Public Choice & The Public Sector
Many decisions in the U.S. economy are made in the public sector (by government).

Public choice theory applies economic principles to public sector decision making. 

Government failure – occurs when government action results in a less efficient allocation of resources.

The primary motivation in the public sector is assumed to be self-interest.

Voters cannot vote for the exact political policies that they favor.

Low voter turnout occurs because many voters see the costs of voting as greater than the benefits.
  • It is very unlikely that one person’s vote will decide the outcome of an election.
  • It is rational to remain ignorant if the cost of gaining information is greater than the benefit of having the information.  Most voters will not be well-informed due to rational voter ignorance.
The median voter model suggests that the median voter must be captured to achieve a majority vote.  Thus, a candidate will:
  1. Aim for a middle-of-the-road position
  2. Label his or her opponents as extremists
  3. Adjust his or her positions in response to polls
  4. Speak in general rather than specific terms
Elected officials will tend to support policies that yield benefits in the short run and impose costs in the long run.  Elected officials will tend to oppose policies that yield costs in the short run and yield benefits in the long run.

Elected officials will tend to be responsive to special-interest groups.

The influence of special-interest groups is increased by:
1.  Low voter turnout
2.  Rational ignorance
3.  Lobbying

Because of special-interest group influence, elected officials will tend to favor policies that yield concentrated benefits and impose dispersed costs, and will tend to oppose policies that impose concentrated costs and yield dispersed benefits.

A congressional district can be a special-interest group.  Legislators often trade votes in order to pass legislation beneficial to their own districts.  This vote trading is called logrolling.  Logrolling often leads to “pork barrel” legislation.
The actual functioning of government is usually through government bureaus. 

Government bureaus are likely to be very inefficient because:
1.  They have no profit motive.  Thus, the bureau will be motivated to spend all of its
     funding and to be less concerned about minimizing costs.
2.  They have no owner.  There is no owner with an incentive to monitor the efficiency of
     the bureau.
3.  They usually face no competition.  Thus, they do not have to be very responsive to
     consumer demand, or very concerned about minimizing costs of production.
4.  They seek to grow.  A govt. bureau is a special-interest group in favor of its own
     continued existence and growth.
Other sources of government failure:
1.  Difficulty in measuring the marginal social benefit and the marginal social cost of
     government spending.
2.  Taxes collected do not reflect the full cost of a govt. program.  Two types of costs are incurred when the government collects taxes and uses resources.
     a.  the opportunity cost of the resources used.  The opportunity cost may be greater
          than the price paid by the government.
     b.  the excess burden of the tax
3.  The inefficiencies caused by income redistribution
     a.  income redistribution reduces the incentive for productivity
     b.  income redistribution encourages rent seeking
     c.  income redistribution leads to higher tax rates, which increases the excess burden
          of taxation.
4.  Unintended consequences of government policies.
5.  Majority voting may be economically inefficient.   
6.  Government may stand in the way of creative destruction.  Creative destruction 
     describes the short run upheaval caused by the development of new technology. 
     Creative destruction will impose concentrated costs and yield dispersed benefits.
7.  Government suffers from the principal-agent problem.
Market Failure
  • Our goal is to produce the optimal mix of output, that is, the most desirable combination of output attainable with existing resources, technology and social values.
  • The market mechanism moves resources from one industry to another in response to consumer demands.
    1. Market Mechanism – The use of market prices and sales to signal desired outputs (or resource allocations).
    2. Changes in market prices direct resources from one industry to another, moving us along the perimeter of the production-possibilities curve.
    3. The market mechanism may produce a mix of output that is different from the one society desires.  This is called market failure.
    4. Market Failure – An imperfection in the market mechanism that prevents optimal outcomes.
    5. Market failure implies that the forces of supply and demand have not led us to the best point on the production-possibilities curve.
    6. Market failure establishes a basis for government intervention.
  • Sources of Market Failure
    1. Public goods.
    2. Externalities.
    3. Market power.
    4. Equity.
Public Goods
  • Private Good - A good or service whose consumption by one person excludes consumption by others.
    • An example of a private good is a donut.  When one person consumes the donut, the process of consumption excludes others from consuming that same donut.
  • Public Good - A good or service whose consumption by one person does not exclude consumption by others.
    • An example of a public good is national defense.  One person’s consumption of national defense does not preclude others from consuming the same amount of national defense.
The Free-Rider Dilemma
  • The “communal” nature of public goods may cause consumers to try for a free ride. 
  • Free Rider – An individual who reaps direct benefits from someone else’s purchase (consumption) of a public good. 
  • The consumers will not demand the product hoping that someone else will purchase it thus providing them with the benefit(s) of the good or service without any cost to them.
  • An example of the free rider problem is flood protection.  If your neighbor provides flood protection for her home and that also protects your home, then you will not provide your own flood protection.
  • If public goods were marketed like private goods, everyone would wait for someone else to pay.  The result might be a total lack of public services.
  • Either the government or the private sector can produce public and private goods.
  • Because of the inability of the market mechanism to get us to the optimal mix of output (public goods), we need a non-market force (government intervention) to get there.
Externalities
  • Externalities  - Costs (or benefits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity.
  • The Social Demand is the market demand minus the external cost of consumption (assuming the externalities are associated with consumption).
  • The optimal production mix is where the social demand curve intersects the social supply curve.
  • When externalities are present, the market mechanism will not get us the optimal mix of output; we may need government intervention.
  • Market Power
    • With public goods and externalities, the market fails to achieve the optimal mix of output because the price signal is flawed. 
    • Market power -  The ability to alter the market price of a good or service
    • Market power gives a producer the ability to maximize profits rather than produce the optimal mix of output. 
    • A natural monopoly is the classic example.
    • Natural Monopoly – An industry in which one firm can achieve economies of scale over the entire range of market supply
    • Government intervention is necessary to prevent or dismantle concentrations of market power.
Inequity
  • The distribution of goods and services generated by the marketplace is not necessarily “fair”.
  • Taxes and Transfer Payments - these are the principal tools for transferring money from those who have “too much” to those who have “too little”.
  • Federal Taxes
    1. Income Tax
    2. Social Security
    3. Corporate Taxes
    4. Excise Taxes
  • State and Local Revenues
    1. Taxes
      • Income Tax
      • Property Tax
      • Sales Tax
      • Regressive Tax - a tax system in which tax rates fall (in a relative sense) as incomes rise
    2. Federal Aid
    3. User Charges



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this page is maintained by Reed Fisher
last updated January 15, 2011