Topic I: Economics and the Public Sector Business Administration and Management Fall

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1 Topic I: Economics and the Public Sector Business Administration and Management Fall Departament d Economia Pública, Economia Política i Economia Espanyola

2 Bibliography Rosen and Gayer: Chapter 1 Chapter 4 Chapter 5 2

3 Outline 1. The Public Sector: Introduction 2. Functions of the public sector: Why does the public sector intervene in a market economy? i. Efficiency (public goods) ii. Redistribution iii. Stabilization of the economic cycle Musgrave, (1959)

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5 Introduction: What if the State bans private property The Soviet Union contains some of the most fertile agricultural land in the world. Prior to the communist revolution of 1917 Russia was the world s largest exporter of grain. Collectivization of agriculture during the 1920s and 1930s was quickly followed by dramatic declines in agricultural output. Between five and ten million Russians died of starvation during these years with twelve to thirteen million more saved by food donated from the Western capitalist countries. Incentives matter!

6 Introduction: The Public Sector What is Public Economics or Public Finance? Part of economics that studies the intervention of the public sector in a market economy, mainly through financial activity (i.e. public revenues and expenses). Public Economics: Economic decisions of the public sector and/or the reaction of private agents to the public sector Public Finance: Decisions directly related to public revenues and expenditures. Economics Public Economics

7 (Public) Economics & Policy 7

8 (Public) Economics & Policy 8

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10 Introduction: The Public Sector Twofold approach: 1. What are the measureable effects of government programs and interventions? (positive analysis) 2. What should the government do if we can choose optimal policy? (normative analysis) Closely related: Political Economy Why do governments behave the as they do? (e.g. climate change)

11 Functions of the Public Sector When we do NOT need a public sector First Welfare Theorem Private markets provide a Pareto efficient outcome under the following conditions: Private good No externalities Perfect competition 1) All firms sell an identical product 2) All firms are price takers 3) All firms have a relatively small market share 4) Buyers have complete information about the product being sold and the prices charged by each firm 5) The industry is characterized by freedom of entry and exit.

12 Functions of the Public Sector How it should be P Aggregate demand (Marginal Revenue) The market maximizes the consumer s and producer s surpluses Aggregate Supply (Marginal Cost) p* Q * Q If Q<Q *, the marginal revenue exceeds the marginal cost (under-provision) If Q>Q *, the marginal cost exceed the marginal revenue (over-provision)

13 Functions of the Public Sector Market Failures The market is not always in this equilibrium due to the existence of market failures. Public goods (goods that are non-rival and non-excludable) Externalities Natural Monopolies Information asymmetry (adverse selection and moral hazard)

14 Functions of the Public Sector How it should be Private goods Rival: a good taken off the shelf it isn t there for other people to consume. Excludable: once you buy it, you own it and can consume it as you please. The aggregate demand for private goods is derived by summing individual demand horizontally: We sum private goods horizontally, because consumers cannot consume the same units

15 Functions of the Public Sector How it should be Private goods A simple example: Fig Leaves (f) Source: Rosen and Gayer (Chapter 4)

16 Functions of the Public Sector How it should be Private goods: e.g. Fig Leaves price=marginal cost: efficient provision Source: Rosen and Gayer (Chapter 4)

17 Functions of the Public Sector Market Failures: Public Goods Characteristics of public goods (e.g. national defense): 1. Non-rival consumption: The consumption of a good by an individual doesn t the available q for the rest of individuals. The mg cost of a new individual that starts consuming is equal to 0. a good cannot be taken off the shelf because individuals enjoy the same. 2. Non-excludable consumption: It is not possible to prevent the consumption of a good by someone who is not paying for it. everybody can enjoy the public good. The aggregate demand for public goods is derived by summing individual demand vertical: We sum public goods vertically, because consumers can consume the same units.

18 Functions of the Public Sector Market Failures: Public Goods A simple example: Fireworks Source: Rosen and Gayer (Chapter 4)

19 Functions of the Public Sector Market Failures: Public Goods A simple example: Fireworks EFFICIENT PROVISION Source: Rosen and Gayer (Chapter 4)

20 Functions of the Public Sector Market Failures: Public Goods Why are public goods a market failure? Inefficient market provision - unlike price, quantity is not an effective market mechanism: For a given quantity, individuals will not automatically self-select their optimal price, but will instead wish to pay the lowest price possible when they cannot be excluded from consuming the good. If the consumption of a good is non-excludable, the market will not provide it. the free rider problem occurs when those who benefit from resources, goods, or services do not pay for them, which results in an under-provision of those goods or services. Public Sector Interventions: public provision

21 Functions of the Public Sector Market Failures Public goods goods provided by the public sector Public sector might or might not provide public goods Goods Classification: rival yes no excludable yes private good natural monopoly (e.g. cable tv) no common resource (Fishing grounds) public good (national defense)

22 Functions of the Public Sector Market Failures: Non-rival and Excludable Goods If the consumption of a good is non-rival but excludable, there may be private provision, but it will be sub-optimum Example: Natural Monopoly Public Sector Interventions: public provision?

23 Functions of the Public Sector Market Failures: Natural monopolies In some industries, there are very high fixed costs associated with the starting of the activity (natural barriers to entry) Railways Energy Gas Telephony Decreasing average costs (due to the high fixed costs) Efficient solution: A single producer, public or private?

24 Monopoly Pr AC MC D MR Q 25

25 Monopoly Pr In perfect competition: Pr=MC In Monopoly: Pr>MC Pm AC MC Monopoly profits: Not efficient! Qm MR D Q 26

26 Monopoly Pr Pm P* AC MC D Qm MR Q* Q 27

27 Monopoly Pr Pm Loss for the monopolist: he is in deficit P* Qm MR AC Q* MC D Q 28

28 Monopoly Pr Pm Possible solutions: A. Regulation 1. price at the average cost level (still not efficient!) 2. Taxes to finance the deficit (even more inefficient?) B. Incentivize competition C. Nationalization Pac P* AC MC D MR Qm Qac Q* Q 29

29 Functions of the Public Sector Market Failures: Externalities Externality: Utility or production of an agent depends directly on the actions of another agent This effect is NOT included in the price Defined in 2 dimensions: Positives vs. Negatives Production vs. Consumption Positives / consumption Vaccine, Education Negatives / consumption Tobacco, Alcohol, Hydrocarbon Positives / production R&D, on-the-job training Negatives / production Contamination of a river, Noise pollution

30 Functions of the Public Sector Market Failures: Externalities e.g. Vaccines (positive) Ext MC (S) Q m Q * MR social=d+ext Marginal Benefit (MB) Qm=Sub-optimal demand for the good PS Intervention : Increase the consumption of the good (subsidize vaccine)

31 Functions of the Public Sector Market Failures: Externalities e.g. contamination of a river (negative) MC social=s+ext MC private (S) Ext Marginal Benefit (MB) Q * Q m Qm=Over-provision of the good PS Intervention: Decrease the production of the good (tax on the dumping of waste, regulation, )

32 Functions of the Public Sector Market Failures: Externalities IF the costs of bargaining are low And IF the owners can identify the source of damages and legally prevent them An efficient solution will be achieved simply by assigning property rights without any State intervention (known as Coase Theorem) e.g. Animal hunting

33 Functions of the Public Sector Market Failures: Externalities Lisa fishes in the river Bart owns a firm polluting a river: Bart creates a negative externality Externalities are due to inability to establish property rights: why? If Lisa owned the river, she could tax Bart for polluting, in turn Bart will reduce his level of pollution to save money If Bart owned the river, he could tax Lisa for fishing, in turn Bart will reduce his level of pollution otherwise Lisa would stop fishing

34 Functions of the Public Sector Market Failures: Externalities Animal hunting: Elephant populations in Africa Kenya s approach in 1977: ban hunting Drop in elephants from to by 1989 Zimbabwe in 1982: individuals owning lands get property rights to wild animals Increase in elephants from to by 1995 In Kenya the cost of an elephant killed was 0 for the landowner; In Zimbabwe the landowner had an incentive (tourists safari) to protect the animals.

35 Functions of the Public Sector Market Failures: Externalities e.g. Vaccines (positive) Ext MC (S) Q m Q * MR social=d+ext Marginal Benefit (MB) Qm=Sub-optimal demand for the good PS Intervention : Increase the consumption of the good (subsidize vaccine)

36 Functions of the Public Sector Market Failures: Externalities e.g. contamination of a river (negative) MC social=s+ext MC private (S) Ext Marginal Benefit (MB) Q * Q m Qm=Over-provision of the good PS Intervention: Decrease the production of the good (tax on the dumping of waste, regulation, )

37 Functions of the Public Sector Market Failures: Externalities private MC + MD = Marginal Social Cost private MC Marginal Damage (MD) Marginal Benefit (MB) Q * Q m Fixed amount of pollution per unit of output

38 Functions of the Public Sector Market Failures: Externalities private MC + MD = Marginal Social Cost private MC Loss for Bart Marginal Damage (MD) Marginal Benefit (MB) Gain for Lisa Q * Q m Fixed amount of pollution per unit of output

39 Functions of the Public Sector Market Failures: Externalities Empirical issues: Which pollutions do harm? What activities produce pollution? What is the value of the damage done? E.g. effect on houses prices

40 Functions of the Public Sector Market Failures: Externalities private MC + MD = Marginal Social Cost private MC + cd private MC Marginal Damage (MD) c Marginal Benefit (MB) d Q * Q m Pigouvian Tax: a tax on each unit of output in an amount equals to the marginal damage at the efficient output

41 Functions of the Public Sector Market Failures: Externalities Compensating Lisa with the tax will be inefficient as others will decide to fish just to receive the compensation: the result is an inefficient amount of fishing in the river Empirically: difficult to implement in some circumstances E.g. tax on gasoline instead of tax of miles driven (difficult to measure in different points in time and space) Other solutions: Fees on emissions instead of units of output, on units of pollution Cap-and-Trade The government sells pollution permits

42 Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries 1. Adverse selection (example: insurance) In the insurance market, there are high-risk and low-risk individuals If the company can t distinguish the 2 types of individuals, Low-risk individuals won t contract the insurance (too costly for them!) High-risk individuals will contract the insurance (but then profit <0) Public Sector Interventions: Public provision: public health insurance Regulation: compulsory health insurance (everybody need to get insurance)

43 Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries E.g. medical insurance Lisa is a very healthy girl, she is willing to pay up to 1000euro per year for a medical insurance Marge is a ordinary middle age woman, she is willing to pay up to 5000euro per year for a medical insurance Homer is troublesome guy, he is willing to pay up to 7000euro per year Mr Burns is a very old sicky guy, he is willing to pay up to 10000euro per year for a medical insurance The insurance know the average health costs, he cannot perfectly distinguish among sick and healthy people: ( )/4=5750 Only Homer and Mr Burns will buy the insurance for an average cost of ( )/2=8500 The insurance company will lose: (2*8500)-(2*5750)=-5500

44 Functions of the Public Sector Market Failures: Incomplete markets and information asymmetries 2. Moral Hazard: the insurance modifies the behavior of individuals, reducing the effort on preventing the risk from realizing. If individuals can affect the probability of the risk (losing a job), no one will provide insurance for it (unemployment insurance) Public Sector Intervention: Public provision: e.g., public unemployment insurance

45 Functions of the Public Sector Stabilization Objective: Stabilizing the economics fluctuations by fiscal policy: Expansive during recessions: Increase the disposable income (increase expenditure and/or decrease taxes) Restrictive during expansions: Decrease the disposable income (decrease expenditure and/or increase taxes) Automatic stabilizers: government budget policies, particularly income taxes and welfare spending, automatically act to dampen fluctuations in real GDP during recessions: unemployment benefits automatically increase during expansions: income and corporate tax revenues increase

46 Outline 1. The Public Sector: Introduction 2. Functions of the public sector: Why does the public sector intervene in a market economy? i. Efficiency (public goods) ii. Redistribution iii. Stabilization of the economic cycle Musgrave, (1959)

47 Economic Inequality Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve Inequality Trends Causes of Inequality Effects of Inequality Most of the content of this unit are not in the book!

48 Economic Inequality DEFINITION: Inequality studies focus on the unequal distribution of resources among agents (e.g. individuals, countries) Source: World Bank (various )

49 Lorenz Curve A curve showing the proportion of national income earned by a given percentage of the population. E.g. what proportion of national income is earned by the top 10% of the population?

50 Lorenz Curve % of National Income This line represents the situation if income was distributed equally. 30% The poorest 10% would earn 10% of national income, the poorest 30% would earn 30% of national income. 10% 10% 30% Percentage of Population

51 Lorenz Curve Lorenz Curve % of National Income In this second example, the Lorenz curve lies further below the line of equality. Now, the poorest 30% only earn 7% of the national income. 20% 7% 30% Percentage of Population

52 % of National Income Gini Coefficient Gini Coefficient= A / (A + B) A B Percentage of Population

53 The Great Gatsby Curve The Great Gatsby Curve illustrates the connection between concentration of wealth in one generation and the ability of those in the next generation to move up the economic ladder compared to their parents (economic mobility) Social Mobility important source of economic growth, innovation and political stability

54 Left axis: intergenerational elasticity of income - how much a 1 percent rise in your father s income affects your expected income

55 Kuznets Curve Before Industrialization: low inequality First stages of Industrialization: inequality goes up Only some social classes benefit (productivity gap, e.g. industry Vs agriculture) Later Stages of Industrialization: wealth spreads to other social classes (e.g. rural areas)

56 Kuznets Curve Is it true? Kuznets curve seems valid only for comparisons across countries and not within countries

57 Economic Inequality Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve Inequality Trends Causes of Inequality Effects of Inequality

58 Inequality: Perceived Vs Real Source: Norton, M. I., & Ariely, D. (2011). Building a better America One wealth quintile at a time. Perspectives on Psychological Science, 6(1),

59 Inequality: Perceived Vs Real Source: Norton, M. I., & Ariely, D. (2011). Building a better America One wealth quintile at a time. Perspectives on Psychological Science, 6(1),

60 Inequality Over time Source: IMF

61 Inequality Over time Source: IMF

62 Inequality Over time Source: IMF

63 Source: IMF

64 A Global Perspective: Inequality

65 Main Points Inequality mostly increased in the last decades at the country level Inequality slightly decreased in the last decades at the global level Global Inequality is higher than inequality across countries Income increased mostly in some developing countries (e.g. China) and at the very top of the income distribution (i.e. top 1%) Perceived inequality is lower than real and ideal inequality

66 Economic Inequality Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve Inequality Trends Causes of Inequality Effects of Inequality

67 Causes of Inequality Difficult to identify clear mechanisms, however most plausible reasons of the recent increase in inequality are (source IMF): Skill-biased technical change and globalization: increased demand for high skill jobs and decreased demand for low skills jobs Indeed, supply of high skill workers did not increase sufficiently

68 Causes of Inequality Unions power declined: union membership declined and globalization reduced unions bargaining power Change in social norms: we accept more inequality (e.g. compared to the past, we tolerate huge pay gaps)

69 Capital in the 21 st century Piketty s point: In an economy where the rate of return to wealth (or capital) is higher than the rate of economic growth, inherited wealth will always grow faster than earned wealth

70 Capital in the 21 st century 2 individuals, A and B A does not work but he owns and he gets rents out of it = r B does not own anything but he works and B s wage depends upon economy growth rate = g In economic terms, r = net-of-tax rate of return on capital; g = growth rate If r>g A will become richer and richer compared to B

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72 Capital in the 21 st century Piketty s point: In an economy where the rate of return to wealth (or capital) is higher than the rate of economic growth, inherited wealth will always grow faster than earned wealth Inequality goes up This was typical pre-industrial society Piketty warns we are going back to this scenario

73 Economic Inequality Definitions: Gini coefficient, Kuznets Curve, Great Gatsby Curve Inequality Trends Causes of Inequality Effects of Inequality

74 Consequences of Inequality Inequality might decrease social mobility (Great Gatsby Curve) Efficiency Vs Equity good or bad for growth? Effects on social outcomes Political Rent Seeking

75 Consequences of Inequality GOOD: Providing incentives for innovation and entrepreneurship (Lazear and Rosen, 1981) Raising saving and investment if rich people save a higher fraction of their income (Kaldor, 1957)

76 Consequences of Inequality BAD: It deprives the poor of the ability to stay healthy and accumulate human capital It generates political and economic instability that reduces investment It impedes the social consensus required to adjust to shocks and sustain growth

77 Efficiency Vs Equality In a nutshell Good inequality increase incentives for innovation, entrepreneurship and economic growth. Bad inequality creates obstacles for poor people to receive education and to access credit, that impediment economic development

78 Recent studies mostly argue that too high inequality can be disruptive for growth (e.g. IMF s studies and Alesina and Rodrik, 1994)

79 Consequences of Inequality Political Rent Seeking: The Price of Inequality (Stiglitz, 2012) Those with power use it to insulate themselves from competitive forces by winning favourable tax treatment and government-protected market share E.g. decreasing taxes on top income & corporations; electoral campaign contributions; think tanks This might lead to the growth of populist movements

80 Consequences of Inequality Solution: more redistributive policies? They might have the reverse effect (decrease growth and additionally foster inequality)! E.g. of win-win policies Taxes on activities with negative externalities paid mostly by the better-off (such as, perhaps, excessive risk-taking in the financial sector) Cash transfers aimed at encouraging better attendance at primary schools in developing countries Fight tax-avoidance