CHAPTER 4 - THE PUBLIC SECTOR

This chapter attempts to answer the following questions:

1. Under what circumstances do markets fail?

2. How can government intervention help?

3. How much government intervention is desirable?

MARKET FAILURE

OPTIMAL MIX OF OUTPUT

The optimal mix of output is the most desirable combination of output attainable with existing resources, technology and social values.

(Figure 4.1, Page 70)

PRODUCTION POSSIBILITIES CURVE
The market mechanism should lead us to point X or the optimal mix of output. In the market mechanism, price signals in the market place should move factors of production from one industry to another in response to consumer demands. Changes in market prices direct resources from one industry to another – moving us along the perimeter of the PP curve.

MARKET FAILURE

Market failure is an imperfection in the market mechanism that prevents optimal outcomes. According to the graph, the forces of supply and demand haven’t led us to the best point on the PPF. Market failure opens the door for government intervention. We look to the government to push market outcomes closer to the ideal.

CAUSES OF MARKET FAILURE

There are four specific sources of market failure: Public goods, Externalities, Market Power, and Equity.

1. PUBLIC GOODS
   A Private good is a good or service whose consumption by one person excludes consumption by others (for example, a candy bar, a stereo or a car). Other people are excluded from enjoying your consumption choice.
   
   A public good on the other hand is a good or service whose consumption by one person does not exclude consumption by others.
   
   EXAMPLE:
   National Defense is not a divisible force. If one person builds up a mechanism for national defense, others will surely benefit from this.
   Flood Control
   If a series of dams is built to protect against floods, there is no way to prevent all of the people living in the area from benefiting from flood control.
   
   The free-rider dilemma makes it necessary for the government to supply public goods. A free-rider is an individual who reaps direct benefits from someone else’s purchase (consumption) of a public good.
   
   EXAMPLE
   In the examples of flood control and national defense which we made above, everyone is waiting and hoping that someone else will pay for flood control. Everyone wants a free ride.
   
   If we leave it to free market forces, no one will demand flood control and defense.
   
   Questions:
   Why might 4th of July fireworks be considered a public good? Who should pay for them? What about airport security?
   
   Do you ever listen to NPR or watch PBS on TV? Do you contribute during their fundraising campaigns or are you a free rider?
   
   Public goods result from TECHNICAL CONSIDERATIONS. We do not have the technical capability to exclude non-payers. This is a key factor in identifying public goods.
   
   EXAMPLES
   Administration of justice, regulation of commerce, conduct of foreign relations, airport security, 4th of July Fireworks. In each instance it’s impossible or prohibitively expensive to exclude non-payers form the services provided.
   
   UNDERPRODUCTION OF PUBLIC GOODS
   
   If public goods were marketed as private goods, everyone would wait for someone else to pay resulting in total lack of public services. The market tends to under produce public goods and overproduce private goods. If we want public goods, we need a non-market force (government intervention) to provide them.
   
   (See Figure 4.2, Page 73)
    

2. EXTERNALITIES
   Externalities are costs or benefits of some market activities that “spill-over” onto 3rd parties. We can also define externalities as the difference between the social and private costs (or benefits) of a market activity.
   
   EXAMPLE:
   Smoking
   You may not smoke but if the person next to you is smoking, you suffer the costs of his/her market transaction (buying and smoking cigarettes). You may suffer because you’re allergic, because second-hand smoke is more deadly than firsthand smoke or for any other reasons.
   
   Pollution
   When a polluter pollutes, he/she doesn’t care about how the pollution affects other people in society (increased cancer rates, smog, etc.). Pollution also has external costs.
   
   Education has external benefits to society. (Did you know that?) Education may provide people with more income and thereby they will be paying more taxes. People with an education are more likely to vote, less likely to be chronically unemployed and less likely to commit violent crimes. Also, you may learn something in this class which you share with a family member or friend, thereby passing along knowledge which may benefit that third person.
   
   Whenever externalities are present, the preferences expressed in the marketplace won’t be a complete measure of a good’s value to society. The market will fail to produce the right mix of output. It will under produce goods that yield external benefits and overproduce those which generate external costs.
   
   (Figure 4.3, Page 75)
   
   EXTERNAL COSTS
   Social Demand = Market demand + externalities
   
   For social costs, we must subtract the external cost from market demand to get a full accounting of social demand. We subtract the amount of external cost from every price on the market demand curve.
   
   The social demand curve tells us how much society would be willing and able to pay for cigarettes if the preferences of both smokers and nonsmokers were taken into account.
   
   Pollution is an example of a production externality. Power plants may be damaging the surrounding environment and will produce more power than is socially desired.
   
   EXTERNAL BENEFITS
   
   Why should taxpayers subsidize public colleges and universities? What external benefits are generated by higher education?
   
   Immunizations prevent infectious diseases and may not only benefit those people who are immunized but also those around them who are spared from infection.
   
   If a product yields external benefits, the social demand is greater than the market demand. The social value exceeds the market price (by the amount of external benefit). Society wants more of the product than the market mechanism alone will produce at any given price. Government has to intervene with subsidies and other policies (for example: student loans, grants, state-funded universities, government-subsidized immunizations or “free” immunization clinics).
   
   The market fails by: overproducing goods that have external costs and under producing goods that have external benefits.
   
   For public goods and externalities, the price signal is flawed because the price consumers are willing to pay for a specific good doesn’t reflect all the benefits or costs of producing that good. The response to price signals may be flawed.
    

3. MARKET POWER
   
   Market power occurs when a single producer has the ability to alter the market price of a good or service.
   
   A monopoly is a firm that produces the entire market supply of a particular good or service. Monopolies can charge the price they want without having to worry about losing customers to competitors.
   
   Anti-trust policy is government intervention to alter market structure or prevent abuse of market power.
   
   EXAMPLE
   Microsoft’s near monopoly on operating systems. The government wanted to change the way Microsoft behaved.
   
   A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. Natural monopolies include utility companies, local telephone service, subway systems, Cable TV. The government has to regulate these companies to ensure that consumers get the benefits of that greater efficiency which is achieved by economies of scale.
    

4. INEQUITY
   
   Inequity addresses the FOR WHOM QUESTION because the market may enrich some people while leaving others in dire straits.
   
   Taxes and transfers are the principal method for redistributing incomes.
   
   Transfers are payments to individuals for which no current goods or services are exchanged, like Social Security, welfare and unemployment benefits.
   
   A MERIT GOOD is a food or service of which society deems everyone is entitled to some minimal quantity. Merit goods are distributed by the government in the form of in-kind transfers like food stamps, housing vouchers and Medicaid. In-kind transfers take the place of cash transfers (Social Security, welfare checks).
   Inequity is also subject to the free-rider problem. Private charities do not provide adequate support for those who do not have enough to eat or don’t have housing. Because of the free-rider problem, people will expect everyone else to provide for charity.
   
   MACRO INSTABILITY
   
   The micro failures of the marketplace imply that we’re at the wrong point on the PPC or inequitably distributing the output produced. To reach the curve, we must utilize all available resources and technology.
   
   Unemployment is a macroeconomic instability because of the inability of labor-force participants to find jobs.
   
   Inflation is also an example of macroeconomic instability. Inflation is an increase in the average level of prices of goods and services. Rising prices can further impoverish people who may have already been left behind by the market.
   
   The goal of micro intervention is to foster economic growth, to get us on the PPC (full employment), maintain a stable price level (price stability) and increase our capacity to produce.

GROWTH OF GOVERNMENT

The potential micro and macro failures of the marketplace provide specific justifications for government intervention.

FEDERAL GROWTH

Until the 1930s government intervention in the economy was limited to national defense (a public good), a common legal system (a public good), and a postal service (equity).

During the Great Depression, government took an increased role in the economy including welfare, Social Security programs (equity), minimum wage laws and workplace standards (regulation) and massive public works (public goods and externalities).

During the 1950s government addressed macroeconomic stability (macro failure) and became more interested in protecting the environment (externalities) and safeguarding public health (externalities and equity).

**All of these different types of government intervention have greatly increased the size of the public sector. In 1902 the government employed less than 350K people and spent $650 million. Today, the government employs 4 million people and spends upward of $2 trillion a year.

(Figure 4.4, Page 78)

DIRECT EXPENDITURE
After WWII there was a massive increase in size of federal government. The federal share of total US output grew on an unprecedented scale. Since the 1950s, the public sector has been growing more slowly than private sector, reducing the relative size of government expenditure. Other industrialized countries have significantly larger public sectors than does the U.S.

INCOME TRANSFERS
Expenditure only shows government expenditure on goods and services. Virtually all recent growth in federal expenditure has come from increased income transfers, not purchases of goods and services.

STATE AND LOCAL GROWTH
During WWII, state and local government spending hit a low in total share of output. Since the 1960s, local and state spending has caught up with federal spending and exceeded it ever since.

EDUCATION
States: Most direct spending at the state level is on colleges.
PRISONS (PUBLIC SAFETY) and WELFARE are the fastest growing areas for state expenditure.

Local: Most direct spending on the local level is for elementary and secondary education.
SEWAGE/TRASH are fastest growing areas for local expenditures.

TAXATION

We pay for government spending in tax dollars and in a mixed change of output. Government expenditures on goods and services absorb factors of production that could be used to produce consumer goods. The cost of government spending is measured by the private-sector output sacrificed when the government employs scarce factors of production.

Remember that opportunity cost is the most desired goods or services that are foregone in order to obtain something else. Opportunity cost is not always apparent in the case of government spending (and difficult to measure).

The primary function of taxes is to transfer command over resources (purchasing power) form the private sector to the public sector.
Taxes are the primary source of government revenues.

FEDERAL TAXES

1. INCOME TAXES
   The 16th amendment to US constitution in 1915 granted the federal government authority to collect income taxes. Nowadays it’s about $1 trillion a year and individual income tax the largest single source of government revenue.
   
   Our income tax system is progressive, that is, tax rates rise as incomes rise. A person who makes below $8500 pays no tax. A person who makes from $8,500-15,000 pays a 13% tax; and a person who makes $15-35,000 pays 27%. Incomes over $300,000 pay a 38.6% tax rate. (Please note: these rates have changed with the Bush tax cut).
    

2. SOCIAL SECURITY TAXES
   Social security taxes are controlled with mandatory payroll deductions. The employer pays 7.65% of total wages and the employee pays 7.65%. Incomes above $85,000 aren’t taxed so workers with really high salaries turn over a smaller fraction of their incomes than do low wage workers. So Social Security is a regressive tax (a tax system in which tax rates fall as incomes rise).
   
   A proportional tax is a tax that levies the same rate on every dollar of income.
    

3. CORPORATE TAXES
   There are four million corporations but their profits small in comparison to total consumer income. $200 billion collected in 2001 – 34% of corporate profits.
    

4. EXCISE TAXES
   Excise taxes are sales taxes imposed on specific goods and services like liquor (13.50 per gallon), gas (18.4 cents per gallon), cigarettes (39 cents per pack), telephone service (3%), and the 9/11 tax on airline tickets.
   
   Excise taxes discourage production and consumption of these goods by raising their price and reducing the quantity demanded – they also raise a substantial amount of revenue.

STATE AND LOCAL REVENUES

1. TAXES
   Cities – Property Taxes
   States – Sales Taxes
   Both have income taxes (much less than state and property taxes).
   
   Mostly State and Local taxes are REGRESSIVE. They take a larger share of income from the poor than the rich. For example, in the case of local property taxes the poor devote a larger portion of their incomes to housing costs.
   
   State Lotteries – low-income spenders spent more of their income on lottery tickets than upper income spenders.
   
   Question: Are subway fares progressive or regressive? How about highway tolls?
    

2. FEDERAL AID
   
   CATEGORICAL GRANTS – Federal grants to state and local governments for specific expenditure purposes. These grants cannot be shifted from one use to another. (Categorical grants of $300 billion in 2001 went towards employment programs, Medicaid, schools and highways). Categorical grants accounted for 1/5 of all state and local revenues.
    

3. USER CHARGES
   Fees paid for the use of a public-sector good or service.
   Example: tuition for a state college or community college.

GOVERNMENT FAILURE

Government failure occurs when government intervention fails to move us closer to our economic goals.

(Figure 4.1, Page 70)

On the Production Possibilities Frontier if government intervention moves us from point M to farther away from point X, government failure has occurred.

If the distribution of income got worse instead of better or if the costs of government intervention exceeded the benefits of an improved output mix, cleaner production methods, fairer distribution of income, etc.

PERCEPTIONS OF WASTE
Government waste (29 cents of a dollar in state and 42 cents in federal) implies inefficiency and that we are producing inside our PPF.

EFFICIENCY – Are we getting as much service as we could from the resources we allocate to government?

OPPORTUNITY COST – Are we giving up too many private-sector goods in order to get those services. Everything the government does entails opportunity costs. The opportunity cost of more police and teachers is fewer workers available to private industry. We must consider not only what governments do but also what we give up to allow them to do it.

How big is too big? (It is clear that services like National Defense, environmental protection and law enforcement are necessary).

COST-BENEFIT ANALYSIS
Additional public-sector activity is desirable only if the benefits from that activity exceed its opportunity costs. We compare the benefits of a public project to the value of private goods given up to produce it. We locate the optimal mix of output – the point at which no further increase in public spending activity is desirable.

Unfortunately, there are valuation problems because it is difficult to measure the benefit of expanded public services. With private market goods and services, we can gauge the benefits of a product by the amount of money consumers are willing to pay for it. There is no price signal for public services because of externalities and the nonexclusive nature of public goods (free-rider problem).
The value of benefits of public services must be estimated because they don’t have (reliable) market prices. The same problem occurs with income redistribution.

BALLOT BOX ECONOMICS

In our political system voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them. Governments choose the level and mix of output (and related taxation) that seem to command the most votes.

Bond referenda ask voters to approve certain public goods but are equal to less than 1% of state and local expenditures (and none of federal expenditures). Voters have very little control over government spending but can be an indirect influence.

- Voters can dictate the general level and pattern of public expenditures but have little direct influence on everyday output decisions. We don’t know what the real demand for public services is and votes alone don’t reflect the intensity of individual demands.
- Because of politics and self-interest, members of Congress may pursue legislative favors like tax breaks for supporters more diligently than they pursue public interests.
- The Theory of Public Choice introduces the concept of the role of self-interest in public decision-making or the rational self-interest of decision makers and voters. Bureaucrats are just as selfish (utility-maximizing) as everyone else.

THE ECONOMY TOMORROW

Question: Should the government be downsized? What functions should be cut back?

Increasing skepticism about government intervention has prompted a worldwide downsizing of the public sector (especially in the Former USSR, Europe/Latin America). These countries have experienced privatization of government-owned industries. George Bush says downsizing is a policy priority in the United States.

The problem with downsizing the government is what to reduce. Any cuts in social spending will cause protest and 9/11 made it impossible to reduce defense-spending anytime soon).

Few people expect the government sector to shrink further in the economy tomorrow.