1. Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard Stroup, and Russell Sobel The Economic Role of Government Chapter 5

2. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. What is Government?

3. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n The entity that has a monopoly over the legitimate use of force to modify the actions of adults. What is Government? n An institutional process through which individuals collectively make choices and carry out activities.

4. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Competitive behavior is present in both the market and public sectors. Private sector action is based on voluntary choice; public sector is based on majority rule. Differences and Similarities in Public and Private Decision-Making

5. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n The most fundamental function of government is the protection of individuals and their property against acts of aggression. Protective Function of Government:

6. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Involves the provision of a limited set of goods that are difficult to supply through the market. Productive Function of Government:

7. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Corrective Function of Government: n Involves the maintenance of a legal structure within which people interact peacefully and provision of a mechanism for the settlement of disputes while maintaining a competitive market.

8. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Shortcomings of The Invisible Hand

9. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Monopoly Four Reasons the Invisible Hand May Fail to Allocate Resources Efficiently: 2. Externalities 3. Public Goods 4. Asymetric Information

10. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Sellers may gain by restricting output and raising price. Why the Invisible Hand May Fail: (1) Monopoly n Too few units will be produced.

11. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Q P D MR S = MC PcPc PmPm QcQc QmQm At MR=MC A monopolist will sell less units at a higher price than in competition An industry in pure competition sells where supply and demand are equal INEFFICIENCY OF PURE MONOPOLY

12. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Externalities exist when the market fails to register fully costs and benefits. Why the Invisible Hand May Fail: (2) Externalities n External Costs: u Present when the actions of an individual or group harm the property of others without their consent. u The Problem arises because property rights are imperfectly defined and/or enforced. n External Benefits: u Present when the actions of an individual or group generate benefits for nonparticipating parties.

13. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Because costs are not fully registered, the supply curve understates the true cost of production. Characteristics of an Externality with - An External Cost n Units may be produced that are valued less than their cost. n From the viewpoint of efficiency, too many units are produced. n Pollution problems are often a side effect.

14. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. then the new supply curve ( S 2 ) would result in an output of Q 2 ( P 1 ). External Costs Failure to register fully costs. Price Quantity / Time Consider the market to the right. Under initial supply and demand conditions an output of Q 1 and a price of P 1 exist. The result of an externality with external costs (a negative externality) is that too many units are produced at a price below that which would prevail if all the costs of the production, provision, and consumption of the good were identified and factored into it. D (includes external costs) S 2 S 1 Q2Q2 P2P2 P1P1 Q1Q1 Ideal output Actual price and output If, though, all costs are fully identified and measured...

15. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Demand curve understates total value of output. Characteristics of an Externality with - An External Benefit n Units that are more highly valued than costs may not be produced. n From the viewpoint of efficiency, too few units may be produced.

16. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. D2D2 (includes external benefits) then the new demand curve ( D 2 ) would result in an output of Q 2 ( > Q 1 ) and a price P 2 ( > P 1 ). External Benefit Failure to register fully benefits. Price Quantity / Time Consider the market to the right. Under present supply and demand conditions an output of Q 1 and a price of P 1 exist. The result of an externality with external benefits (a positive externality) is that too few units are produced at a price below that which would prevail if all the benefits of the good were identified and factored into it. S Q2Q2 P2P2 P1P1 Q1Q1 Ideal output If, though, all benefits are fully identified and measured... D1D1 Actual price and output

17. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Goods that are : Why the Invisible Hand May Fail: (3) Public Goods u jointly consumed Individuals can simultaneously enjoy consumption of same product or service u non-excludable Consumption of the good cannot be restricted to the customers who pay for it

18. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n If a public good is made available to one person, it is simultaneously made available to others. Characteristics of a Public Good: n Because those who do not pay cannot be excluded, no one has much incentive to help pay for such goods. Each has an incentive to become a free rider u a person who receives the benefits of the good without helping to pay for its cost. n But, when a lot of people become free riders, too little is produced.

19. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n It is the characteristics of the good, not the sector in which it is produced, that distinguishes a public good. Characteristics of a Public Good: n Examples of public goods: u national defense u radio and television broadcast signals u clean air. n Markets often develop ways of providing public goods (e.g. use of advertising to support provision of radio and television). Nonetheless, public goods often cause a breakdown in the harmony between self-interest and the public interest.

20. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Either the potential buyer or potential seller has important information that the other side does not have. Why the Invisible Hand May Fail: (4) Asymetric Information n Major problems of conflicting interests and unhappy customers can arise when goods are either u difficult to evaluate on inspection and seldom repeatedly purchased from the same producer, or, u potentially capable of serious and lasting harmful side effects that cannot be predicted by a lay person.

21. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n The consumers information problem is minimal if the item is purchased regularly. n Brand names, franchises, and product warranties are helpful ways of dealing with information problems Why the Invisible Hand May Fail: (4) Asymetric Information

22. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Relative Size and Extent of Government

23. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 020 Sweden Denmark Netherlands Germany France Belgium Italy Austria Greece Canada United Kingdom Ireland Australia Japan United States Singapore South Korea Thailand Hong Kong 406080 Government Expenditures as a % of GDP (1996) 66.1 60.8 58.1 56.0 54.7 52.7 49.4 46.4 43.7 37.7 37.5 36.9 34.4 23.7 22.8 20.3 17.6 54.5 The Size of Government The U.S. spends about a third of GDP on local, state, and federal government. This is 3 times what it was in 1930, but not as much as many of its trade partners.

24. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 10.4 4.3 6.5 6.3 8.7 5.6 1.3 13.7 6.3 11.8 5.0 11.4 3.8 8.1 2.7 0 19601997199019801970 (a) Defense expenditures as a % of GDP 20 15 10 5 (b) Expenditures as a % of GDP 19601997199019801970 0 20 15 10 5 Income Transfers Health Care Defense spending as a % of GDP has declined sharply since 1960. The increase in income transfers and health care spending during the past 4 decades has more than offset the reduction in defense expenditures. As was seen before, during this period federal government spending increased. The Extent of Government

25. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 19971994 Social Security 23%Education 28% Public welfare and health 22% Administrative and other expenditures 21% Income security 14% Medicare and health 20% Defense a 18% Net interest 15% Highways 3% Federal spending: $1752 billion Other 7% Insurance trusts 8% Interest on debt 4% Utilities and liquor stores 7% Highways 6% Police and fire protection 4% State & local spending: $983 billion How Government Spends: The way that the respective levels of government spend money differs significantly.

26. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 19971994 Federal taxes: State & local taxes: How Government Taxes: The way that the respective levels of government tax differs significantly. Corporate income 12% Excise taxes 4% Customs duties 1% Corporate income 2% Other 4% Other 3% Property 15% Payroll 12% Personal income 10% User charges a 24% Sales and excise 17% From federal government 16% Payroll 34% Personal income 46%

27. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Government Revenue n Taxes u Progressive u Proportional u Regressive

28. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Taxation n Ability to Pay n Benefits Received

29. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Opportunity Cost of Government

30. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Opportunity cost of resources used to produce goods supplied through the public sector. The Opportunity Cost of Government Includes: n Cost of resources expended in the collection of taxes and the enforcement of government mandates. n Excess burden (deadweight loss) of taxation.

31. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Overview of Collective Decision Making

32. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. -- applies the tools of economics to the political process in order to provide insight concerning how the process works. Public Choice Analysis n Self-interested behavior is present in both market and political sectors. n Political process can be viewed as a complex exchange process involving: u voter-taxpayers u politicians u bureaucrats

33. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Public Choice Analysis: n The Voter-Consumer: u Voters will tend to support those candidates whom they believe will provide them the most government services and transfer benefits, net of personal costs. u Rational Ignorance Effect: -- Recognizing their vote is unlikely to be decisive, most voters have little incentive to obtain information on issues and alternative candidates. u Because of the rational ignorance effect, voters will be uninformed on many issues; such issues will not enter into their decision making process.

34. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Public Choice Analysis: n The Politician-Supplier: u Political officials are interested in winning elections. Just as profits are the lifeblood of the market entrepreneur, votes are the lifeblood of the politician. u Rationally uninformed voters often must be convinced to want a candidate. u Legislative bodies are something like a Board of Directors

35. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Public Choice Analysis: n Civil Servants (Government Bureaucrats) as Political Participants: u Bureaucrats (persons that handle day-to-day operations of government) seek promotions, job security, power, etc. u The interests of bureaucrats are often complementary with those of interest groups they serve. This is called the CAPTURE problem. u Bureaucrats can usually expand their own interests, as well as that of their constituents, by working for larger budgets and program expansion.

36. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. When Voting Works Well

37. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Other things constant, legislators will have a strong incentive to support political actions that provide voters with large total benefits relative to costs. n If a government project is really productive, it will always be possible to allocate the projects cost so that all voters will gain. n When voters pay in proportion to benefits received, all voters will gain if the government action is productive (and all will lose if it is unproductive.) Under these circumstances, there is a harmony between good politics and economic efficiency. When Voting Works Well

38. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Voter Adams Chan Green Lee Diaz Total T AX P AYMENT Benefits Received (1) $20 12 4 2 2 $40 Plan A (2) $ 5 5 5 5 5 $25 Plan B (3) $12.50 7.50 2.50 1.25 $25.00 Consider the government program above. As with many such programs, individuals receive varying levels of benefits. If tax plan A is adopted to fund this program, it may be simple and seem fair, but even as Adams is getting a real deal (values the program at $20 and only pays $5) Green, Lee, and Diaz do not even receive the value of their taxes paid in benefits. When each voter pays in proportion to benefits received (tax plan B), each receives more in benefits than it costs them in taxes. If tax plan B is used, all voters gain and the program would pass unanimously. This example shows that harmony between good politics and economic efficiency can exist. Benefits Derived by Voters from Hypothetical Road Construction Project

39. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. When Voting Conflicts with Economic Efficiency

40. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Special Interest Effect - generates substantial personal benefits for a small number of constituents while imposing a small individual cost on a large number of other voters. u Interest group members will feel strongly about an issue that provides them with substantial personal benefits. Such issues will dominate their political choices. u Politicians have a strong incentive to favor special interest even if action is inefficient. u Logrolling and pork-barrel legislation strengthen the special interest effect. When Voting Conflicts with Economic Efficiency

41. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. In total, A, B, and C voters come out ahead despite the costs involved in paying taxes for activities in other districts if they agree to vote together. In total, the sum of benefits for the group of all voters come out negative despite the positive benefits for district A, B, and C voters. The benefits to A, B, and C voters vary by project. Consider a composite bill in Congress that would build a post office in district A, dredge a harbor in B, and construct a military base in C. Vote Trading and Passing Counterproductive Legislation Construction of Post Office In A Dredging Harbor In B Voters of District * A B C D E Total Net Benefits (+) or Costs (-) To Each Voter in District +$10-$03- - +$10-$03 - - +$10 -$03- - - - - Construction of Military Base In C +$4 + + -$9 - -$02- - -$6 Total * We assume the districts are of equal size. With this bill, there are no direct benefits to district D and E voters. In a majority rule voting system, the majority can pass counterproductive legislation benefiting themselves but creating negative net benefits for the whole.

42. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Shortsightedness Effect -- Issues that yield clearly defined current benefits at the expense of future costs that are difficult-to- identify. u Political process is biased toward the adoption of such proposals even when they are inefficient. When Voting Conflicts with Economic Efficiency

43. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Rent Seeking -- Actions by individuals and interest groups designed to restructure public policy in a manner that will either directly or indirectly redistribute more income to themselves. u Widespread use of the taxing, spending, and regulatory powers of government that favor some at the expense of others will encourage rent seeking. u Rent seeking moves resources away from productive activities. The output of economies with substantial amounts of rent seeking will fall below their potential. When Voting Conflicts with Economic Efficiency

44. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Lack of Incentive for Operational Efficiency u In the public sector, the absence of the profit motive reduces the incentive of producers to keep costs low. Neither is there a bankruptcy process capable of weeding out inefficient producers. u Public-sector managers are seldom in a position to gain personally from measures that reduce costs. u Because public officials and bureau managers spend other peoples money, they are likely to be less conscious of cost than they would be with their own resources. When Voting Conflicts with Economic Efficiency

45. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Economics of the Transfer Society

46. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n There is nothing in positive economics that indicates one distribution of income is better than another. Economics of the Transfer Society n A large and growing part of government is devoted to transferring income.

47. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n There are three major reasons why large-scale redistribution will reduce the size of the economic pie: Economics of the Transfer Society u When taxes take a larger share of ones income, the individual reward derived from hard work and productive service is reduced. u As public policy redistributes a larger share of income, more resources will flow into wasteful rent seeking activities. u Higher taxes to finance income redistribution and an expansion in rent-seeking will induce taxpayers to focus less on income-producing activities, and more on actions to protect their income.

48. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Public Sector Vs. Market Sector: A Summary

49. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4 Factors that Weaken the Case for Market Allocation: n Lack of competition n External costs and benefits n Public goods n Poor information

50. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4 Factors that Weaken the Case for Public Allocation: n The power of special interests n The shortsightedness effect n Rent seeking costs n Lack of signals and incentives to promote operational efficiency

51. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Implications of Public Choice: Getting More From Government

52. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Both bad news and good news flow from public-choice analysis: u The bad news: For certain classes of economic activity, unconstrained democratic government will predictably be a source of economic waste and inefficiency. u The good news: Properly structured constitutional rules can improve the expected result from government. Implications of Public Choice: Getting More From Government

53. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 5