Chapter 5. Introduction. Learning Objectives. Public Spending and Public Choice. Why have shortages existed in markets for vaccines?

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1 Chapter 5 Public Spending and Public Choice Introduction Why have shortages existed in markets for vaccines? Why might the government have a role in trying to correct this situation? Copyright 2008 Pearson Addison Wesley. All rights reserved. 5-2 Learning Objectives Explain how market failures, such as externalities, might justify economic functions of government Distinguish between private and public goods and explain the nature of the free-rider problem Describe the political functions of government that entail its involvement in the economy Copyright 2008 Pearson Addison Wesley. All rights reserved

2 Learning Objectives (cont'd) Analyze how Medicare affects the incentives to consume medical services Explain why increases in government spending on public education have not been associated with improvements in measures of student performance Discuss the central elements of the theory of public choice Copyright 2008 Pearson Addison Wesley. All rights reserved. 5-4 Chapter Outline What a Price System Can and Cannot Do Correcting for Externalities The Other Economic Functions of Government The Political Functions of Government Public Spending and Transfer Programs Collective Decision Making: The Theory of Public Choice Copyright 2008 Pearson Addison Wesley. All rights reserved. 5-5 Did You Know That... The U.S. government collects more than $1 trillion annually in income taxes? Local, state, and federal governments raise more than $1 trillion in other taxes? Government takes care of some of the functions that the price system does not? Copyright 2008 Pearson Addison Wesley. All rights reserved

3 What a Price System Can and Cannot Do In its most ideal form, a price system allows resources to move from lowervalued 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. Copyright 2008 Pearson Addison Wesley. All rights reserved. 5-7 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) Copyright 2008 Pearson Addison Wesley. All rights reserved. 5-8 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

4 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved Correcting for Externalities (cont'd) Externalities 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

5 Correcting for Externalities (cont'd) Externalities are examples of market failures. Pollution is an example of a negative externality. Inoculations generate external benefits. Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 5-1 External Costs and Benefits, Panel (a) Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 5-1 External Costs and Benefits, Panel (a) Copyright 2008 Pearson Addison Wesley. All rights reserved

6 External Costs and Benefits Resource misallocations of externalities External costs market overallocates External benefits market underallocates Government can correct negative externalities Special taxes Regulation Copyright 2008 Pearson Addison Wesley. All rights reserved External Costs and Benefits (cont'd) Effluent Fee A pollution tax Copyright 2008 Pearson Addison Wesley. All rights reserved External Costs and Benefits (cont'd) How the government can correct positive externalities Government financing and production Subsidies Regulation Copyright 2008 Pearson Addison Wesley. All rights reserved

7 The Other Economic Functions of Government Providing a legal system Promoting competition Providing public goods Ensuring economywide stability Copyright 2008 Pearson Addison Wesley. All rights reserved The Other Economic Functions of Government (cont'd) Providing a legal system Enforcing contracts Defining and protecting property rights Establishing legal rules of behavior Copyright 2008 Pearson Addison Wesley. All rights reserved The Other Economic Functions of Government (cont'd) Promoting competition Market failure may occur if markets are not competitive. Antitrust legislation Monopoly power Copyright 2008 Pearson Addison Wesley. All rights reserved

8 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

9 The Other Economic Functions of Government (cont'd) Characteristics of public goods 1. Can be used by more and more people at no additional opportunity cost 2. Difficult to charge for a public good based on consumption the exclusion principle Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

10 The Political Functions of Government Merit Goods Goods deemed socially desirable through the political process Museums Demerit Goods Goods deemed socially undesirable Illegal substances Copyright 2008 Pearson Addison Wesley. All rights reserved 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? Copyright 2008 Pearson Addison Wesley. All rights reserved The Political Functions of Government (cont'd) Income redistribution: includes progressive income tax system and transfers Copyright 2008 Pearson Addison Wesley. All rights reserved

11 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

12 Figure 5-2 Total Government Outlays over Time Copyright 2008 Pearson Addison Wesley. All rights reserved Figure 5-3 Federal Government Spending Compared to State and Local Spending Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

13 Figure 5-4 The Economic Effects of Medicare Subsidies Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

14 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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? Copyright 2008 Pearson Addison Wesley. All rights reserved Economic Issues of Public Education State and local governments provide primary, secondary, and postsecondary education at prices well below those that would otherwise prevail in the marketplace. Copyright 2008 Pearson Addison Wesley. All rights reserved

15 Economic Issues of Public Education (cont'd) Economics of public education Publicly subsidized, similar to government subsidized healthcare Education priced below market Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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%. Copyright 2008 Pearson Addison Wesley. All rights reserved

16 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 decisions Copyright 2008 Pearson Addison Wesley. All rights reserved Collective Decision Making: The Theory of Public Choice (cont'd) Theory of Public Choice The study of collective decision making Copyright 2008 Pearson Addison Wesley. All rights reserved

17 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

18 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

19 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved

20 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 Copyright 2008 Pearson Addison Wesley. All rights reserved 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. Copyright 2008 Pearson Addison Wesley. All rights reserved 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 Copyright 2008 Pearson Addison Wesley. All rights reserved

21 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 Copyright 2008 Pearson Addison Wesley. All rights reserved End of Chapter 5 Public Spending and Public Choice 21