Chapter 5
Public Spending
and Public Choice
Three areas of concentration
1. Explain how market failures, such as externalities, might
justify economic functions of government
2. Distinguish between private and public goods and explain the
nature of the free-rider problem
3. Describe the political functions of government that entail its
involvement in the economy
When the market fails… it is
a double edge sword
Market Fails if not optimal mix.
* Optimal Mix of Output……
“Most desirable combination of output
attainable with existing resources,
technology and social values.”
Market Failure
*“An imperfection in the market
mechanism that prevents optimal
outcomes.”
Market Failure
Is this evident in today’s market?
*market moves resources from one
industry to another. (price directs
resources) (demand responds) (price
moves the resources then to another
demand choice) (at this point
(competition begins to prevail to
level the prices)
P
P
Q
D1
D2
Q
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)
In real words?
Not enough public parks…
Not enough care for environment…
Not enough welfare…
Not enough healthcare…
Too much separation between top 10%
income earners and median income
earners…
Not adequate security within our
borders….
Too many immigrants….
Socially Optimal Amount (Output)
Sometimes, the socially optimal
amount is referred to as the efficient
amount.
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
Market failure = (forces of S & D not
leading us to BEST point on ppc…
Who decides what is defined as
BEST?
Enter…. Government intervention!
Did you hear the words tax and
subsidy?
Will they perform magic?
Correcting for Externalities
• 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
Correcting for Externalities
(cont'd)
• Externalities are examples of market
failures.
• Pollution is an example of a negative
externality.
• Inoculations generate external
benefits.
Correcting for Externalities
• Resource misallocations of
externalities
– External costs—market overallocates
– External benefits—market
underallocates
• Government can correct negative
externalities
– Special taxes (i.e. a pollution tax or
“effluent fee”)
– Regulation
Correcting for Externalities
(cont'd)
• How the government can correct
positive externalities
– Government financing and production
– Subsidies
– Regulation
There are two main types of economic instruments used in
environmental policy, both of which aim to provide an
incentive to use resources sustainably:
• Price-based measures use charges,
taxes and subsidies to persuade
polluters to reduce their discharges.
• Rights-based measures "create
rights to use environmental
resources, or to pollute the
environment, up to a pre-determined
limit, and allowing these rights to be
traded"
Other Economic Functions
of Government
• Providing a legal system
• Promoting competition
• Providing public goods
• Ensuring economy wide stability
The Other Economic
Functions of Government
(cont'd)
• Providing a legal system
– Enforcing contracts
– Defining and protecting property rights
– Establishing legal rules of behavior
The Other Economic Functions
of Government (cont'd)
• Promoting competition
– Market failure may occur if markets are
not competitive.
• Antitrust legislation
• Monopoly power
The Other Economic Functions
of Government
• 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
The Public
Sector:Government’s role.
Questions to ponder:
• What is Public Sector?
• When do markets fail?
• Should government step in?
• Can people “ride free” in public
sector?
• Governments Enter the Market
to assure:
1. Public Goods
2. Externalities (positive or
elimination of negative)
3. Market power
4. Equity
Two concepts to remember
• Public goods… can be equally
consumed by all… no restrictions
Skateboarding in the park…
Terrorists… can also go to the park…
Illegal immigrants can go to school…
• Private goods… consumption by
one person excludes consumption by
another..
( my doughnut… my car… etc)
But, if mix of output gets totally
out of whack…. Government takes
over.
Translation
If government and/or the consumer was
not acting as a watchdog…. Would
corporations be diligent about
utilizing the proper mix of resources…If
they are, can they compete?
Telecommunications Industry?
Does that always mean regulation
increased?
Could it mean that consumer sovereignty
switches to another desire… BUT…
what about things like energy…
would we really know if the
provider was efficient? What about
government-driven choices?
Methods to Reduce Pollution
Government sets pollution standards
Market environmentalism –
Government allocates pollution
permits and then allows them to be
bought and sold
Government Allocates Pollution
Permits (allows market to operate)
 Agreement that a certain area can handle
“acceptable” amt of pollution.
 The amount is quantified, then parceled
into permits that “polluters” bid for in
auction.
 Can buy and sell pollution rights among
companies bidding.
 Allows some companies to pollute more
than others… ones that are really “good”
sometimes get perks like tax benefits…
others have opportunity to pass on to
their consumers (TXU)
 Government reallocates resources if 1)
market produces “wrong” amount of
certain g&S and 2) market fails to
allocate resources to some g&s that are
in best interest of society.
 What are externalities? “costs or
benefits of a market activity borne by a
third party.”
 Spillovers…an action when one
individual or group harms the property
of others without their consent.
Examples of spillovers
Throwing trash in someone’s back
yard
Burning ties in the alley
Playing your stereo loudly at 3:00
a.m.
Businesses dumping wastes, sludge
into rivers
People trashing the beach or
highway.
Electric Companies burning
phosphorous fuels
Spillover Examples that perpetrate on
others
Calling police when loud party of
teenagers next door (actions of
teens imposing unwanted cost on
neighbor)
Living in downstairs apartment..
Having upstairs neighbors doing
Tai Bo when they get off work at
4:00 a.m.
Calling the city when a neighbor
doesn’t keep his yard mowed on
regular basis.
Externalities can be positive or
negative
Homeowners keep lawns immaculate
(benefits the neighborhood)
Scientific study for polio vaccine
(others benefit beyond scientists’
recognition)
 Education……. How would this be a
benefit?
How can spillovers be corrected?
Most obvious way is Legislation.
1. To prohibit
2. To heavily tax the specific product and
manufacturer. Tax would be derived
to allow for off-setting the clean-up
cost. (Super Fund is example)
3. Subsidize both consumers or
producers
4. ***Tax incentives… if reduction of
pollution and compliance adhered to,
taxes reduced.
A Corrective Tax Gone
Wrong
Government may miscalculate
external costs and impose a tax
that moves the supply curve
from S1 to S3 instead of from S1
to S2.
As a result, the output level
will be farther away from the
socially optimal output than
before the “corrective” tax was
applied.
Q3 is farther away from Q2
than Q1 is from Q2.
Federal Government
Spending Compared to State
and Local Spending
Sources: Budget of the United States government; government
finances.
2008 FY category – Tax +
Policy Center
2008 FY- Tax Policy Center
Public Spending and
Transfer Programs
• 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/ no cap
• Second biggest domestic program in
existence
– Medicaid
• Subsidizes people with lower incomes
The Economic Effects of
Medicare Subsidies
Subsidy M = customers pay Pd for quantity Qm
Providers receive price Ps for supply the good.
Collective Decision Making: The
Theory of Public Choice
• 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
Equity or perhaps better stated
as Inequity.(ensuring market
economy)
1)Inadequate income (redistribute to havenots)
2) Merit goods (everyone entitled to some
minimum of food,clothing, shelter) In-kind
transfers in food stamps, housing
vouchers, health clinics)
3)Social Security and unemployment
compensation protect people’s economic
security by providing money when they
retire or are unable to work.
Opportunity cost… if government
provides health care, private
sector cannot compete.
Government “crowds” out the
private .
**** Remember, the largest
opportunity cost of an item
supplied by government is the
best alternative use that could
have been made of the resources
required to provide that good.
We are at a crossroadsWhich path should the U.S. take?
Free Markets?
Private markets?
Government Regulated Markets?
Government Driven Markets?
Government Run Markets?