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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