The Economics of Government

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The Economics of Government
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Study Questions

• 1. What is the role of government to insure
  public goods are available to society?
• 2. What is the role of government when dealing
  with a negative externality?
• 3. What is the role of government when dealing
  with a positive externality?
• 4. List four activities where government acts as
  the agent for society.

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Study Questions

• 5. Contrast a progressive tax system with a
  regressive tax system.
• 6. What is the function of a transfer payment?
• 7. Relate the government budget to the national
  debt.
• 8. Contrast decision making in the voting booth
  with decision making in the market place.

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Study Questions

• 9. Contrast running a bureaucracy with running a
  business.
• 10. How does government define the poverty line?
• 11. Describe the conflict between the two
  economic goals of equity and efficiency.

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Roles of Government

• Agent of society.
• make society function smoothly and efficiently
• pass laws to govern our conduct
• adjudicate and resolve conflict
• provide assistance to needy society members
• provide or arrange for goods and services
• consumes goods and services

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Public goods

• private good
• rival in consumption
• exclusionary
• public good
• non-rival in consumption
• non-exclusionary

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Public goods

• Free rider problem
• Once produced, a public good can be used by
  everybody for free
• Therefore, nobody will pay for a public good
• Firms see nobody who will pay, so they do not
  produce the public good

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Public goods

• Solution
• government becomes the buyer
• firms produce the good and get paid by government
• people use the good for free
• government collects taxes or fees to fund the
  purchase

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What is Market Failure?

• When the market produces more or less than the
  ideal optimal good or service. OR the wrong mix
  of input is given for output..
• Brings about externalities and public goods.

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When the market fails it is a double edge sword

• Market Fails if not optimal mix.
• Optimal Mix of Output Most desirable
  combination of output attainable with existing
  resources, technology and social values.
• Market Failure
• An imperfection in the market mechanism that
  prevents optimal outcomes.

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Market FailureIs this evident in todays market?

• market moves resources from one industry to
  another. (price directs resources) (demand
  responds) (price moves the resources then to
  another demand choice) (at this point
  (competition begins to prevail to level the
  prices)
• Changes in market prices directs resources

P
P
D1
D2
Q
Q
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How do you know if optimal mix is met?

• Optimal mix of ANY GOOD or SERVICE
• MB MC
• (Marginal benefit Marginal Cost)
• If the cost exceeds the benefit the failure
  occurs. If benefit exceeds the cost, then market
  is functioning according to other factors (price,
  demand, etc.)

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Plano City Council issues no smoking in
restaurants, bars, or outside bars on patios.

• What is the marginal private cost to Sports Bar?
• What is the external cost to Plano?
• What is the social cost? C gt B?

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Think!

• If the Plano allows restaurants and bars to allow
  smoking what is the accelerated health cost or
  hazard? (is there any?)
• If Plano does not allow smoking in restaurants,
  etc, will businesses be able to make a profit?
  Will the sports bar still have the draw for
  watching f-ball?

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What is a Social Cost?

• The cost to society resulting from a negative
  externality or wrong mix of output of resources.
  Too much secondary smoke in a restaurant.
• Is there a socially optimal amount of output?
• The amount that adjusts the benefits (external
  and private) with the costs (external and private)

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Externalities

• A cost or benefit arising from an activity that
  falls on a third party (someone other than the
  producer or the consumer)
• Third party cost? Negative externality
• Third party benefit? Positive externality

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Negative externality

• Example pollution
• Producer keeps costs low by dumping waste into a
  river
• People living along the river suffer a cost as
  they live in a degraded environment
• Society adds this externalized cost to the
  private costs of buyer and seller

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The Negative Externality Case

• Because of a negative externality, marginal
  social costs (MSC) are greater than marginal
  private costs (MPC)
• The market output is greater than the socially
  optimal output.
• The market is said to fail in that it
  overproduces the good.

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Negative externality

• Social costs private costs external (third
  party) costs.
• Society says these goods are
• over consumed
• over produced
• External costs are not included in market
  decision making.
• Government intervenes.

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Negative externality

• Government can
• force the producer to internalize the cost.
• prohibit the producer from making the product.
• reward the producer for reducing the external
  cost.

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Examples of spillovers

• Throwing trash in someones back yard
• Living downstairs from a Tai Bo person
• Playing your stereo loudly at 300 a.m.
• Businesses dumping wastes, sludge into rivers
• People trashing the beach or highway.
• Electric Companies burning phosphorous fuels

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Positive externality

• Social benefits private benefits external
  (third party) benefits.
• Society says these goods are
• under consumed
• under produced
• External benefits are not included in market
  decision making.
• Government intervenes.

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In real words?

• Not enough public parks
• Not enough care for environment
• Not enough welfare
• Too much separation between top 10 income
  earners and median income earners
• Not adequate security within our borders.
• Too many immigrants.

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But, if mix of output gets totally out of whack.
Government takes over.
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Translation

• If government and/or the consumer was not acting
  as a watchdog. Would corporations be diligent
  about utilizing the proper mix of resourcesIf
  they are, can they compete? . NOW..
• Telecommunications Industry?
• Does that always mean regulation increased?
• Could it mean that consumer sovereignty switches
  to another desire BUT what about things like
  energy would we really know if the provider was
  efficient?

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Positive externality

• Government can
• subsidize the producer to produce more
• subsidize the consumer by offering the good at a
  very low price
• coerce the consumer by mandating the use of the
  good

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Establish Rules of Conduct

• Government provides and enforces a level within
  which an economy can operate.
• law of contracts
• fraud laws
• protection of property rights

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Property rights

• If protected
• people work hard, earn more, and accumulate
  property to obtain a better standard of living.
• enables those in poverty to move upward and
  create a prosperous middle class.
• If not protected
• incentive to work and accumulate is removed.
• those in poverty are doomed to stay there.

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Taxes

• Government earns nothing and produces no wealth.
• Taxes provide an income stream for government.
• Taxes are paid by income earners.
• Taxes transfer the earners purchasing power to
  the government.
• Government becomes the buyer.

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3 Kinds of Taxes

• Progressive
• Regressive
• Proportional

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• The primary function of taxes is to transfer
  command over resources (purchasing power) from
  the private sector to the public sector.

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• Types of Taxes
• Progressive tax rate increases as the tax base
  increases
• Proportional tax rate remains the same
  regardless of the base
• Regressive tax rate decreases as the base
  increases. (often cited as unfair because it
  places heaviest burden on the least able to pay
  ---sales tax--- social security tax.)
• What is your preference?

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Kiplinger report 2009Income earners (family 4)

• 1 380,354
• 5 159,619
• 10 113,018
• 25 66,532
• 50 32,879

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Transfer payments

• A payment from the government that a person or
  institution receives because he or it is entitled
  to it by law.
• There is no requirement for the recipient to do
  or to provide anything in return.
• Government redistributes some of the taxpayers
  income to provide a social safety net.

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Special interest groups

• Not all transfer payments go to low income
  earners.
• Special interest groups petition government for
  special favors handouts, subsidies, favoritism
  in government contracts, and tax breaks.
• Lobbying for these favors can impact decision
  making by members of Congress and by bureaucrats.

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Government budgeting

• Most state and local government agencies must
  operate with a balanced budget
• Revenues must equal spending.
• The Federal government usually does not have a
  balanced budget
• Deficit Revenues less than spending.
• Surplus Revenues greater than spending.

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Budget deficits and the national debt

• Federal budget is usually in deficit.
• Increased spending is politically palatable.
• Increased taxes are not politically palatable.
• To finance the deficit, the US Treasury
  Department must borrow by offering government
  securities to the public.
• This added borrowing increases the national debt.

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Problems with deficit spending

• Crowding out
• When the government needs to borrow, it taps into
  the same funds pool used by consumers and
  businesses to borrow.
• More for government? Less for the private sector.
• Interest payments
• Government must pay interest to all debt holders.
• More debt? More interest payments must be funded
  by taxes.

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The tax burden

• Ideally, high income earners should pay more
  taxes than middle- or low-income earners.
• In reality, high-income earners lobby for special
  tax breaks and hire accountants and lawyers to
  help them avoid paying high taxes.
• Middle- and low-income earners cant do this
  they simply pay their taxes.
• In our system, middle-income earners end up
  paying most of the taxes.

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Decision making in government

• Each government decision maker uses his own value
  system to do cost-benefit analysis.
• In government, however, the benefits and costs do
  not accrue to the decision maker, but to other
  groups.
• The decision maker cannot properly evaluate the
  costs and benefits as well as an individual would
  for himself.

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Decision making in government

• Benefits accrued by one group will be offset by
  costs accrued by another group.
• Special interest groups will lobby the government
  decision maker with incentives and penalties,
  which influence the decision making.

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Voting booth vs. Market

• Voting booth
• vote for the candidate that satisfies you the
  most
• get the winner (who was preferred by the
  majority), who might not have been your preference

• Market
• vote for the product that satisfies you the most
• get that product (no matter what the majority of
  customers prefer)
• markets are more democratic than voting booths

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Bureaucracy

• A business firm has a profit motive.
• produce a customer satisfying product (otherwise,
  the customer will choose a rivals product)
• constantly strive to keep costs low
• the measure of success is to increase profits

• A bureaucracy has no profit motive.
• customers have no alternative to choose from.
• the measure of success is to increase the
  bureaucracys budget (increase costs)

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Figure 5-1. Profit-Seeking Firms and Bureaucratic
Agencies
cost per unit
Economies of scale ATC decrease as size increases
Economies of scale ATC increase as size increases
ideal sized firm/ agency
bureaucratic agencies operate here
size of firm/agency
profit-seeking firms operate here
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Income distribution

• Income is earned.
• Produce goods in high demand earn a high income.
• Produce goods in low demand earn a low income.
• Produce nothing earn nothing.
• Income is distributed unequally in America (and
  in all other countries of the world).

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Unequal Income Distribution

• Reasons why
• education level
• intact vs. broken family structure
• work ethic
• talents and skills availability
• age and experience
• health
• willingness to take risks or endure hardship
• discrimination in hiring
• luck (be in the right place at the right time)

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Poverty 2008 statistics

• For 2008, the poverty threshold for a single
  person under age 65 was an income of 11,201, or
  less than 1,000 a month.
• For a family of four, the threshold was 21,834.
• For a family of six, 28,769.
• Recession just completed finds 40 million in U.S.
  living in poverty.

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Economics of Transfer Payments

• Redistribution through public sector will reduce
  the size of the economic pie
• Weakens the link between productive activity and
  reward (taxes increased reduce individual reward
  for hard work-less productive.
• As public policy redistributes large share of
  income,more resources flow into increasing it

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Economics of Transfer

• Higher taxes to finance redistribution will
  induce taxpayers to focus less on income
  producing activities and more on income shelters
  higher incomes have greater opportunity here
• When leakages flow in taxes rather than in
  savings (money is unproductive)
• Money that is productive generates more capital
• More capital generates more jobs.
• More jobs generates more income.

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Merit Goods

• The government is called upon to distribute merit
  goods when the market does not provide enough.
• A merit good is a good or service society deems
  everyone is entitled to some minimal quantity .
  Public goods have two particular characteristics.
  They are
• Non-excludable - once the goods are provided, it
  is not possible to exclude people from using them
  even if they haven't paid. This allows
  'free-riders' to consume the good without paying.
  
• Non-rival - this means that consumption of the
  goods by one person does not diminish the amount
  available for the next

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• Taxes paid today go to pay benefits for people
  drawing today.
• Do you think there is a special fund where the
  SS dollars go???

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More Grim Statistics Concerning SS

• 70 of SS goes to retirees - avg monthly benefit
  of 898.20
• 15 to disabled workers and families
• May, 2003- avg benefit for disabled workers was
  837.70
• 15 goes to widows, widowers, and families avg
  check of 850.80
• By 2030-twice as many older Americans 35 million
  to 70 million. Now there are 3.4 workers for
  every beneficiary by 2030 there will be just 2.1
  workers for each beneficiary.

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Equality vs. Efficiency

• These goals are in conflict.
• Unequal incomes generate a highly efficient,
  productive society with the highest standard of
  living.
• Requiring equal incomes destroys incentive to
  work hard, to improve oneself, or to seek better
  opportunity. Society is less efficient, less
  productive, and has a lower standard of living.

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Why is the U.S. Economy owing billions of
dollars?If you subsidize something you get more
of it.Dr. Milton Friedman, Free to Choose

• Virtually all of the recent growth in federal
  expenditure has come from increased income
  transfers, not purchases of goods and services.

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So, it all gets back to Joe Q Citizen Taxes paid
to government.

• Question is
• What kind of an economy do we Joe Qs want?
• The primary function of taxes is to transfer
  command over resources (purchasing power) from
  the private sector to the public sector.
• Why from private to public? Why not the other
  way around?

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• Government failure occurs when government
  intervention fails to improve economic outcomes.

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Perceptions of Waste

• Government waste implies that the public sector
  isnt producing as many services as it could with
  the sources at its disposal.
• With such inefficiency, we are producing inside
  our production-possibilities curve.
• Opportunity cost
• The issue of government waste encompasses
  questions of efficiency and opportunity cost.

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FY09 Budget Priorities