Download Econ 201 Week 5_6 Economics of the Public Sector

Economics of the Public
Sector
The Role of Government

Capitalism is associated with limited government, but
government is necessary for three reasons:

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Establish and maintain legal system to protect property
rights.
Promote equity in the distribution of income and wealth.
Correct inefficiencies that arise from markets (externalities,
public goods, and monopoly power).
Public Finance/Choice is the area of economics that
studies the public sector.

Incentives are different in markets versus political sphere– in
capitalism preference are revealed with purchases versus
votes.
Another Look at Efficiency

Efficiency in competitive markets occurs
where MB=MC. Where MB= private (max.)
willingness to pay and MC= private (min.)
willingness to sell.
 More correctly, society will see the outcome
as efficiency where marginal social benefits =
marginal social costs.
 Externalities drive a wedge between private
and social benefits and private and social
costs.
Figure 1 The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Equilibrium MB=MC
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Externalities

Externalities are benefits (costs) received (borne) by
neither the seller or the buyer but by third parties.
 Private benefits + external benefits = social benefits
 Private costs + external costs = social costs
 Since external benefits and costs are not perceived
by buyers and sellers they are not captured in
markets.
 Therefore, markets may fail to allocate resources
inefficiently.
Negative externalities

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Marginal social costs are greater than marginal
private costs.
Pollution is a cost that may not be borne by sellers,
but it is a cost nonetheless to society.
Private markets will overproduce (devote too many
resources) to the production of goods with negative
externalities.
External costs and the supply curve.
Missing the extra costs, markets generate an
outcome where MSC > MSB, signal that decreasing
output will increase net social benefits.
Is zero pollution efficient?
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
Cost =MSC
Cost of
pollution
Supply
(private cost)
=MPC
MSC
MSC
Optimum
Equilibrium
MSB
MSB
Demand
(private value)
MPB=MPB
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Positive externalities

Marginal social benefits are greater than
marginal private benefits.
 Education is a benefit not only to the
individual but to society in general.
 Private markets will underproduce (devote
too few resources) to the production of goods
with positive externalities.
 External benefits and the demand curve.
 Missing the extra benefits, markets generate
outcomes where MSB > MSC, a signal that
increasing production will increase net social
benefits.
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Copyright © 2004 South-Western
Internalizing or Correcting
Externalities

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Efficiency versus who ought to modify their behavior?
Moral and Ethical Codes
Non-governmental organizations or Charities
Integrating certain activities (bee keepers and fruit
growers)
Contract between parties
Coase Theorem – if negotiation costs are zero,
private parties can resolve the problem of
externalities.

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An optimal compensatory payment (bribe) = one that makes
both parties better off.
Initial distribution of rights does not affect the efficient
outcome, but it does determine who will pay whom.
Example of heating the apartment in Santiago

Government policies

Regulation

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Limits to pollution
Specific technology requirements
Government production
Regulation and least cost solutions
Taxes and Subsidies (Pigovian)

Who should pay the tax or receive the subsidy?

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Tax /subsidy incidence is the same
External costs, supply (demand) and the optimal tax.
External benefits, demand (supply) and the optimal
subsidy.
 Tradeable
Pollution Permits
The higher costs of avoiding pollution, i.e. the
higher the benefits from polluting, the more a
firm is willing to pay.
 Equivalence of Pigovian Taxes and Pollution
Permits

 Criticism
of Economic Solutions to Taxes
To live is to pollute
 Natural carrying capacity

Figure 4 The Equivalence of Pigovian Taxes and
Pollution Permits
(a) Pigovian Tax
Price of
Pollution
Pigovian
tax
P
1. A Pigovian
tax sets the
price of
pollution . . .
Demand for
pollution rights
0
Q
2. . . . which, together
with the demand curve,
determines the quantity
of pollution.
Quantity of
Pollution
Copyright © 2004 South-Western
Figure 4 The Equivalence of Pigovian Taxes and
Pollution Permits
(b) Pollution Permits
Price of
Pollution
Supply of
pollution permits
P
Demand for
pollution rights
0
2. . . . which, together
with the demand curve,
determines the price
of pollution.
Q
Quantity of
Pollution
1. Pollution
permits set
the quantity
of pollution . . .
Copyright © 2004 South-Western
The Invisible Hand and
Invisible Benefits and Costs
Externalities are “invisible” to buyers and
sellers in markets. In some cases,
government action may be needed to make
them visible and ensure they are included in
economic decision-making.
 The efficient allocation of resources occurs
where:

MSB=MSC
Public Goods and Common
Resources

Certain kinds of goods or services are
underproduced in markets because the
market does not contain sufficient incentives
to produce them in efficient amounts.
 Certain kinds of resources are overused
because they are owned collectively or
people cannot prevent them from being used.
Classifying Different Kinds of
Goods and Services

Exclusion or non-exclusion– can individuals
be excluded from consuming the good or the
resource. (e.g. hamburger, houses, physical
examination versus fireworks, national
defense, and the ocean outside of territorial
waters)?
 Rival or non-rival – does one person’s use of
the good or resource affect another persons
use. (e.g. hamburger versus lighthouse,
uncongested versus congested highway)
Figure 1 Four Types of Goods
Rival?
Yes
Yes
No
Private Goods
Natural Monopolies
• Ice-cream cones
• Clothing
• Congested toll roads
• Fire protection
• Cable TV
• Uncongested toll roads
Common Resources
Public Goods
• Fish in the ocean
• The environment
• Congested nontoll roads
• Tornado siren
• National defense
• Uncongested nontoll roads
Excludable?
No
Copyright © 2004 South-Western
Private Good – excludable and rival
(hamburger)
 Public Good – not excludable and non-rival
(lighthouse, warning siren)
 Common Resource – rival but not excludable
(ocean, old days pasture land)
 Natural Monopoly – excludable but non-rival
(protecting another house – MC is small)

Public Goods
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Examples are fireworks, national defense, basic
research, alleviating poverty)
Free-rider problem – another example of revealed
preference. If people cannot be excluded, they have
no little incentive to pay for the good or service).
Free-riders make it difficult for private providers to
provide the optimal amount of a public good.
Voluntary exchange does not work efficiently and
efficiency may be provided by government coercion.
Government Provision versus
Production of Public Goods

The government must perform cost-benefit
analysis to decide if it is worthwhile to provide
the good and determine how much should be
produced (valuing a life).
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Stoplights
Highways – public or private, uncongested or
congested
Taxes are then imposed to provide for the
good.
Tragedy of the Commons
Commons – overuse of a rival
resource where individuals were not
purposively not excluded.
 Ocean Fishing
 Bison versus Cattle – the importance of
property rights
 Pricing in national parks
 Boston
Summary
 Efficiency
and the market system
 Market failures
 Government failures