PP640 Seminar Week 3

Public/Private Goods

Two Watershed Elections in 20th Century Franklin Delano Roosevelt -32nd President of the United States ( ) -“True individual freedom cannot exist without economic security and independence.” → Elected during Great Depression → Signed Social Security Act of 1935 to provide public insurance against poverty → A ‘Liberal’ President Franklin D. Roosevelt (1940) Source: Franklin D. Roosevelt Library

Ronald Reagan -40th President of the United States ( ) -“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.” → Elected during stagflation of late 1970s → ‘Conservative’ response to FDR → Proposed largest tax cut in history and drastic spending cuts to social programs Official Portrait of President Reagan (1981) Source: Ronald Reagan Library

How much did social spending change during and after Reagan? Not much – Through the following residents (Republican & Democratic) spending as % of GDP changed little So what is difference between Liberals and Conservatives? – Not as great as might be suggested in popular press – Differences are more normative than positive

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 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?

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 pg. 17

Market Failure Free rider problem Externalities Information asymmetry

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 2. 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 3. Private/Asymmetric Information: -One party in a two-party transaction possesses more information than the other -Firms may possess more information -Example: Product quality, drug safety/effectiveness, etc. -Individuals may possess more information -Example: Individual health, personal risk-avoidance, etc. -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

Violations of the Market Assumptions continued 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.

Government Response to Market Failure in the U.S. continued