Microeconomics
Unit 4
The Economics of the Public Sector
In this Unit, You will learn…
• Externalities
• Public and Private Goods, Common Resources,
and Natural Monoplolies
• Progressive, Regressive, and Proportional Tax
Systems
Chapter 10
Externalities
Economics
PRINCIPLES OF
N. Gregory Mankiw
Introduction
• Externalities are a type of market failure
where there is one or more “side effects” to a
transaction.
• These side effects can either be positive or
negative
• Self-interested buyers and sellers neglect
these external costs or benefits of their
actions,
so the market outcome is not efficient.
Negative Externalities
Examples of Negative Externalities include:
• The neighbor’s barking dog
• Noise pollution from
construction projects
• Health risk to others from
second-hand smoke
• Air pollution from a factory
Graphing Negative Externalities
The market for gasoline
P
$5
You are all familiar with Market
Supply & Demand Graphs.
Here is one for the Gas Market
4
Equilibrium price= $2.50
Equilibrium quantity= 25 gallons
3
$2.50
2
1
0
0
10
20 25 30 Q
(gallons)
Analysis of a Negative Externality
The Negative externality is the
harmful effect of smog and
greenhouse gas emissions
The market for gasoline
P
$5
Social
cost
4
S
This is the shift in
Private + External Cost
3
2
D
1
0
0
10
20 25 30 Q
(gallons)
•External cost is the value of the negative
impact on bystanders
•Here you see the Negative externality
increases total social costs
•This needs to be changed by
“Internalizing the externality”
•Without this, the market is inefficient
since quantity is higher than social
efficient point
•In other words, the social cost of the last
gallon is
greater than its value to society.
“Internalizing the Externality”
• Internalizing the externality: The altering of
incentives so that people take account of the
external effects of their actions
• In our example, the $1/gallon tax on sellers
makes sellers’ costs = social costs, so supply
shifts left
• Imposing the tax on buyers would achieve the
same outcome
Positive Externalities
• Being vaccinated against
contagious diseases protects
not only you, but people who
visit the salad bar or produce
section after you.
• R&D creates knowledge
others can use.
• People going to college raise the population’s
education level, which reduces crime and
improves government.
Graphing Positive Externalities
P
$ 50
The market for Flu Shots
Once again, the Market Supply &
Demand Graph this time for flu shots.
40
Equilibrium price= $20
Equilibrium quantity= 25 gallons
30
$20
10
0
0
10
20 25 30 Q
(gallons)
ACTIVE LEARNING
1
Answers
Socially optimal Q
= 25 shots.
P The market for flu shots
$ 50
To internalize the
externality, use
subsidy = $10/shot.
external
benefit
40
S
30
Social value
= private value
+ $10 external benefit
20
10
D
0
Q
0
10
20 25 30
Chapter 11
Public Goods and
Common Resources
Economics
PRINCIPLES OF
N. Gregory Mankiw
Introduction
• We consume many goods without paying:
parks, national defense, clean air & water.
• When goods have no prices, the market forces
that normally allocate resources are absent.
• The private market may fail to provide the
socially efficient quantity of such goods.
Important Characteristics of Goods
• A good is excludable if a person can be
prevented from using it.
– Excludable: fish tacos, wireless internet access
– Not excludable: FM radio signals, national defense
• A good is rival in consumption if one person’s
use of it diminishes others’ use.
– Rival: fish tacos
– Not rival:
An MP3 file of Kanye West’s latest single
The Different Kinds of Goods
Private goods: excludable, rival in consumption (Not
much more to them)
Example: food
Public goods: not excludable, not rival (Covered more
in depth in chapter)
Example: national defense
Common resources: rival but not excludable (Covered
more in depth in chapter)
Example: fish in the ocean
Natural monopolies: excludable but not rival (Same as
for Private goods, not much to them)
Example: cable TV
Public Goods
• Public goods are difficult for private markets to provide
because of the free-rider problem.
• Free rider: a person who receives the benefit of a good but
avoids paying for it
– If good is not excludable, people have incentive to be free
riders, because firms cannot prevent non-payers from
consuming the good.
• Result: The good is not produced, even if buyers collectively
value the good higher than the cost of providing it.
• Important Public Goods: National defense, Knowledge created
through basic research, Fighting poverty
Cost-Benefit Analysis
• Cost-benefit analysis: a study that compares
the costs and benefits of providing a public
good
• If the benefit of a public good exceeds the cost
of providing it, govt should provide the good
and pay for it with a tax on people who
benefit.
• Cost-benefit analyses are imprecise, so the
efficient provision of public goods is more
difficult than that of private goods.
Common Resources
• Like public goods, common resources are not excludable.
– Cannot prevent free riders from using
– Little incentive for firms to provide
– Role for govt: seeing that they are provided
• Additional problem with common resources:
rival in consumption
• Tragedy of the Commons: A parable that illustrates why
common resources get used more than is socially desirable.
– The tragedy is due to an externality: one person’s use of
the resource diminishes other’s use of it.
– This cost is neglected leading to over use
• Important Common Resources: Clean air and water,
Congested roads, Fish, whales, and other wildlife
Chapter 12
The Design of the Tax System
Economics
PRINCIPLES OF
N. Gregory Mankiw
Introduction
• As stated in Ch. 10 and 11, the government can improve
market outcomes by:
– Providing public goods
– Regulating use of common resources
– Remedying the effects of externalities
• To perform its many functions,
the goverment raises revenue through taxation. Remember
that:
– A tax on a good reduces the market quantity
of that good.
– The burden of a tax is shared between buyers and sellers
depending on the price elasticities
of demand and supply.
– A tax causes a deadweight loss.
Income and Consumption taxes
• income taxes reduce the incentive to save:
– If income tax rate = 25%,
8% interest rate = 6% after-tax interest rate.
– The lost income compounds over time.
• Some economists advocate taxing
consumption instead of income.
– Would restore incentive to save.
– Better for individuals’ retirement income security
and long-run economic growth
Marginal and Average Tax Rates
• Average tax rate
– total taxes paid divided by total income
– measures the sacrifice a taxpayer makes
• Marginal tax rate
– the extra taxes paid on an additional dollar of
income
– measures the incentive effects of taxes
on work effort, saving, etc.
Lump Sum Taxes
• A lump-sum tax is the same for every person
Example: lump-sum tax = $4000/person
• A lump-sum tax is the most efficient tax:
– Causes no deadweight loss: Does not distort
incentives.
– Minimal administrative burden: No need to hire
accountants, keep track of receipts, etc.
• But they are perceived as unfair:
– In dollar terms, the poor pay as much as the rich.
– Relative to income (as a percentage), the poor pay
much more than the rich.
Principles with Taxes
• Benefits principle: the idea that people should pay taxes
based on the benefits they receive from government services
– Tries to make public goods similar to private goods – the
more you use, the more you pay
• Ability-to-pay principle: the idea that taxes should be levied
on a person according to how well that person can shoulder
the burden
– Suggests that all taxpayers should make an “equal
sacrifice” that depends not just on the tax payment, but on
the person’s income and other circumstances
– Called Vertical equity: the idea that taxpayers with a
greater ability to pay taxes should pay larger amounts
Tradeoff of Efficiency and Equity
• There are two types of equity:
• Vertical equity: the idea that taxpayers with a
greater ability to pay taxes should pay larger
amounts
• Horizontal equity: the idea that taxpayers with
similar abilities to pay taxes should pay the same
amount
– Problem: Difficult to agree on what factors,
besides income, determine ability to pay.
• The tradeoff of efficiency and equity leads
governments to try and find the pest possible tax
system
Three Tax Systems
• Proportional tax:
Taxpayers pay the same fraction of income,
regardless of income
• Regressive tax:
High-income taxpayers pay a smaller fraction
of their income than low-income taxpayers
• Progressive tax:
High-income taxpayers pay a larger fraction of
their income than low-income taxpayers
Flat Taxes
Flat tax: a tax system under which the marginal tax
rate is the same for all taxpayers
– Typically, income above a certain threshold is taxed at a
constant rate
– The higher the threshold, the more progressive
the tax
– Radically reduces administrative burden
– Not popular with
• people who benefit from the complexity of the current
system (accountants, lobbyists)
• people who can’t imagine life without their favorite
deduction/loophole
– Used in some central/eastern European countries
End Of Unit 4
“Government's view of the economy could be
summed up in a few short phrases: If it moves, tax
it. If it keeps moving, regulate it. And if it stops
moving, subsidise it” Ronald Reagan (America’s
40th US President (1981- 89), 1911-2004)