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Seminar Unit 1
-
“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.”
-
- Ronald Reagan, 40th President of the United States
Unit 1 Seminar
1.
2.
3.
Public Sector Theory
Market Failures
Welfare Economics
Fundamental Theorems
Three Normative Aspects of
Public Sector Economics
1.
Public expenditure theory


2.
Theory of taxation

3.
What government expenditures do we expect,
and why?
How should government carry out its desired
functions?
What principles should guide design of
government tax policy
Theory of fiscal federalism
Fiscal Federalism
Refers to multi-tiered
system of government
Questions
• Which tiers should
provide which
government
• functions?
• How do people
sort themselves
across tiers?

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
Most
individual
freedom

Decentralized Capitalist
Economy: Limited
government; individuals
and firms make all
important economic
decisions
Where do Current Economies
Least
Most
Fall?
individual
individual
freedom
freedom
China
United States
• Often referred to as
 Often referred to as
“communist” economy
‘capitalist’ economy
• Gov’t spending 30% of
 52.8 % free according
GDP
to Heritage
Foundation’s Index of
 80.6% free in 2008
Economic Freedom
according to Heritage
freest
in world)all lie well
Foundation’s
Index of
 (126th
Modern
economies
within bounds
Economic Freedom (5th
freest in world)
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
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
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?
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 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 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 decisionmaking process
 After that all decisions can be made by different rule
(i.e. majority rule)
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 selfinterest in private and
public affairs
Assumes narrow selfinterest in private affairs
only
Pros and Cons of Public Choice Theory
More desirable aspects
Better able to explain and
predict actual gov’t behavior
Focuses more on process
than outcomes
Less desirable aspects
Has a thin normative base
which makes correct
decisions on gov’t
intervention in cases of
market failure difficult to
determine
Belief in self-interest in all
aspects of life appealing to
economists
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
Market Failures
-
-
How do markets fail?
What activities should government be involved
in?
To answer these questions, we must consider …
- Structure of individual product and factor
markets
- Nature of individual preferences and production
technologies
The Market Assumptions
Best market structure → Perfect competition
(1) Many, many consumers and firms
(2) Homogenous product
(3) Perfect information for buyers and sellers
(4) Free entry and exit in Long-run
The First and Second Fundamental
Theorems of Welfare Economics
First Fundamental Theorem of Welfare
Economics
-
If all technical assumptions hold, a perfectly
competitive market generates an efficient
allocation of resources
Implications
1. Full Pareto optimality holds in terms of people
2.
No other system can do better in terms of
efficiency
The First and Second Fundamental
Theorems of Welfare Economics continued
Second Fundamental Theorem of Welfare
Economics
-
If all technical assumptions hold, a
perfectly competitive economy can
generates any of the feasible efficient
allocations of resources with a suitable
distribution of initial resources
The First and Second Fundamental
Theorems of Welfare Economics continued
-
Adam Smith (1723-1790) – One
of the first modern economic
thinkers
-
Published the An Inquiry into the
Nature and Causes of the Wealth
of Nations in 1776
-
Observed that the market
economy functions as if guided by
‘invisible hand’ to generate proper
allocation of resources
The First and Second Fundamental
Theorems of Welfare Economics continued
Combined Implication of the Theorems
- Markets are simple
(1)
(2)
(3)
-
Yet markets are potentially very powerful
-
-
Markets are decentralized
Markets are anonymous
Market rules are entirely self-serving
According to the two fundamental theorems of
Welfare Economics, perfectly competitive markets
can provide economically efficient outcomes
Experience suggests that most markets work
exceedingly well
The First and Second Fundamental
Theorems of Welfare Economics continued
-
-
Theory suggests potential power of markets, but …
do markets always function well?
Musgrave (1959) focuses on three separate
branches of public economics to address this
question
1. Distribution branch
- Addresses failures to achieve end-results or
process equity
2. Allocation branch
- Addresses failures to achieve Pareto Optimal
outcomes
3. Stabilization branch
- Addresses failures in macroeconomic policy
PARETO OPTIMALITY

Paretian System

Two fundamental components of Paretian
value system
 1. Individual preferences count
 2. Prevailing income distribution is desireable
PARETO OPTIMALITY

Pareto Criterion

Purpose


Pareto criterion is a technique for comparing or
ranking alternative states of the economy
Definition of Pareto Criterion

If it is possible to make at least one person better
off in moving from state A to state B without
making anyone else worse off, state B is ranked
higher by society than state B
PARETO OPTIMALITY

Pareto Criterion

Pareto Improvement


A movement from state A to state B
Pareto Criterion vs.Unanimity

Pareto criterion allows indifference by some
individuals (some not made worse off)
PARETO OPTIMALITY

Pareto Optimum

A state of the economy from which it is
impossible to make one person better off
without making another person worse off.
 If society finds itself in a position from which
there is no Pareto improvement, then there is
a Pareto optimum
 If economy is not in Pareto optimum, some
inefficiency in the economy
PARETO OPTIMALITY

Weak Pareto Criterion


Strong Pareto Criterion


Everyone is made better off.
Some people are made better off, while noone
is made worse off.
Pareto criterion breaks down if even one
individual is made worse off.
PARETO OPTIMALITY

Graphically
Utility Person B
Set of Pareto improvements
Pareto-inefficient starting
point
• Utility Possibility
Curve
• Corresponds to all
possible combinations of
utility for individuals A and
B for given production
possiblity frontier
Utility Person A
PARETO OPTIMALITY AND
INCOME DISTRIBUTION
Pareto optimality gives an efficient
resource allocation and maximum social
welfare for a given income distribution
 If change existing income distribution, then
new Pareto optimum
 Hence, many Pareto optimum may exist
associated with different factor
endowments (incoome distributions)

PARETO OPTIMALITY AND
INCOME DISTRIBUTION
Implies cannot solve problem of efficiency
and income distribution in two stages by:
 1. First, Pareto-efficient resource
allocation
 2. Optimum distribution
 No solution by Pareto criterion

LIMITATIONS TO PARETO CRITERION
1. Breaks down if single individual made worse off
2. Many alternatives simply not comparable




Alternative Pareto optimum (corresponding to
different income distributions) not Pareto comparable
Pareto criterion does not allow choosing between
alternative income distributions
3. Favors status quo
4. Not all first-best Pareto-optimal choices are
superior to some second-best (Pareto-inefficient)
choices

Second-best may have superior income distribution
Violations of the Technical Assumptions
There are several potential reasons that markets
fail in allocation …
1. Externalities
Consumption by individual or production by firm that
affects utility function or production function of at
least one other individual or firm
Can be positive (utility increasing) or negative
(cost increasing)
Examples: Positive - education, urban renewal,
public health, R&D, etc; Negative - air pollution,
noise pollution, etc.
Violations of the Technical Assumptions
continued
-
Problem: Additional utility (cost) is not
recognized by market which leads to underproduction (over-production)
-
Solution: Government intervenes in market
by taxes, subsidies, and/or regulation to
create more efficient outcome
Violations of the Technical Assumptions
continued
Nonexclusive (Public) goods
A good for which, once someone buys, it everyone is able to
enjoy the full amount of the services provided by the good
-
Examples: national defense, highways, parks, pools, golf
clubs, etc.
-
Problem: If you can consume a good whether you pay for it
or not, you have no incentive to contribute to production (the
free-rider problem) which results in under-production
Solution: Government provides more efficient level of
production which is financed through collection of taxes
-
Violations of the Market Assumptions
1. Property Rights and Enforceable Contracts
- Problem: If property rights are not protected (i.e. I can
steal what you produce) there is no incentive to
undertake economic activity
- Solution: Government regulation and enforcement
2. Decreasing Costs/Economies of Scale
- Goods for which the average cost of production
decreases as quantity produced increases over a large
scale
- Example: Public utilities, public transportation,
telecomms, etc.
- Problem: Efficient production results with one (or few)
large firms.
-
Such a market has incentive to act as monopoly which
results in under-production
Violations of the Market Assumptions
continued
Private/Asymmetric Information:
- One party in a two-party transaction possesses
more information than the other
-
Problem: Party possessing more information can
take advantage of other party which results in
inefficient outcome
-
Solution: Government creates oversight bodies
that regulate functioning of such markets (e.g.
FDA, FTC, etc.) to create more efficient outcome
Stabilization
Conclusion
Problems in allocation branch usually require
government intervention to make markets operate
more efficiently
Government Response to Market Failure in the U.S.
-
Government addresses different concerns at different levels
(→ Fiscal Federalism)
At federal level
Government provides:
National defense → (~20% of spending in U.S. in 2006)
Social insurance → (~40% of spending in U.S. in 2006)
Public Assistance → (~15% of spending in U.S. in 2006)
Federal regulating agencies
Grants-in-aid to states and localities
Government Response to
Market Failure in the U.S. continued
At state and local level
Government provides:
Public education → (~15% of spending in U.S. in
2006)
Transportation funds → (~6% of spending in U.S. in
2006)
Public Welfare → (~25% of spending in U.S. in
2006)
etc.