Title: Part 2: A Framework for the Analysis of Public Expenditure
1Part 2 A Framework for the Analysis of Public
Expenditure
- Part 1 discussed WHEN to have government
intervention. - Part 2 discusses HOW government can intervene.
2Part 2 A Framework for the Analysis of Public
Expenditure
- Chapter 4 Public Goods
- Chapter 5 Externalities
- Chapter 6 Income Redistribution
- Chapter 7 Cost-Benefit Analysis
3Chapter 4 Public Goods
- Public Goods no one wants to pay for them, but
everyone benefits from them. - How does the government decide WHICH public goods
are provided and HOW MUCH IS provided? - Should the private market be used to provide or
produce government commodities?
4Chapter 4 Public Goods
- What is a Public Good?
- Efficient Provision of Public Goods
- The Efficiency Conditions
- Public Goods and Distortionary Taxation
- Private Provision of Public Goods
- Free-Riders
- Privatization
5Theory - What is a Public Good?
- A PURE PUBLIC GOOD has two features
- Nonrival once provided, another person can
consume it at no additional cost - Nonexcludable once provided, it is impossible
or highly expensive to prevent anyone from
consuming it
6Pure Public Good Examples
- National Defense is a good example of a pure
public good - Nonrival all Canadians benefit
- Nonexcludable its impossible to prevent a
Canadian from benefitting - Other examples Conventional Radio, A Beautiful
View, A Canada-Wide Sunglass dome designed to
block harmful sun rays (Canadome)
7What is a Private Good?
- A PRIAVATE GOOD has two features
- Rival once consumed, another person cannot
consume it - Excludable others can be prevented from
consuming it - Food (ie pizza or sushi) is a good example of a
private good. Once I eat it, its gone and
youre left hungry.
8Pure Public Good Issues
- 6 Issues arise out of Pure Public Goods
- Different Values
- Public Goods Arent Absolute
- NONRIVAL ? NONEXCLUDABLE
- Unconventional Public Good
- Private Provision
- Private Production
91) WHILE EVERYONE CONSUMES THE SAME AMOUNT,
PEOPLE MAY VALUE IT DIFFERENTLY
- -National defense protects everyone equally.
Paranoid people love it and peace activists hate
it. - -The Canadome is popular among people concerned
with cancer and unpopular with people wanting
tans. It affects everyone, however
102) PUBLIC GOODS ARE NOT ABSOLUTE
- -technology and the market can affect a public
good. A free TV station becomes private if you
need a decoder. A view becomes rival if too many
people crowd. - -An IMPURE PUBLIC GOOD is to some extent rival or
to some extent excludable - -most public goods are impure, but analysis of
pure public goods still gives valuable results
for impure public goods
113) NONRIVAL ? NONEXCLUDABLE
- -National parks are excludable if they have
gates, but practically nonrival as they are so
big - -My office hours are nonexcludable, as everyone
is welcome, but rival if too many people are
waiting in line
124) VARIOUS THINGS HAVE SIMILARITIES WITH PUBLIC
GOODS
- -Inspiration can be nonrival and nonexcludable
(such as coming from a sunset) - -Fear is nonrival, as one person being afraid
doesnt prevent others. Fear is also
nonexcludable, as its hard to prevent. - -Income distribution or honesty are public goods
as everyone benefits
135) THE PUBLIC SECTOR CAN PROVIDE PRIVATE GOODS
- -Medical services, housing, licenses, and
utilities can all be provided by the government
and/or private sector - -The label public or private doesnt indicate
what sector provides the item
146) PUBLIC PROVISION ?gt PUBLIC PRODUCTION
- -Some public services are contracted out to
private contractors - -For example, the City of Edmonton contracts out
much of its snow removal business - -it provides the public service through private
contractors
15Efficient Provision of Private Goods
- -To cover efficient provision of public goods, we
first look at efficient provision of private
goods - -Consider Maka and Susans individual demands for
video games - -At a market price, we add up Maka and Susans
quantity demanded for video games to find market
demand - -This results in a HORIZONTAL SUMMATION
16Efficient Provision of Private Goods
Maka
Susan
Market demand
P
P
P
100
40
Q
Q
Q
2
5
7
_at_ P40, QMQSQD 257
17Efficient Provision of Private Goods
When market supply intersects market demand, we
find equilibrium price and individual demand.
Maka
Susan
Market
P
P
P
S
100
65
40
Q
Q
Q
2
5
7
Q5
3.5
1.5
_at_ P65, QMQSQ 1.53.55
18Efficient Provision of Private Goods
- -From microeconomic theory, we know that a
consumer maximizes utility where MRSxyPx/Py - -If we normalize Py to 1, this simplifies to
MRSxyPx - -Since price is found on the demand curve, Makas
(Susans) demand expresses Makas (Susans) MRS
at each level of consumption
19Efficient Provision of Private Goods
- -From microeconomic theory, the supply curve
comes from MC - -MRTxyMCx/MCy, but since PyMCy and Py1,
MRTxyMCx - -therefore the supply curve represents MRTxy
- Then, at equilibrium, SupplyDemand, and
Pareto Efficiency Condition
20Efficient Provision of PUBLIC GOODS
- -Consider Maka and Susans individual demands for
a public good radio shows - -Radio shows are nonrival and nonexcludable one
persons consumption doesnt affect the other - -The key difference in a public good is that BOTH
can consume a purchased good it is not used up - -This results in a VERTICAL SUMMATION to
calculate willingness to pay
21Efficient Provision of Public Goods
Market demand
Maka
Susan
P
P
P
11
10
7
4
Q
Q
Q
2
2
2
Maka is willing to pay 4 each for 2 radio shows,
and Susan is willing to pay 7 each, therefore
the market is willing to pay 11 each
22Efficient Provision of Public Goods
Market demand
Maka
Susan
P
P
P
S
11
10
7
6
4
4
2
Q
Q
Q
2
3
2
3
3
The market Supply gives an equilibrium quantity
of 3. Here price paid in the market (6) is the
sum of Makas payment (2) and Susans payment
(4).
23Efficient Provision of Public Goods
- -Once again, if we normalize our other good to
1, demand (willingness to pay) represents MRS
for each person. - -The sum of both peoples willingness to pay
(market demand), is therefore the sum of
individual MRS. - -The supply curve still represents MC and
therefore MRT, so we have
24Efficient Provision of Public Goods
- -Furthermore, again since Py1,
-Intuitively, public goods should therefore be
provided until the point where the marginal cost
of the good is equal to the sum of marginal
benefits -The private good equation can also be
rewritten as
25THEORY - Distortionary Taxes and Public Goods
- If Public Goods are funded by distortionary
taxation, we have two additional effects - 1) We have to consider the cost of raising an
additional dollar through a distortionary tax, or
marginal cost of public funds (MCF). Gross cost
then becomes
26Distortionary Taxes and Public Goods
- 2) The public good may encourage economic
activity, which translates into new taxes,
captured by
-Therefore, optimal provision of a public good
then occurs when
27Distortionary Taxes and Public Goods
- Note that if MR is positive (the public good
benefits the economy), benefit becomes
Alternately, if MR is negative (the public good,
though it may benefit people, hurts the economy
(such as a free themepark hurting private
themeparks),cost becomes
28Public Goods Conclusion
- In short, public goods are always best provided
where - Total Marginal Benefit Marginal Cost
- Providing a public good through distortionary
taxes may increase or decrease its provision when
compared to lump-sum taxation funding
29Theory - Private Provision of Public Goods
- If a public good is provided privately, its
efficiency depend on how people represent their
willingness to pay - -For private goods, people have no incentive to
misrepresent their willingness to pay - -if the price is 10, and that lies in their
willingness to pay, they will pay the 10,
consume the good and be happy
30Private Provision of Public Goods
- -For public goods, people have an incentive to
misrepresent their willingness to pay - -if the price is 10, a person could hope
someone else pays the price, then they get to
enjoy it (they are a FREE RIDER) - -for example, at an alligator reserve, people
can pay money to throw meat into the water and
watch the alligators go, and often wait for
someone else to buy and throw the meat
31Private Provision of Public Goods
- -If the public good can be made excludable (ie
entrance fee), it is still provided
inefficiently, as the MC of an additional
consumer is zero, therefore PgtMC - -The one way to avoid the free rider problem is
through PERFECT PRICE DISCRIMINATION everyone
pays their willingness to pay - -this requires full information, therefore
private provision is often doomed to be
inefficient
32The Free Rider Problem
- THE FREE RIDER PROBLEM comes from the incentive
to let others pay while you enjoy the benefits - -Yet empirically, people do band together to
raise funds for public goods such as libraries - -Studies have shown that although people may be
willing to contribute some towards public goods,
this contribution generally falls short
33The Free Rider Problem Example
- Many people are willing to help construct homes
for low income families. - People go to great lengths to help construct
these homes, and one low income family is very
happy. - -But the project never continues until a city
reaches zero homelessness - -Similarly, private provision of public goods
only goes so far
34Privatization of Government Functions
- Government functions (both public and private
commodities) can be provided privately IF THEY
ARE EXCLUDABLE - Privatization has 2 LEVELS
- Private Provision private firms provide the
good or service - Private Production private firms produce the
good or service, which can then be provided by
the government
35Private Provision Debate
- Many government functions can be and are provided
privately IF THEY ARE EXCLUDABLE - Home/private schooling vs. public schooling
- Police force vs. Private security
- Private swimming pool vs. Public lake
- -To debate the merits of private provision of
government functions, a variety of issues need be
examined
36Private Provision Debate
- Input costs
- -Do private firms or the government pay lower
input costs (wages, materials, etc) for the good
or service? - -Are there unions or unique suppliers involved?
- 2) Administrative Costs
- -Typically, government can reduce administration
costs through size and economies of scale - -This is not always the case
37Provision Debate
- 3) Diversity of Tastes
- -If people have a variety of tastes (quality,
quantity, environmental footprint, etc), private
provision allows for variety - 4) Quality of Information
- -If individuals are poorly informed about the
quality of the good, government provision may be
best - -sofa selection is a lot easier than healthcare
selection
38Provision Debate
- 5) Distributional Issues
- -Does fairness imply that some goods and services
should be available to EVERYONE, (COMMODITY
EGALITARIANISM (Tobin, 1970)) - -This argument is often made for healthcare
39Public Production Debate
- The argument about who should PRODUCE public
goods often hinges on two concepts - Cost vs. Quality
-private companies often produce inferior
products (as in US health insurance refusing
coverage or charging high premiums)
-private companies often have lower costs due to
a focus on profit and lack of unions
40Production Debate
- Some argue that quality can be maintained through
good contracts - -Some contracts are straightforward cut the
park lawn once a week - -Some contracts are near impossible treat this
yet-to-be-discovered disease with the following
yet-to-be-discovered drugs
41Production Debate
- Market structure also needs to be considered
- -If the government has a monopoly, is lack of
competition causing inefficiency? - -If privatization creates a monopoly or
oligopoly, will market power cause inefficiency?
42Case Study Alberta Liquor Privatization
- West (1997) studied the 1993 privatization of
Alberta liquor stores and learned the following - -the number of liquor stores rose from 258 to
604, and although selection and individual stores
fell, overall selection increased - -liquor prices rose between 8.5 and 10
(compared to 5 inflation)
43Case Study Alberta Liquor Privatization
- -Liquor store employment tripled as wages fell by
up to 50 (the union was replaced) - -There was no evidence of increased alcohol
consumption or alcohol-related crimes
44Case Study Alberta Liquor Privatization
- Was privatization good?
- More stores vs. poorer selection
- Liquor Price Increases
- More employment vs. Lower wages
- If this privatization is so complex, what does
that say about privatizing healthcare, utilities
or schools?
45Chapter 4 Summary
- Public goods are nonrival and nonexcludable
- With lump-sum taxation
- Public Goods are efficiently provided where
?MRSMRT or ?MBMC - (Private goods are efficiently provided where
MRSA MRSB MRT) - With distortionary taxes, the marginal cost of
public funds (MCF) and the tax revenue effect of
the public good must be taken into account - Efficient provision still occurs where Total
Benefit Total cost
46Chapter 4 Summary
- It is unlikely that markets would provide public
goods efficiently, even if they are excludable - Free-riding limits private provision of public
goods - Privatization entails private provision or
production of a government function - 5 issues were raised in the debate between public
or private provision - Two issues with public production are efficiency
and quality