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