1. Public Spending and Public Choice
Chapter 5
Public Spending and Public Choice

2. What a Price System Can and Cannot Do
In its most ideal form, a price system allows resources to move from lower- valued to higher-valued uses through voluntary exchange.
Economic efficiency arises when all mutually advantageous trades have taken place.
There are, however, situations when a price system does not generate the desired results.

3. What a Price System Can and Cannot Do (cont'd)
Market Failure
A situation in which the unrestrained market economy leads to too few or too many resources going to a specific economic activity
Prevents economic efficiency and individual freedom
Is addressed by public policy (government)

4. Correcting for Externalities
In a pure market system, economic efficiency occurs when individuals know and must bear the true opportunity cost of their actions.
In some cases, the price that someone actually pays for a resource, good, or service is higher or lower than the opportunity cost that all society pays.

5. Correcting for Externalities (cont'd)
Market failure: an example
Assume
No government regulation against pollution
A town with clean air
A steel mill opens and emits smoke that causes
More respiratory diseases
Dirtier clothes, houses, cars

6. Correcting for Externalities (cont'd)
Market failure: an example
Market failure occurs
Steel mill does not pay for the clean air
Costs of production have “spilled over” to the residents (third parties)
Lower production cost
More steel is produced than would otherwise be the case

7. Correcting for Externalities (cont'd)
Occur when the consequences of an economic activity spill over to affect third parties
Third Parties
Parties who are not directly involved in a given activity or transaction
Property Rights
Rights of an owner to use and exchange property

8. Correcting for Externalities (cont'd)
Externalities are examples of market failures.
Pollution is an example of a negative externality.
Inoculations generate external benefits.

9. Figure 5-1 External Costs and Benefits, Panel (a)

10. Figure 5-1 External Costs and Benefits, Panel (a)

11. External Costs and Benefits
Resource misallocations of externalities
External costs—market overallocates
External benefits—market underallocates
Government can correct negative externalities
Special taxes
Regulation

12. External Costs and Benefits (cont'd)
Effluent Fee
A pollution tax

13. External Costs and Benefits (cont'd)
How the government can correct positive externalities
Government financing and production
Subsidies
Regulation

14. The Other Economic Functions of Government
Providing a legal system
Promoting competition
Providing public goods
Ensuring economywide stability

15. The Other Economic Functions of Government (cont'd)
Providing a legal system
Enforcing contracts
Defining and protecting property rights
Establishing legal rules of behavior

16. The Other Economic Functions of Government (cont'd)
Promoting competition
Market failure may occur if markets are not competitive.
Antitrust legislation
Monopoly power

17. The Other Economic Functions of Government (cont'd)
Antitrust Legislation
Laws that restrict the formation of monopolies and regulate certain anticompetitive business practices
Monopoly
A firm that can determine the market price, in the extreme case is the only seller of a good or service

18. The Other Economic Functions of Government (cont'd)
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.

19. The Other Economic Functions of Government (cont'd)
Principal of Rival Consumption
Recognizes individuals are rivals in consuming private goods
Public Goods
Can be jointly consumed by many individuals simultaneously

20. The Other Economic Functions of Government (cont'd)
Characteristics of public goods
Can be used by more and more people at no additional opportunity cost
Difficult to charge for a public good based on consumption—the exclusion principle

21. The Other Economic Functions of Government (cont'd)
Exclusion Principle
Anyone can enjoy the benefits of a public good, even if they have not paid for it.
Free-Rider Problem
Arises when some individuals take advantage of the fact that others will take on the burden of paying for public goods

22. The Other Economic Functions of Government (cont'd)
Ensuring economywide stability
Smooth ups and downs in overall business activity
Full Employment Act 1946
Full employment
Price stability
Economic growth

23. The Political Functions of Government
Merit Goods
Goods deemed socially desirable through the political process
Museums
Demerit Goods
Goods deemed socially undesirable
Illegal substances

24. Policy Example: Civic Centers Grow as Exhibition Attendance Declines
More than 50 new government-funded civic centers are under construction in the United States.
Although one measure of merit— attendance—is declining.
Who bears the cost?

25. The Political Functions of Government (cont'd)
Income redistribution: includes progressive income tax system and transfers

26. The Political Functions of Government (cont'd)
Transfer Payments
Money payments made by governments to individuals for which in return no services or goods are rendered
Examples are Social Security old age and disability benefits and unemployment insurance benefits

27. The Political Functions of Government
Transfers in Kind
Payments that are in the form of goods and services
Include food stamps, subsidized public housing, medical care

28. Public Spending and Transfer Programs
Government Outlays
All federal, state and local spending
Examples
Defense, income security, Social Security—at the federal level
Education, health and hospitals, public welfare—at the state level

29. Figure 5-2 Total Government Outlays over Time

30. Figure 5-3 Federal Government Spending Compared to State and Local Spending

31. 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

32. Figure 5-4 The Economic Effects of Medicare Subsidies

33. 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.

34. 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.

35. 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 or sooner.
Congress will have to increase taxes or cut benefits or both.

36. 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?

37. 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.

38. Economic Issues of Public Education (cont'd)
Economics of public education
Publicly subsidized, similar to government subsidized healthcare
Education priced below market

39. 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.

40. Policy Example: What Have Public Schools Done with Subsidies?
Public school enrollments have increased 40% since 1960.
Inflation-adjusted spending per student has increased 200%.
Teachers have increased by 60%.

41. 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.

42. Collective Decision Making: The Theory of Public Choice
How voters, politicians, and other interested parties act and how these actions influence non-market decisions

43. Collective Decision Making: The Theory of Public Choice (cont'd)
The study of collective decision making

44. Collective Decision Making: The Theory of Public Choice (cont'd)
Similarities in market and public-sector decision making
Self-interest
Opportunity cost
Competition
Similarity of individuals, but different incentive structures

45. Collective Decision Making: The Theory of Public Choice (cont'd)
Incentive Structure
The system of rewards and punishments individuals face with respect to their actions

46. Collective Decision Making: The Theory of Public Choice (cont'd)
Differences between market and collective decision making
Government goods at zero price
Use of force
Voting versus spending

47. Collective Decision Making: The Theory of Public Choice (cont'd)
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

48. Collective Decision Making: The Theory of Public Choice (cont'd)
Government or Political Goods
Goods (and services) provided by the public sector
Majority Rule
Collective decision making, decisions based on more than 50%
Proportional Rule
If 10% of “dollar votes” cast for blue cars, 10% of output is blue

49. Collective Decision Making: The Theory of Public Choice (cont'd)
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

50. Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain?
Every fall, millions of U.S. residents stand in line for their flu shots.
During the mid-2000s, shortages of flu vaccines developed.
Flu vaccines were not the only vaccines difficult to obtain.

51. Why are vaccine shortages occurring?
Issues and Applications: Why Can Inoculations Against Disease Be Hard to Obtain? (cont'd)
Why are vaccine shortages occurring?
Paradoxically, because inoculations provide external benefits
The scenario
U.S. government purchases vaccines
Manufacturers required to sell at discount, so receive lower prices
Production is scaled back
Shortages occur

52. Summary Discussion of Learning Objectives
How market failures such as externalities might justify economic functions of government
Market failure is a situation in which an unhindered free market allocates too many or too few resources to a specific economic activity.
Private goods versus public goods and the free-rider problem
Private goods are subject to rival consumption.
Public goods are not subject to rival consumption.
Free-riders anticipate others will pay.

53. Summary Discussion of Learning Objectives (cont'd)
Political functions of government that lead to its involvement in the economy
Merit goods deemed socially desirable
Demerit goods deemed socially undesirable
Redistributing income
Transfer payments
In kind transfers

54. Summary Discussion of Learning Objectives (cont'd)
The effect of Medicare on incentives to consume medical services
Subsidies lead to a higher quantity of medical services consumed.
Medicare encourages people to consume medical services that are low in per-unit value relative to the cost.

55. Summary Discussion of Learning Objectives (cont'd)
Why bigger subsidies for public schools do not necessarily translate into improved student performance
Last unit of educational services provided likely to cost more than its valuation by parents and students
Services provided in excess of those best suited to promoting student learning

56. Summary Discussion of Learning Objectives (cont'd)
Central elements of the theory of public choice
Collective decision making
Voters, politicians, other participants influence nonmarket choices.
Incentive structures
Rewards and punishments affect provision of government goods.
Similarities and differences with market system structures
Scarcity, competition—similarities
Legal coercion, majority rule—differences