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PP640 Seminar Week 3
Public/Private Goods
Two Watershed Elections in 20th Century
Franklin D. Roosevelt (1940)
Source: Franklin D. Roosevelt Library
Franklin Delano Roosevelt
- 32nd President of the United States (19331945)
- “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
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
How much did social spending change during and
after Reagan?
• Not much
– Through the following residents (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
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
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 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
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
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?
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
pg. 17
Market Failure
• Free rider problem
• Externalities
• Information asymmetry
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
2. 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 freerider 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
- Solution: Government grants monopoly and regulates production to
get more efficient outcome
Violations of the Market Assumptions continued
3. Private/Asymmetric Information:
- One party in a two-party transaction possesses more information than
the other
- Firms may possess more information
- Example: Product quality, drug safety/effectiveness, etc.
- Individuals may possess more information
- Example: Individual health, personal risk-avoidance, etc.
- 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
Violations of the Market Assumptions continued
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
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.
Government Response to
Market Failure in the U.S. continued