economy leads to too few or too many resources going to a specific economic activity

3 What a Price System Can and Cannot Do Market failure prevents economic efficiency. Market failure prevents individual freedom. Public policy (government) is often called upon to address market failure.

44 Functions of Government Economic Functions Correcting for externalities Providing a legal system Providing public goods Ensuring economywide stability Political Functions Merit and demerit goods Redistributing income

5 Correcting for Externalities Externalities  Occur when the consequence of an economic activity spillover to affect third parties Third Parties  Parties who are not directly involved in a given activity or transaction

6 Correcting for Externalities Externalities are examples of market failures. Pollution is an example of a negative externality.

7 External Costs and Benefits Figure 5-1, Panel (a) S2S2 S1S1 E1E1 E A Q2Q2 Q1Q1 P1P1 P2P2 Price of Steel per Ton Quantity of Steel per Year Panel (a) D

8 External Costs and Benefits Figure 5-1, Panel (b) S Q2Q2 Q1Q1 P1P1 P2P2 Price of Inoculation Quantity of Inoculations per Year D1D1 D2D2 Panel (b)

9 The Other Economic Functions of Government Providing a legal system  Enforcing contracts  Defining and protecting property rights  Establishing legal rules of behavior Property Rights  The rights of an owner to use and to exchange property

10 The Other Economic Functions of Government Promoting competition  Market failure may occur if markets are not competitive.  Monopoly power A firm that has great control over the price  Antitrust legislation Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices

11 The Other Economic Functions of Government 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.

12 The Other Economic Functions of Government Characteristics of public goods  Indivisible  Additional people can use public goods at no additional cost  Additional users of public goods do not deprive other users  Difficult to charge for a public good based on consumption—the exclusion principle

13 The Other Economic Functions of Government Free-Rider Problem  Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods

14 The Political Functions of Government Merit Goods  Goods deemed socially desirable through the political process Museums Ballet Concerts  Provided through subsidization Demerit Goods Tobacco Alcohol Gambling  Discouraged through taxation

15 Total Government Outlays Over Time Figure 5-2 Source: Facts and Figures on Government Finance and Economic Indicators, various issues

16 Federal Government Spending Compared to State and Local Spending Budget of the United States Government; Government Finances Figure 5.4

5-17 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

5-18 Figure 5-4 The Economic Effects of Medicare Subsidies

5-19 The Economic Effects of Medicare Subsidies 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.

5-20 Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? Medicare spending is growing much faster than employer and employee contributions. If both Medicare and federal tax collections continue to grow at present rates until 2050, Medicare will account for half of all federal tax collections.

5-21 Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd) Because of the growth in program spending, Medicare will lack financial resources to cover promised benefits by 2019 or sooner. Congress will have to increase taxes or cut benefits or both.

5-22 Policy Example: Is the Medicare Program on the Fast Track to Bankruptcy? (cont'd) How do increasing life expectancies contribute to Medicare’s funding difficulties?

5-23 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.

5-24 Economic Issues of Public Education (cont'd) Economics of public education  Publicly subsidized, similar to government subsidized healthcare  Education priced below market

5-25 Economic Issues of Public Education (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.

5-26 Policy Example: What Have Public Schools Done with Subsidies? Public school enrollments have increased 40% since Inflation-adjusted spending per student has increased 200%. Teachers have increased by 60%.

5-27 Policy Example: What Have Public Schools Done with Subsidies? (cont'd) Overall, number of non-teaching staff increased 500%. As predicted by the basic economics of subsidies, schools have allocated funds to activities contributing little to student learning.

28 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 transactions

29 Collective Decision Making: The Theory of Public Choice Theory of Public Choice  The study of collective decision making

30 Collective Decision Making: The Theory of Public Choice Similarities in market and public-sector decision making  Individuals motivated by self-interest  Scarcity and opportunity cost  Competition  Similarity of individuals and incentives Incentive Structure  The system of rewards and punishments individuals face with respect to their actions

31 Collective Decision Making: The Theory of Public Choice Differences between market and collective decision making  Government (political) goods at zero price Goods (and services) provided by the public sector  Use of force

32 Collective Decision Making: The Theory of Public Choice 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

33 Collective Decision Making: The Theory of Public Choice 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

Chapter 5: The Public Sector and Public Choice ECON 152 – PRINCIPLES OF MICROECONOMICS Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.