Transcript Document

Public Choice and
Public Goods
CHAPTER
16
© 2003 South-Western/Thomson Learning
1
Introduction
In most of our previous discussions, we
have been talking about private goods
Private goods have two important
features
They are rival in consumption  the amount
consumed by one person is unavailable for
others to consume
They are exclusive  suppliers can easily
exclude those who don’t pay
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Public Goods
Public goods, such as national defense,
the Center for Disease Control, or a
neighborhood mosquito-control
program are
Nonrival in consumption  one person’s
consumption does not diminish the amount
available to others  once produced, such
goods are available to all in equal amount 
the marginal cost of providing the good to
additional consumers is zero
Once a public good is produced, suppliers
cannot easily deny it to those who fail to
pay  it is nonexclusive
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Public Goods
Because they are nonrival and
nonexclusive, for-profit firms cannot
profitably sell public goods
In this case of market failure,
government can improve the situation
by providing public goods and paying
for them through enforced taxation
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Classification of Goods
An economy consists of more than just
private and public goods
Some goods are nonrival but exclusive
For example, additional households can
watch a TV show without affecting the
TV reception of other viewers
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Classification of Goods
Along the same lines, short of the point
of congestion, additional people can
benefit from a golf course, swimming
pools, and so on
These goods, when not congested, are
non rival, yet producers can, with
relative ease, exclude those who don’t
pay the greens fees, pool admission,
etc.
Once congestion sets in, these quasipublic goods become private goods
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Classification of Goods
Some other goods are rival but
nonexclusive
The fish in the ocean are rival in the
sense that once caught they are not
available for others to catch  are rival
However, these goods are nonexclusive
in the sense that it would be costly or
impossible for a private firm to prevent
access to these goods  open-access
goods
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Optimal Provision of Public Goods
Because private goods are rival in
consumption, the market demand for a
private good is the sum of the quantities
demanded by each consumer 
horizontal sum of all individual demand
curves
The efficient quantity of a private good
occurs where the market demand curve
intersects the market supply curve
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Optimal Provision of Public Goods
But since a public good is nonrival in
consumption, the good, once produced,
is available to all consumers in an
identical amount
Therefore, the market demand curve for
a public good is the vertical sum of each
consumer’s demand for the public good
To arrive at the efficient level of the
public good, we find where the market
demand curve intersects the marginal
cost curve
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Optimal Provision of Public Goods
Suppose the public good in question is
mosquito control in a neighborhood,
which, or simplicity, consists of only two
houses
One is headed by Alan and the other by
Maria
Alan spends a lot of time in the yard, thus
values a mosquito-free environment more
than does Maria
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Optimal Provision of Public Goods
The government pays for the mosquito
spray through taxes, user fees, or some
combination of the two
The efficient approach would be to
impose a tax on each resident equal to
his or her marginal valuation. There
are, however, two problems with this
Once people realize their taxes are based on
how much the government thinks they
value the good, people tend to understate
their true valuation
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Optimal Provision of Public Goods
Why admit you really value the good if, as a
result, you get a higher tax bill?
•Taxpayers are reluctant to offer this information, creating
what is called the free-rider problem
•The free-rider problem occurs because people try to
benefit from a public good without paying for it
•For example, all will benefit from the mosquito abatement
program, whether they pay or not
Even if the government had accurate information
about marginal valuations, some households earn
much more than others  a greater ability to pay
taxes
•Taxing people according to their marginal valuations may
be efficient, but it may not be considered fair or equitable
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Public Choice in Representative Democracy
Government decisions about the
provision of public goods and the
collection of tax revenues are public
choices
In a democracy, public choices usually
require approval by a majority of voters
We can frequently explain the choice of
the electorate with majority rule by
focusing on the preferences of the
median voter
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Median-Voter Model
The median voter is the one whose
preferences lie in the middle of the set
of all voters’ preferences
The median-voter model predicts that
under certain circumstances, the
preference of the median, or middle
voter will dominate other choices
To see the logic of this, consider the
following situation
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Median-Voter Model
Suppose we have three individuals who
are trying to decide whether to buy a TV
and, if so, of what size
The problem is that each of the
individuals have different preferences
Suppose we let N = no TV, S = small TV, and
L = large TV, and p  preferred
Person 1: N p S p L
Person 2: L p S p N
Person 3: S p L p N
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Median-Voter Model
All agree to make the decision by voting
on two alternatives at a time, then
pairing the winner against the
remaining alternative until one
dominates the other
When the small set is paired against the
no-TV option, the small set wins by
getting the vote of individuals 2 and 3
Then when the small set is paired
against the large TV it also wins
because individuals 1 and 3 approve
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Median-Voter Model
Person 3, the median voter in this case,
gets his most preferred choice
In fact, even if person 3 had preferred
the large TV, he would have gotten his
choice
This same principle often holds in public
choices  political candidates try to get
elected by appealing to the median
voter
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Median-Voter Model
This is one reason why candidates often
seem so much alike
Other voters are required to go along
with what the median voter wants
Thus other voters usually end up paying
for what they consider to be either too
much or too little of the public good 
welfare cost of public goods
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Public Choices
Rather than make decisions by direct
referenda, voters elect representatives
In theory, these representatives make
public choices that reflect their
constituents’ views
Under certain conditions, the resulting
public choices reflect the preferences of
the median voter
19
Special Interest and Rational Ignorance
What do governments attempt to
maximize?
There is no common agreement about
what governments maximize or, more
precisely, what elected officials
maximize, if anything
One theory that parallels the rational
self-interest assumption employed in
private choices is that elected officials
attempt to maximize their political
support
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Special Interest and Rational Ignorance
It is possible that elected representatives
will cater to special interests rather than
serve the interests of the majority
The problem arises because of the
asymmetry between special interests and
the public interest
Consider only one of the thousands of
decisions that are made by elected
representatives: funding wool production
21
Special Interest and Rational Ignorance
Under the wool-subsidy program, the
federal government guarantees that a
floor price to sheep farmers that costs
taxpayers over $75 million per year
The only person the testify before
Congress in support of this program was a
representative of the National Wool
Growers Association, who claimed that
the subsidy was vital to the nation’s
economic welfare
Why didn’t single taxpayer challenge the
subsidy?
22
Special Interest and Rational Ignorance
Households consume so many different
public and private goods and services
that they have neither the time nor the
incentive to understand the effects of
public choices on every one of those
products
What’s more, voters realize that each of
them has only a tiny possibility of
influencing the outcome of public
choices
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Special Interest and Rational Ignorance
Finally, even if an individual voter is
somehow able to affect the outcome,
the impact on that voter is likely to be
small
For example, in the case of the wool
subsidy, the average taxpayer would
save less than 60 cents per year in
federal income taxes
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Special Interest and Rational Ignorance
Therefore, unless voters have a special
interest in the legislation, they adopt a
stance of rational ignorance
Rational ignorance  that they remain
largely oblivious to the costs and benefits
of the thousands of proposals considered
by elected officials
The cost to the typical voter of acquiring
and acting on such information is usually
greater than any expected benefits
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Special Interest and Rational Ignorance
In contrast, consumers have more
incentive to gather and act on information
about decisions they make in private
markets because they benefit directly from
such information
Since information and the time required to
acquire and digest it are scarce, consumers
concentrate on private choices rather than
public choices because the payoff in
making wise private choices is usually
more immediate, direct, and substantial
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Distribution of Costs and Benefits
The possible combinations of benefits
and costs yield four categories of
distributions
Widespread benefits and widespread costs
Concentrated benefits and widespread costs
Widespread benefits and concentrated costs
Concentrated costs and concentrated
benefits
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Distribution of Costs and Benefits
Traditional public-goods legislation
Widespread benefits and widespread costs 
nearly everyone benefits and nearly everyone
pays
Usually has a positive impact on the economy
because total benefits exceed total costs
Special-interest legislation
Benefits are concentrated but costs
widespread
Program’s costs are spread across nearly all
consumers and taxpayers
Generally harms the economy, on net, because
total costs often exceed total benefits
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Distribution of Costs and Benefits
Populist legislation
Widespread benefits but concentrated costs
Usually has a tough time getting approved
because the widespread group that benefits
typically remains rationally ignorant of the
proposed legislation  voters provide little
political support
The concentrated group adversely affected will
object strenuously
Tort reform is one example that would benefit
the economy as a whole by limiting product
liability.
However trial lawyers, the group most harmed
by such limits, have blocked passage
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Distribution of Costs and Benefits
Competing-interest legislation
Involves both concentrated benefits and
costs
Example: relative market position of
Microsoft versus AOL
30
Rent Seeking
An important feature of representative
democracy is the incentive and political
power it offers participants to employ
legislation that increases their wealth
either through direct transfers or
through favorable public expenditures and
regulations
Special-interest groups try to persuade
elected officials to approve measures that
provide special interest with some market
advantage or outright transfer or subsidy
31
Rent Seeking
Such benefits are sometimes called rents
The term in this context means that the
government transfer or subsidy
constitutes a payment to the resource
owner that exceeds the earnings
necessary to call forth that resource 
payment exceeding opportunity cost
The activity that interest groups
undertake to elicit these special favors
from government is called rent-seeking
32
Rent Seeking
The government frequently bestows
some special advantage on a producer
group or group of producers, and
abundant resources are expended to
secure these rights
Political action committees, PACs,
contribute millions to congressional
campaigns
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Rent Seeking
To the extent that special-interest groups
engage in rent-seeking, they shift
resources from productive endeavors that
create output and income to activities that
focus more on transferring income to the
special interest
Resources employed to persuade
government to redistribute income and
wealth are unproductive because they do
nothing to increase output and usually end
up reducing it
34
Rent Seeking
Often firms compete for the same
government advantage, thereby wasting
still more resources
If the advantage conferred by government
on some special-interest group requires
higher income taxes, the net return
individuals expect from working and
investing will fall  they may work and
invest less
35
Rent Seeking
As a firm’s profitability becomes more and
more dependent on decisions made in
Washington, resources are diverted from
productive activity to rent seeking, or
lobbying efforts, to gain special advantage
Special-interest groups have little
incentive to make the economy more
efficient
In fact, they will usually support
legislation that transfers wealth to them
even if overall efficiency declines
36
Rent Seeking
Think of the economy’s output in a
particular period as a pie where the pie
represents the total value of goods and
services produced
In answering the “what,” “how,” and
“for whom” questions policy makers
have three alternatives
They can introduce changes that increase
the size of the pie  positive sum game
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Rent Seeking
They can decide simply to carve up the
existing pie differently  redistribute
income
They can start fighting over the how the pie
is carved up, causing some of it to end up on
the floor  negative sum game
38
Underground Economy
It is reasonably accurate to say that
when government taxes productive
activity, less production gets reported
The underground economy is a term
used for all market activity that goes
unreported to the government to either
avoid taxes or because the activity itself
is illegal
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Underground Economy
The introduction of a tax on productive
activity has two effects
First, resource owners may supply less of
the taxed resource since the after-tax wage
declines
Second, to evade taxes, some people will
shift from the formal, reported economy to
an underground, “off-the-books” economy
40
Underground Economy
Must distinguish between
Tax avoidance: a legal attempt to arrange
one’s economic affairs so as to pay the least
possible tax
• Example: buying municipal bonds because they
yield tax-free interest
Tax evasion : illegal
• Takes the form of either failing to file a tax return
or filing a fraudulent return by understating
income or overstating deductions
41
Underground Economy
Research around the world indicates that
the underground economy grows more
when
Government regulations increase
The tax rate increases
Government corruption is more widespread
U.S. Commerce Department estimates
that official figures capture only 90% of
U.S. income while the Internal Revenue
Service estimates only 87% of taxable
income gets reported
42
Summary
Those who pursue rent-seeking activities
and those involved in the underground
economy view government from opposite
sides
Rent seekers want government to become
actively involved in transferring wealth to
them
Those in the underground economy want to
avoid government contact
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Bureaucracy
Elected representatives approve
legislation
However, the task of implementing that
legislation is typically left to bureaus
Bureaus are government departments
and agencies whose activities are
financed by appropriations from
legislative bodies
44
Ownership and Funding of Bureaus
Taxpayers are in a sense the “owners” of
government bureaus in the jurisdiction in
which they live
If the bureau earns a “profit,” taxes may
decline; if it operates at a “loss,” as most
do, this loss must be covered by taxes
Each taxpayer has just one vote,
regardless of the taxes paid and
ownership is not transferable
45
Ownership and Funding of Bureaus
Bureaus are typically financed by a
budget appropriation from the
legislature which comes from taxpayers
Becomes of the differences in the forms
of ownership and in the sources of
revenue, bureaus have different
incentives than do for-profit firms 
they are likely to behave differently
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Ownership and Behavior
A central assumption of economics is
that people behave rationally and
respond to economic incentives
The more closely compensation is linked
to individual incentives, the more
people will behave in accordance with
those incentives
A private firm receives a steady stream
of consumer feedback
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Ownership and Behavior
If the price is too high or too low to
clear the market, surpluses or shortages
will become obvious
Not only is consumer feedback
abundant, but the firm’s owners have a
profit incentive to act on that
information to satisfy consumer wants
The promise of profits also creates
incentives to minimize costs
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Ownership and Behavior
Since public goods and services are not
sold in markets, government bureaus
receive less consumer feedback and
have less incentive to act on any
feedback they do receive
There are usually no prices and no
obvious shortages or surpluses
They also have less incentive to act on
the information available
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Ownership and Behavior
Because any “profits” or “losses” arising
in the bureau are spread among all
taxpayers, and because there is no
transferability of ownership, bureaus have
less incentive to satisfy customers or to
produce their output using the least-cost
combination of resources
Some pressure may be communicated by
voters to their elected representatives and
thereby to bureaus. However, even this is
not very precise
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Ownership and Behavior
Voters can leave a jurisdiction if they
believe government is inefficient
This mechanism, whereby people “vote
with their feet,” does promote some
efficiency and consumer satisfaction at
the state and local level
However, voters dissatisfied with the
biggest spender, the federal
government, cannot easily vote with
their feet
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Bureaucratic Objectives
What sort of objectives will bureaus
pursue?
The traditional view is that bureaucrats
are “public servants,” who try to serve the
public the best they can
Is this a realistic assumption for
bureaucrats in a general sense  that is,
why should we assume self-sacrificing
behavior by public sector employees?
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Bureaucratic Objectives
One widely discussed theory of
bureaucratic behavior claims that bureaus
try to maximize the bureau’s budget
According to this view, bureaus are
monopoly suppliers of their output to the
legislature
Rather than charge a price per unit,
bureaus offer the legislature the entire
amount as a package deal in return for the
requested appropriation
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Bureaucratic Objectives
The legislature has only limited ability to
dig into the budget and cut particular
items
If the legislature does try to cut the
bureau’s budget, the bureau will threaten
to make those cuts as painful to the
legislature and constituents as possible
Budget maximization results in a larger
budget than that desired by the median
voter
54
Private versus Public Production
Simply because some goods and services
are financed by the government does not
mean that they must be produced by the
government
Profit-making firms now provide
everything from fire protection to prisons
in certain jurisdictions
Elected officials may also use some
combination of bureaus and firms to
produce the desired output
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Private versus Public Production
The trend is toward increased
privatization  production by the
private sector of government provided
goods and services
When governments produce public
goods and services, they are using the
internal organization of the government
– the bureaucracy – to supply the
product as opposed to using the market
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Private versus Public Production
Legislators might prefer dealing with
bureaus rather than firms for two
reasons
In situations where it is difficult to specify a
contract that clearly spells out all the
possible contingencies, the internal
organization of the bureau may be more
responsive to the legislature’s concerns
than the manager of a firm would be
Bureaus provide legislators with
opportunities to reward friends and
supporters with government jobs
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