Chapter 5 Public Spending and Public Choice Introduction Many feel that ethanol-based motor fuel offers a winwin situation: less reliance on gasoline derived largely from foreign oil and reduced carbon pollution from auto emissions. The U.S. government agrees—to the tune of more than $8 billion in annual government subsidies for ethanol production. 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 freerider problem • Describe the political functions of government that entail its involvement in the economy 5-3 Learning Objectives • 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 5-4 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. 5-5 What a Price System Can and Cannot Do • 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) 5-6 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. 5-7 Correcting for Externalities • 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 5-8 Correcting for Externalities • 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 5-9 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 5-10 Correcting for Externalities • Externalities are examples of market failures. • Pollution is an example of a negative externality. • Inoculations generate external benefits. 5-11 External Costs and Benefits 5-12 External Costs and Benefits 5-13 Correcting for Externalities • Resource misallocations of externalities – External costs—market over allocates – External benefits—market under allocates • Government can correct negative externalities – Special taxes (i.e. a pollution tax) – Regulation 5-14 Correcting for Externalities • How the government can correct positive externalities – Government financing and production – Subsidies – Regulation 5-15 The Other Economic Functions of Government • Providing a legal system • Promoting competition • Providing public goods • Ensuring economywide stability 5-16 The Other Economic Functions of Government • Providing a legal system – Enforcing contracts – Defining and protecting property rights – Establishing legal rules of behavior 5-17 The Other Economic Functions of Government • Promoting competition – Market failure may occur if markets are not competitive. • Antitrust legislation • Monopoly power 5-18 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 5-19 The Other Economic Functions of Government • 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. 5-20 The Other Economic Functions of Government • Principal of Rival Consumption – Recognizes individuals are rivals in consuming private goods • Public Goods – Can be jointly consumed by many individuals simultaneously 5-21 The Other Economic Functions of Government • 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 5-22 The Other Economic Functions of Government • 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 5-23 The Other Economic Functions of Government • Ensuring economywide stability – Smooth ups and downs in overall business activity 5-24 The Political Functions of Government • Merit Goods – Goods deemed socially desirable through the political process • Museums • Demerit Goods – Goods deemed socially undesirable • Illegal substances 5-25 The Political Functions of Government • Income redistribution: includes progressive income tax system and transfers 5-26 The Political Functions of Government • 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 5-27 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 5-28 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 5-29 Figure 5-3 Federal Government Spending Compared to State and Local Spending Sources: Budget of the United States government; government finances. 5-30 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 • Second biggest domestic program in existence – Medicaid • Subsidizes people with lower incomes 5-31 Public Spending and Transfer Programs • 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. 5-32 Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It • Most professionals regard telephone and e-mail as indispensable tools for communicating with clients. • In contrast, phone consultations and e-mail contact with physicians are very rare. • Medicare pays for face-to-face visits with physicians, but not for telephone or email consultation with patients. 5-33 Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It • Thus, Medicare gives physicians incentives to schedule appointments with patients in their offices but provides no incentives to utilize more efficient modes of communication. • Physicians then schedule office visits with patients and avoid phone calls and e-mail communications. 5-34 Policy Example: If the Government Doesn’t Pay for It, Physicians Don’t Do It • Who pays for the fact that Medicare’s payment rules promote higher-priced, faceto-face physician-patient communications instead of lower-priced, remote communications? 5-35 Public Spending and Transfer Programs 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. 5-36 Public Spending and Transfer Programs • Economics of public education – Publicly subsidized, similar to government subsidized healthcare – Education priced below market 5-37 Public Spending and Transfer Programs • 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. 5-38 Collective Decision Making: The Theory of Public Choice • Collective Decision Making – How voters, politicians, and other interested parties act and how these actions influence nonmarket decisions 5-39 Collective Decision Making: The Theory of Public Choice • Theory of Public Choice – The study of collective decision making Assumes that individuals will act within the political process to maximize their individual (not collective) well-being. 5-40 Collective Decision Making: The Theory of Public Choice • Similarities in market and public-sector decision making – Self-interest – Opportunity cost – Competition – Similarity of individuals, but different incentive structures 5-41 Collective Decision Making: The Theory of Public Choice • Incentive Structure – The system of rewards and punishments individuals face with respect to their actions 5-42 Collective Decision Making: The Theory of Public Choice • 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 5-43 Collective Decision Making: The Theory of Public Choice • Government or Political Goods – Goods (and services) provided by the public sector 5-44 Collective Decision Making: The Theory of Public Choice • 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 5-45 Issues and Applications: An Ethanol Bonanza, or an Ethanol Boondoggle? • From the U.S. government’s point of view, the use of gasoline as a motor fuel presents two problems. • Many reserves are located in the politically unstable Middle East and air pollution. • The key ingredients for ethanol are homegrown and less pollution is created. 5-46 Issues and Applications: An Ethanol Bonanza, or an Ethanol Boondoggle? • The government has designated ethanol as a merit good and provides a subsidy to ethanol producers of just over $1 per gallon. • Paradoxically, the cost of producing ethanol is very high relative to the benefits. • Gasoline consumption would drop by no more than 20% and decreases in pollution would be minor. 5-47 Issues and Applications: An Ethanol Bonanza or an Ethanol Boondoggle? • Finally, some critics of ethanol subsidies argue that ethanol produced using corn actually requires more energy than the ethanol ultimately creates. 5-48 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 freerider problem – Private goods are subject to rival consumption. – Public goods are not subject to rival consumption. – Free-riders anticipate others will pay. 5-49 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 5-50 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. 5-51 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 5-52 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 5-53