Chapter 5 Powerpoint

Chapter 5
Public Spending
and Public Choice

Introduction
The U.S. Postal Service (USPS) delivers nearly 40
percent of the world’s mail. Yet, its annual mail volume
has declined by more than 20 percent since 2006.
Continuation of USPS operations is dependent on the
more than $15 billion in loans provided by the federal
government.
Why does government sponsor the provision of certain
items, rather than allowing private firms to supply
them? We will explore this question in Chapter 5.

Copyright ©2014 Pearson Education, Inc. All rights reserved.

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 (cont'd)
• 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

Chapter Outline
• What a Price System Can and Cannot Do
• Correcting for Externalities
• The Other Economic Functions of
Government
• The Political Functions of Government
• Public Spending and Transfer Programs
• Collective Decision Making: The Theory of
Public Choice


5-5

Did You Know That ...
• A woman searching for scrap metal in the Eastern
European nation of Georgia accidentally halted all
Internet communication to Armenia?
• In shoveling below ground to find unused wires
containing copper, the woman sliced through a
fiber optic cable.
• In her defense, the woman claimed that she was
pursuing her own self-interest by looking for scrap
metal that could be sold for a profit.
• This event is an example of how the market
system may cause negative spillovers for third
parties.

5-6

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


5-7

What a Price System Can and Cannot
Do (cont'd)
• 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)


5-8

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


5-9

Correcting for Externalities (cont'd)
• 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


5-10

• 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


5-11

• 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

5-12

• Externalities are examples of market
failures
• Pollution is an example of a negative
externality
• Inoculations generate external benefits


5-13

Figure 5-1 External Costs and Benefits,
Panel (a)


5-14

Figure 5-1 External Costs and Benefits,
Panel (b)


5-15

Correcting for Externalities (cont’d)
• Resource misallocations of externalities
– External costs—market overallocates
– External benefits—market underallocates

• Government can correct negative
externalities
– Special taxes (a pollution tax or “effluent fee”)
– Regulation


5-16

Example: Hungary’s Tax on
Prepackaged Snacks
• The Hungarian government has determined
that there are external spillovers on the
nation’s health care system from the snack
food market.
• The government wants to discourage
production of sweets, salted snacks, and
energy drinks.
• Therefore, it has imposed a tax on foods
with a high content of sugar, salt,
carbohydrates, or caffeine.

5-17

• How the government can correct positive
externalities
– Government financing and production
– Subsidies
– Regulation


5-18

Policy Example: Stop the Presses for
Subsidies!
• As newspaper readership has declined over
the past decade, some government officials
have argued that local newspapers provide
positive externalities.
• They reason that the information provided
by newspapers may save lives.
• As a consequence, some state governments
provide subsidies for local newspapers.


5-19

The Other Economic Functions of
Government
• Providing a legal system
• Promoting competition
• Providing public goods
• Ensuring economy-wide stability


5-20

Government (cont'd)
• Providing a legal system
– Enforcing contracts
– Defining and protecting property rights
– Establishing legal rules of behavior


5-21

Government (cont'd)
• Promoting competition
– Market failure may occur if markets are not
competitive.
• Antitrust legislation
• Monopoly power


5-22

Government (cont'd)
• 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


5-23

Government (cont'd)
• Providing public goods
– Goods to which the principle of rival
consumption does not apply
• These are goods that may be consumed jointly by
many individuals at the same time.

– In contrast, private goods can be consumed by
one individual at a time


5-24

Government (cont'd)
• What truly distinguishes public goods from
all private goods is that the costs incurred
in excluding nonpayers from consuming a
public good are prohibitive
• Individuals in the private sector have little
incentive to provide public goods


5-25

Government (cont'd)
• 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


5-26

Example: Private Companies Look to Place
Humans in Orbit – and Beyond

• Bigelow Aerospace, a private firm, has
designed and tested low-cost inflatable
space stations in which humans can reside.
• Another firm, Moon Express, offers a lowcost method of landing people on the moon.
• Other firms are working on the technology
to get humans into orbit.


5-27

Government (cont'd)
• Free-Rider Problem
– Arises when some individuals take advantage of
the fact that others will take on the burden of
paying for public goods
– The free-rider problem often emerges in
connection with sharing the burden of
international defense


5-28

Government (cont'd)
• Ensuring economy-wide stability
– Smooth ups and downs in overall business
activity
– Full Employment Act 1946
• Full employment
• Price stability
• Economic growth


5-29

The Political Functions of
Government
• Government-Sponsored Goods
– Goods deemed socially desirable through the
political process
• Museums

• Government-Inhibited Goods
– Goods deemed socially undesirable
• Certain psychoactive drugs


5-30

Government (cont'd)
• Income redistribution: includes progressive
income tax system and transfers
– Transfer payments
– Transfers in kind


5-31

Government (cont'd)
• 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


5-32

Government
• Transfers in Kind
– Payments that are in the form of goods and
services
– Include food stamps, subsidized public housing,
medical care


5-33

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


5-34

Figure 5-2 Total Government Outlays
over Time

Sources: Facts and Figures on Government Finance, various issues; Economic Indicators, various issues.

5-35

Programs (cont'd)
• 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


5-36

Figure 5-3 Federal Government Spending
Compared to State and Local Spending

Sources: Economic Report of the President, Economic Indicators.

5-37

Figure 5-4 The Economic Effects of
Medicare Subsidies


5-38

Programs (cont’d)
• 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


5-39

Policy Example: The Great Underestimates of
Health Care Expenses
• In 1965, officials estimated the 1990 cost of
Medicare to be $12 billion, but the actual program
cost in 1990 was $110 billion.
• Similarly, the actual $45 billion cost of Medicaid in
1990 far exceeded the initial estimate of $7 billion.
• Why were the initial estimates inaccurate?
– Congress expanded the number of people eligible for both
programs.
– Officials did not take into account the fact that the use of
medical services would increase once these subsidies were
provided.


5-40

Programs (cont’d)
• Health Care Subsidies Continue to Grow
– The cost of Medicare is now $550 billion per
year, and unfunded guarantees of future
spending exceed $25 trillion.
– In addition, the federal government pays the
expenses of Medicaid, a program that provides
health care for low-income citizens.
– The current cost of Medicaid is more than $400
billion per year.


5-41

What If . . . the federal government reduces outof-pocket prices consumers pay for health care
services?

• If out-of-pocket prices continue to fall, more
health care services will be demanded by
consumers.
• Yet, providers would require higher prices in
order to expand the volume of care.
• Therefore, higher subsidies would be
required, thereby raising the total
government outlay.


5-42

Programs (cont’d)
• 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
– Publicly subsidized, similar to government
subsidized healthcare
– Education priced below market


5-43

Programs (cont’d)
• The 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


5-44

Example: A Weak Relationship Between
Spending and Schooling Results
• Alaska, New Jersey, New York, Vermont,
and Washington are the states with the
highest levels of per-pupil spending in
public schools.
• The five lowest per-pupil spending states
are Arizona, Idaho, Oklahoma, Tennessee,
and Utah.
• Yet, the educational outcomes do not differ
much between these two groups of states.

5-45

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


5-46

Collective Decision Making: The Theory of
Public Choice (cont'd)
• 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


5-47

• Similarities in market and public-sector
decision making
– Self-interest
– Opportunity cost
– Competition
– Similarity of individuals, but different incentive
structures


5-48

• Incentive Structure
– The system of rewards and punishments
individuals face with respect to their
actions


5-49

• Differences between market and collective
decision making
– Government goods at zero price
– Use of force
– Voting versus spending


5-50

decision making
• Political system versus market system
– Political system run by majority rule
– Market system run by proportional rule


5-51

• Government or Political Goods
– Goods (and services) provided by the public
sector

• Majority Rule
– Collective decision making, decisions based on
more than 50%

• Proportional Rule
– If 10% of “dollar votes” cast for blue cars, 10%
of output is blue

5-52

decision making
• Spending of dollars can indicate intensity of want
• Votes cannot; each vote counts with the same intensity


5-53

You Are There: The U.S. Government Ensures
That an Airport is “Convenient”

• The free parking, short security lines, and
spacious baggage claim areas of the
Hagerstown Regional Airport in Maryland
make it much more convenient than any
major airport.
• But this convenience comes at an expense
to U.S. taxpayers, who provide a subsidy to
finance the operations of Cape Air in
providing its daily flights to Baltimore.


5-54

Issues & Applications: The GovernmentSponsored U.S. Postal Service
• Operating as a government-sponsored
enterprise, the U.S. Postal Service (USPS)
receives an implicit subsidy in the form of
protection from competition.
• As mail volumes have declined, postal
revenues have fallen short of operating
expenses, and federally-provided loans are
making up the difference.


5-55

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


5-56

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


5-57

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


5-58

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


5-59

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


5-60

Chapter 5 Powerpoint

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Viewers also liked

Viewers also liked (20)

Similar to Chapter 5 Powerpoint

Similar to Chapter 5 Powerpoint (20)

More from Malcolm Harrison

More from Malcolm Harrison (20)

Recently uploaded

Recently uploaded (20)

Chapter 5 Powerpoint