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PUBLIC SECTOR
ECONOMICS
Lecture 1:
The Foundations of
Public Sector Theory
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Two Watershed Elections in 20th Century
Franklin D. Roosevelt (1940)
Source: Franklin D. Roosevelt Library
Franklin Delano Roosevelt
- 32nd President of the United States
(1933-1945)
- “True individual freedom cannot exist
without economic security and
independence.”
→ Elected during Great Depression
→ Signed Social Security Act of
1935 to provide public insurance
against poverty
→ A ‘Liberal’ President
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Official Portrait of
President Reagan (1981)
Source: Ronald Reagan Library
Ronald Reagan
- 40th President of the United States
(1981-1989)
- “Government's view of the economy
could be summed up in a few short
phrases: If it moves, tax it. If it keeps
moving, regulate it. And if it stops
moving, subsidize it.”
→ Elected during stagflation of late
1970s
→ ‘Conservative’ response to FDR
→ Proposed largest tax cut in history
and drastic spending cuts to social
programs
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
How much did social spending change
during and after Reagan?
• Not much
– Through the following
presidents (Republican &
Democratic) spending as % of
GDP changed little
• So what is difference between
Liberals and Conservatives?
– Not as great as might be
suggested in popular press
– Differences are more normative
than positive
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Federal Outlays, 192 to 2001
(As a percentage of GDP)
Source: Congressional Budget Office
Three Normative Aspects of
Public Sector Economics
1. Public expenditure theory
– What government expenditures do we expect,
and why?
– How should government carry out its desired
functions?
2. Theory of taxation
– What principles should guide design of
government tax policy
3. Theory of fiscal federalism
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Fiscal Federalism
• Refers to multi-tiered
system of government
Questions
• Which tiers should
provide which
government functions?
• How do people
sort themselves
across tiers?
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Federal - 1
State - 50
Local - 89,000+
What are the Legitimate Economic
Functions of a Government?
Depends on chosen economic system…
Least
individual
freedom
• Centrally Planned
Socialism:
Government owns all
resources and makes
all important economic
decisions
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Most
individual
freedom
• Decentralized Capitalist
Economy: Limited
government; individuals
and firms make all
important economic
decisions
Where do Current Economies Fall?
Least
individual
freedom
China
• Often referred to as
“communist” economy
• 52.8 % free according to
Heritage Foundation’s
Index of Economic
Freedom (126th freest in
world)
Most
individual
freedom
United States
• Often referred to as ‘capitalist’
economy
• Gov’t spending 30% of GDP
• 80.6% free in 2008 according
to Heritage Foundation’s
Index of Economic Freedom
(5th freest in world)
 Modern economies all lie well within bounds
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
What Economic Functions Should
Government Provide?
•
•
•
Should honor consumer and producer sovereignty
(humanism)
• Gov’t should intervene in cases of market failure
• Functions that government cannot perform at all
or performs sufficiently badly to merit gov’t
intervention
The correct definition of market failure is the main issue
over which Liberals and Conservatives disagree
Both sides do agree that gov’t should not intervene in
markets that are functioning well
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Two Goals of Economies
1: EFFICIENCY
• Efficiency is mainly a positive concept
• Economists measure efficiency as Pareto Optimality
• Definition: An economy-wide allocation of resources is
efficient if in order to increase one person’s utility at
least one other person’s utility must be decreased
Example
• An allocation in which I have everything and you have
nothing is an ‘efficient’ allocation (Pareto Optimal)
– The only way to make you better off is to take some
away from me
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
(Efficiency continued…)
Consider all ‘efficient’ points given our existing resources
• Called the Utility Possibility Frontier
1. Must be downward sloping
• To increase 1’s utility we must
take utility away from 2
2. Points below line are attainable but
not efficient
• Could give some to both 1 and
2 and make them both better
off (Pareto Superior moves)
3. Points beyond line are unattainable
• Would require giving more
utility to both 1 and 2 which is
impossible
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Two Goals of Economies
2: EQUITY (FAIRNESS)
Equity is mainly a normative concept
End-results equity
• Asks whether outcomes are fair.
– For example: Is it fair that over half of income in U.S. goes
to 20% of households? If not, what should be done to
correct it?
Process equity
• Asks whether rules determining process are fair, regardless of
allocation.
– For example: Do children of wealthy families start with an
advantage due to their family’s wealth? If so, then what
should be done to level the playing field?
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
How Should Government Carry Out Its
Desired Functions?
• In general, government should act as agent for
individuals
– Implies that elected officials do not make decisions on
own behalf
– Ignores that elected officials are individuals interested
in their own personal welfare
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Public Choice Theory (1)
Credited to James Buchanan (Nobel Laureate 1986)
• Believed individuals self-interested in both private and
public economic affairs
• Gov’t just another venue through which to pursue
economic self-interest
• Buchanan’s Public Choice Theory adds political content
to concept of individual decision-making
– Argues that gov’t is efficient only if it establishes rules
that allow people to get what they want from gov’t
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Public Choice Theory (2)
• Therefore, what would be an efficient (Pareto Optimal) decision
rule?
• Unanimity: only way to make at least one person better off
without making anyone worse off
– Problem: Unanimity is impractical
• As number of citizens increases what are chances
anything passes?
– Solution: Buchanan argues that unanimity should only be
required when gov’t first agrees on its decision-making
process
• After that all decisions can be made by different rule (i.e.
majority rule)
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
How do Mainstream and
Public Choice Theories Compare?
• Similarities: Both argue that democracy is process that is
most consistent with decentralized market economy that
honors consumer sovereignty
• Differences:
Public choice
Mainstream
Adds political content
Ignores political content
wherever possible
Focuses on process
Focuses on outcomes
Assumes narrow self-interest Assumes narrow self-interest
in private and public affairs
in private affairs only
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Pros and Cons of
Public Choice Theory
More desirable aspects
Less desirable aspects
Better able to explain and
predict actual gov’t behavior
Has a thin normative base
which makes correct decisions
on gov’t intervention in cases of
market failure difficult to
determine
Focuses more on process than
outcomes
Belief in self-interest in all
aspects of life appealing to
economists
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008
Ignores possibility that
individuals have sense of
community
And Finally…
• Recent experiments (Behavioral Economics)
suggest that individual behavior is often more
consistent with Mainstream view
– Individuals appear more self-interested in market
experiments than in public good experiments
PUBLIC SECTOR ECONOMICS
Richard W. Tresch
Lecture Slides © Mike Hilmer, 2008