SURVEY OF ECONOMIC ANALYSIS

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SURVEY OF ECONOMIC ANALYSIS

• LECTURE 6

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Two Generic Classifications of Goods with Unusual
Characteristics

• PUBLIC GOODS
• FINANCIAL GOODS

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• This lecture looks at public goods and presents
  an overview of public sector economic principles.

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This lecture focuses on the underpinnings of
the mixed economies Mixed economies are
fundamentally market economies but have large
public sectors
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MAIN POINTS

• PUBLIC SECTOR
• JUSTIFICATIONS FOR GOVERNMENT IN A MARKET ECONOMY
• FUNCTIONS OF GOVERNMENT
• POSITIVE EXTERNALITIES
• NEGATIVE EXTERNALITIES
• MARKET FAILURES
• SOCIAL COSTS
• SOCIAL BENEFITS

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Growth in Government inMarket Economies
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TOTAL GOVERNMENT OUTLAYS AS PERCENTAGE OF GDP IN
1999

• COUNTRY OUTLAYS
• U.S. 33.6
• JAPAN 39.2
• U.K. 40.8
• GERMANY 47.1
• ITALY 49.2
• FRANCE 54.1
• SWEDEN 60.2

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Trend in the United States federal government
budget
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Explanations for growth in Government

• The government as provider of public goods and
  eliminator of externalities
• The government as redistributor of income and
  wealth
• Interest groups as a cause of government growth
• Bureaucracy as a cause of government growth
• Fiscal Illusion

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Basic Economic Laws ExplainingGovernment
Economic Activity
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• LAW OF EXTERNALITIES IN CERTAIN CASES THE MARKET
  FAILS TO CAPTURE THE FULL COSTS OR BENEFITS OF
  FREE -MARKET DECISIONS.
• PRINCIPLE OF PUBLIC GOODS GOODS THAT ARE
  COLLECTIVE AND NONEXCLUDABLE WILL BE UNDER
  SUPPLIED BY THE MARKET.

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• TENDENCY LAW OF SOCIAL REDISTRIBUTION
  REDISTRIBUTION OF SOCIETAL WEALTH BY GOVERNMENT
  COERCION TENDS TO REDUCE ECONOMIC INCENTIVES.
• PRINCIPLE OF FREE-RIDING IN LARGE GROUP
  DECISIONS WHEN GOODS YIELD COLLECTIVE BENEFITS ,
  INDIVIDUALS WILL TEND TO UNDERSTATE THEIR
  MARGINAL PREFERENCES FOR THE GOOD.-- IF THE GOOD
  IS PRODUCED I WILL BENEFIT WHETHER I PAY OR NOT.

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WHAT DISTINGUISHES THE PRIVATE SECTOR AND THE
PUBLIC SECTOR ?
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• 1. THE PEOPLE RESPONSIBLE FOR
• RUNNING PUBLIC INSTITUTIONS
• ARE ELECTED BY THE GENERAL
• POPULATION.
• 2. THE GOVERNMENT IS ENDOWED
• RIGHTS OF COMPULSION.
• -- EMINENT DOMAIN
• -- POWER TO TAX

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PERVASIVENESS OF GOVERNMENT
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• 1. IT SETS THE LEGAL FRAMEWORK
• WITHIN WHICH ALL PRIVATE
• ACTIONS TAKE PLACE .
• IT ACTS AS A PRODUCER OF , FOR
• EXAMPLE , EDUCATION, SECURITY....
• . IT ACTS AS A CONSUMER OF
• GOODS AND SERVICES.

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ECONOMIC ROLE FOR GOVERNMENT
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• ADAM SMITHS INVISIBLE HAND
• -- GUIDANCE OF SELF-INTEREST / INCENTIVES
• GOVERNMENT PLAYS A ROLE AS
• THE VISIBLE HAND / COERCION

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Adam Smith and the Role of Government in a
Market Economy
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In the Wealth of Nations, Adam Smith enumerated
four justifiable functions of government the
duty of protecting the society from violence and
invasion by other independent societies the
duty of protecting every member of society from
injustice and oppression of every other member of
society the duty of establishing and
maintaining those highly beneficial public
institutions and public works which are of such a
nature that the profit they earn could never
repay the expense to the individuals to provide
them and which it, therefore, cannot be expected
that they would be supplied in adequate
quantities and the duty of meeting expenses
necessary for support of the sovereign
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GOVERNMENT AS A RESPONSE TO DISAPPOINTMENTS WITH
THE MARKET
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• GOVERNMENT AND THE LAWS OF ECONOMICS / TRY TO
  REPEAL THE LAWS OF ECONOMICS
• GOVERNMENT AND THE REDISTRIBUTION OF WEALTH /
• INCENTIVE VS. EQUITY

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• GOVERNMENT AND MARKET FAILURES
• -- STABILIZATION OF THE
• ECONOMY
• -- REALLOCATION OF RESOURCES
• -- EXTERALITIES
• -- NEGATIVE
• -- POSITIVE
• -- SOCIAL/PRIVATE COSTS
• -- SOCIAL /PRIVATE BENEFITS
  

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• -- PUBLIC GOODS
• -- NONEXCLUDABLE
• -- COLLECTIVE
• -- FREE-RIDER ISSUE
• GOVERNMENT OPTIONS
• -- TAKING DIRECT ACTION
• -- NATIONALIZATION
• -- PROVIDING INCENTIVES FOR
• THE PRIVATE SECTOR
• -- TAX BREAKS, SUBSIDIES

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• -- MANDATING ACTIONS IN THE
• PRIVATE SECTOR
• -- COMBINING THE ABOVE OPTIONS
• GOVERNMENT ACTION AND PUBLIC
• FAILURES
• -- GOVERNMENT CAN FAIL JUST
• LIKE MARKETS

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NEGATIVE EXTERNALITIY
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• For negative externalities MSC gt MSB
• A third party effect in the form of a MEC exists
  in the case of negative externalities. So the
  true marginal cost is MSC MPC MEC.
• The free market tends to over-produce goods that
  create negative externalities in their
  production.
• The issue is how do we internalize the
  externality so the market makes a correct
  allocation decision.

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SBT PURE PRIVATE COST
PBT
MARKET PRICE IS TOO LOW
D
QBT
SOCIALLY INEFFICIENT OUTPUT
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SAT SOCIAL COST
SBT PURE PRIVATE COST
TAX
PAT
PBT
D
QBT
QAT
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SAT SOCIAL COST
SBT PURE PRIVATE COST
TAX
Consumer Price
PAT
Tax Wedge
PBT
Producer Price
PAT
D
QBT
QAT
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SAT SOCIAL COST
SBT PURE PRIVATE COST
TAX
PAT
PBT
PRIVATE MARKET PRICE
D
QBT
QAT
PURE PRIVATE MARKET SOLUTION
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SAT SOCIAL COST
SBT PURE PRIVATE COST
TAX
PRICE INCLUDING SOCIAL COST
PAT
PBT
PRIVATE MARKET PRICE
D
QBT
QAT
PURE PRIVATE MARKET SOLUTION
SOCIALLY EFFICIENT OUTPUT
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POSITIVE EXTERNALITIY
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• For positive externalities MSB gt MSC
• A third party effect in the form of a MEB exists
  in the case of negative externalities. So the
  true marginal benefit is MSB MPB MEB
• The free market tends to under-produce goods that
  create negative externalities in their
  production.
• The issue is how to we internalize the
  externality so the market makes a correct
  allocation decision.

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SBS PURE PRIVATE BENEFITS
MARKET PRICE IS TOO HIGH
PBT
D
QBS
SOCIALLY INEFFICIENT OUTPUT
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SBS PURE PRIVATE BENEFITS
SAS SOCIAL BENEFITS
SUBSIDY
PBT
PAS
D
QBS
QAS
PURE PRIVATE MARKET SOLUTION
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SBS PURE PRIVATE BENEFITS
Producer Price
SAS SOCIAL BENEFITS
PAS
PBT
Per Unit Subsidy
Consumer Price
PAS
D
QBS
QAS
PURE PRIVATE MARKET SOLUTION
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SBS PURE PRIVATE BENEFITS
PRIVATE MARKET PRICE
SAS SOCIAL BENEFITS
SUBSIDY
PBT
PAS
PRICE INCLUDING SOCIAL BENEFIT
D
QBS
QAS
PURE PRIVATE MARKET SOLUTION
SOCIALLY EFFICIENT OUTPUT
PURE PRIVATE MARKET SOLUTION
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PURE PUBLIC GOODS
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MARGINAL SOCIAL COSTS
200
MARGINAL SOCIAL BENEFITS
0
10
QUANTITY OF PURE GOOD
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MARGINAL SOCIAL COSTS
200
MARGINAL SOCIAL BENEFITS
70
d1
0
10
QUANTITY OF PURE GOOD
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MARGINAL SOCIAL COSTS
200
130
MARGINAL SOCIAL BENEFITS
70
d2
d1
0
10
QUANTITY OF PURE GOOD
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EFFICIENT OUTPUT OF A PURE PUBLIC GOOD
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• THE EFFICIENT PRODUCTION OF A PURE PUBLIC GOOD IS
  THAT LEVEL OF OUTPUT AT WHICH THE MARGINAL SOCIAL
  BENEFITS,OBTAINED BY VERTICALLY SUMMING THE
  DEMAND CURVES OF ALL CONSUMERS, EQUALS THE
  MARGINAL SOCIAL COSTS ( OPPORTUNITY COST OF
  RESOURCES USED TO PRODUCE THE GOOD)

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Under Construction
Public Choice
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• Public choice theory is a positive approach to
  explaining government activities. It is based on
  self-interest motives by the public and the
  bureaucracies. Essentially, the difference
  between political and economic behavior is not a
  difference in human motives, but a difference in
  the rules and institutions governing human
  interaction in the two spheres.

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Collective Decision Making
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• In a democracy the majority is suppose to rule.
• What does this imply about resource allocation?
• Particularly when voting on issues is generally
  indirect.

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Theories of Public Decision - Making
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• Majority Voting and the Median Voter
• In public policy decisions whose preferences
  dominate?
• How is the optimal amount of public goods decided
  upon.
• How are individual preferences revealed?

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Group Decisions and the Free-Rider Problem
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• In group decision-making there is a problem of
  revealing true preferences.
• Pure public goods once produced are shared
  equally by all.
• Why should you reveal your true preferences and
  pay for something you will receive free?
• Why not be a free-rider?

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Voting and Resource Allocation
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• Direct Majority Voting
• Lets look at a three voter model
• The total cost -- tax financing -- is to be
  shared equally
• The MSC of each unit is 30
• dA , dB , dC individual demand functions for
  the public good. These functions represent the
  marginal benefits to the individual voters.

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30
MSC
Public Goods
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30
MSC
dC
dB
dA
Public Good
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30
MSC
10
MC
dC
dB
dA
Public Good
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30
MSC
10
MC
dC
dB
dA
2
4
10
Public Good
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30
MSC
26

13
MSB

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dC
dB
3
dA
2
4
10
Public Good
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Increase in Cs intensity of demand
30
MSC
26

MSB
13
MSB

dC

dC
dB
3
dA
2
4
10
Public Good
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• In majority voting, an equilibrium occurs at the
  level of output of public goods where any
  proposal either to increase or decrease output
  would be opposed by a majority.
• Majority rule is in equilibrium at the quantity
  favored by the median voter, so called median
  voter model.
• Characteristics of Majority Voting
• The only voter fully satisfied is the median
  voter.
• The model indicates why so many people feel that
  government is not responsive to their individual
  wants.

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• Majority voting is likely to be unresponsive to
  changes in individual wants -- it ignores the
  intensity of individual preferences. See dC in
  the diagrams we just discussed.
• There is no inherent tendency for majority voting
  to produce efficient policies i.e., output
  where MSB MSC.

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The Voting Paradox
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• Nobel laureate Kenneth Arrow proved the
  remarkable result that all voting systems yield
  mathematical inconsistencies and indecision.
• Inconsistencies are inherent in the
  decision-making process of democratic government.
• The only way to ensure that consistent choices
  are made is to entrust all decisions to a single
  individual.
• But this ceases to be a democracy.