The Economics of the Public Sector

1
The Economics of the Public Sector

• Introduction

2
Main Readings

• Stiglitz, J., Economics of the Public Sector,
  Parts 1-3 (2nd Edition), Norton.
• Carneiro, P. and J. Heckman, Human Capital
  Policy, in J. Heckman and A. Krueger, Inequality
  in America What Role for Human Capital Policies,
  MIT Press, 2003.
• Cunha, F., J. Heckman, L. Lochner and D.
  Masterov, Interpreting the Evidence on Life Cycle
  Skill Formation, National Bureau of Economic
  Research Working Paper no. 11331, May 2005.

3
Overview of the Course

• 1. Why do Governments Exist? What do Governments
  Do? Efficiency and Equity
• 2. Efficiency Public Goods, Externalities,
  Market Failures Government Failures
• 3. Equity Redistribution and Social Insurance
  Political Economy, Paternalism
• 4. Human Capital Policy

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• We should think of the government as an entity
  that levies taxes on individuals and firms,
  spends the proceeds of taxation, and regulates
  several aspects of economic activity.
• Why do governments intervene in economic
  activities? Why cant we leave it all to private
  interactions among individuals (markets)?
  Economists usually think of two main motives
• a) Efficiency
• b) Equity

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• In economics, efficiency has a very precise
  meaning. An allocation of resources is said to be
  efficient if there is no rearrangement of
  resources (no possible change in production or
  consumption) such that someone can be made better
  off without at the same time, making someone else
  worse off. (Stiglitz)

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• Equity is a much more vague term. There is no
  best definition of equity. Each individual has
  his or her own definition of equity. Ideally,
  governments should be able to aggregate the
  different visions of equity in the population and
  provide a solution agreeable to all. As we will
  see this is an impossible endeavour.

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• Therefore, it is much easier for economists to
  discuss efficiency issues than equity issues.
  Efficiency can be discussed without resource to
  any moral or philosophical principle. This is not
  the case with equity.

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• Efficiency
• It is possible to prove, mathematically, that
  under certain conditions, competitive markets
  produce efficient outcomes. Under these
  conditions one could not argue for government
  intervention in the economy on the grounds that
  it promotes efficiency.
• This assertion is stated in the Two Fundamental
  Theorems of Welfare Economics.

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• First Theorem of Welfare Economics
• Under certain conditions, competitive markets
  produce an efficient allocation of resources.
• Second Theorem of Welfare Economics
• Under certain conditions, any efficient
  allocation of resources can be achieved with
  competitive markets.

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• There are two crucial expressions in the
  statement of the theorems
• i) under certain conditions
• ii) competitive markets.
• Failure of either one, or both, can result in
  inefficient outcomes, and provide reasons for
  government intervention in the economy.

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• Failure of Competition
• A market is competitive if all sides of the
  market behave competitively, i.e., take prices as
  given when making their decisions.
• In general, in order to have competition we need
  to have a large number of agents transacting in
  either side of the market, so that no single
  party is large enough to influence prices
  substantially.

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• When competition does not exist, either in the
  supply side of the market (ex Monopoly) or in
  the demand side (ex Monopsony), one or both
  sides have market power which they can exploit to
  extract rents at the expense of the other side
  and at the expense of efficiency.
• Another case of inexistence of competition is
  the inexistence of markets altogether. One
  example is communism, but there are many other
  examples. It is possible that communism generates
  efficient outcomes, but it is also very unlikely.

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• Failure of Other Conditions
• Public Goods
• Externalities
• Other failures, such as information asymmetry or
  credit constraints.

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• There are many types of failures that can occur
  in markets. However
• i) Can the market correct itself, and has it
  done so already?
• ii) Can the government do better? Will the
  government do better?

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• There are several problems that hamper the
  actions of governments
• i) Information Does the government have the
  information needed to correct market failures?
• ii) Distortions Is the government introducing
  new distortions in the market when acting to
  correct and existing distortion?
• iii) Incentives What are the incentives of
  public bureaucrats? How well are incentive
  schemes designed in public bureaucracies?

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• EQUITY
• Why is the allocation of resources resulting
  from the market operation inequitable?
• Why is equity a problem of the government?

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• There are two important aspects to consider
• i) Achieving a more equitable allocation of
  resources than the one produced by the market may
  or may not be desirable. It depends on the values
  of each person.
• ii) If we think that the market outcome is
  efficient but not equitable and the government
  needs to intervene, then very often this implies
  that the new more equitable allocation of
  resources is also less efficient equity is
  costly.

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• Equity has Efficiency Costs
• Most government interventions in the market
  imply some kind of distortion in incentives. If
  incentives were conducive of efficiency to start
  with, then distorting them is likely to produce
  inefficiencies. It is important to acknowledge
  and quantify these distortions in order to
  understand the costs of redistribution programs,
  which can be very high. For example, progressive
  taxation distorts incentives to work at the top
  of the income distribution, while welfare
  programs distort these incentives at low income
  levels.

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• Different Individuals have Different Views on
  Equity
• Then, which one should we adopt? How equitable
  is equitable enough? How much inefficiency are we
  willing to trade-off for a given increase in
  equity?
• Different individuals have different
  preferences. We need a mechanism to aggregate
  preferences of individuals into a social
  preference (social welfare function).

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• There are two extremes we can think of tyranny
  and direct democracy. However, there are many
  other ways to aggregate preferences, that do not
  even correspond to a particular political system.
• Even if we can construct such a social welfare
  function, do we usually think of the government
  as exercising the will of society (maximizing the
  social welfare function)?

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• Merit Goods
• These are goods that the government believes
  individuals should consume more of (or less of)
  what they currently consume. The reason
  individuals do not consume adequate quantities of
  these goods is because, even though they are good
  for them, they do not know better and make bad
  decisions. This may be one reason (but not the
  only one) for compulsory schooling. In these
  cases we say that the government acts
  paternalistically.