Chapter 18 Government Functions

Primary Functions
- Define & enforce property rights.
- Allocate resources when markets fail.
- Modify income distributions.
- Stabilize the economy.

Government Sector

The Government Sector is like the Energizer Rabbit. It just keeps "growing & growing."
It accounts for:
- over 35 % of GNP
- nearly 20 % of total employment
Its actions affect every aspect of your life.

Federal Expenditures

State & Local Expenditures

Government Size

Government Spending Real expenditures per person in labor force.
- 1929 $3,240
- 1993 $17,260
Government Employment
- 1860 1 out of 800
- 1940 1 out of 70
- 1990 1 out of 7
Spending as a % of GDP

Year Federal State Total

Government Revenue

Govt. Revenue Sources
- FEDERAL
  - Individual Income Taxes 35 %
  - Social Security Taxes 30
  - Borrowing 22
  - Corporate Taxes 7
  - Other Taxes 6
- STATE
  - Sales Taxes 28 %
  - Federal Grants 23
  - Individual Income Taxes 19
  - User Fees 19
  - Other Taxes 11
- LOCAL
  - Grants 35 %
  - Property Taxes 30
  - User Fees 25
  - Sales & Other Taxes 10

Fiscal Federalism : 1

The concept of fiscal federalism states that government responsibilities and revenue sources are divided among the levels of government according to the different functions they provide.

FEDERAL
- Primary Responsibilities
  - Income Transfers
  - National Defense
- Primary Taxes
  - Individual income taxes
  - Payroll taxes

Fiscal Federalism : 2

STATE
- Primary Responsibilities
  - Higher Education
  - Roads
- Primary Taxes
  - Sales Taxes
  - Individual Income Taxes
  - Users Fees
Local
- Primary Responsibilities
  - K - 12 Education
  - Police / Fire / Utilities
- Primary Taxes
  - Property Tax
  - Users Fees

Market Failures

There are three situations where markets may fail to allocate goods efficiently:
- Public Goods
- Monopoly
- Externalities
And one situation that may create public policy concerns:
- Economic Inequality
Economic analysis of Government choices related to these situations may be positive or normative.

Distribution

How does a nation decide what is a "fair" distribution of income ?
- Equality of Opportunity -- provide everyone an "equal start and a fair game."
  - The "fair game" part is easy to do.
  - The "equal start" part is impossible.
- Equality of Results -- redistribute income directly based on need.

The USA is moving from the "Equality of Opportunity" to the "Equality or Results" concept.

Public Goods

A pure public good is a good or service that can be consumed simultaneously (nonrival) by everyone and from which no one can be excluded (nonexcludable).

Public radio
National defense

Some goods have a "public" element. For example, a highway may be a public good until it becomes so congested that additional cars lower the quality of services available to everyone else.

Free-Rider Problem

A free-rider is a person who consumes a good without paying for it.
Public goods create a free-rider problem. People can consume public goods without paying for them.
It is worthwhile to invest in public goods up to the point where the marginal benefits (MB) equal the marginal costs (MC).

Public Goods Production

Private companies will under-produce public goods because free-riders will not pay them the value the free-riders receive from the goods. As a result, we either

turn to public production (defense)

or allow private companies to exclude free-riders from consuming the goods -- i.e. convert otherwise public goods to private goods. (Scramble TV signals)

Government Failure

Government Failure occurs when the government over-provides or under-provides public goods.
How do you know when either over- or under- production occurs ?
Would you rather have overproduction or underproduction of defense services ?

Public Choice: 1

Public choice theory assumes that voters, politicians, and bureaucrats_ make their economic choices to best further their own objectives.

In public choice theory:
- Voters perceptions rather than reality guide their choices.
- The objective of a politician is to get elected. They work for votes the way firms work for $'s.
- Bureaucrats_ seek to maximize their utility.

Public Choice: 2

Public Choice Theory -- assumes that people will pursue their self-interest via politics as well as via private markets. It predicts that government failures may occur because:

Majority voting may not reveal true consumer preferences.
Voters are uninformed.
Special interest groups' preferences are weighted more heavily than justified by the number of persons they represent.
Legislative process leads to overproduction.
Bureaucrats_ place their self-interest above those of tax payers.

Voting

Majority voting yields an "all or nothing" result. Thus minority groups receive less than they want while majority groups receive_ everything they want. Outcomes in private markets, however, are proportional to dollar votes.

When only a small portion of the population votes, the outcome does not reflect total voters' interests. In the U.S. a candidate can usually win with the support of only 1 out of 4 potential voters.

Political Equilibrium

Political equilibrium is a situation in which the choices of voters, politicians, and bureaucrats_ are compatible and no group can improve its position.

Public interest theory predicts that governments make choices that achieve efficiency.
Public choice theory recognizes the possibility of inefficient outcomes. These are called "government failures."

Bureaucrats_' Goals

Suppose the goal of bureaucrats_ to to maximize their department's budget. To do so, they will push to spend up to the point where total benefits (TB) of a program are equal to the total cost (TC) . This is higher than the level of output that maximizes net benefits.

Bureaucrats

Bureaucrats seek to maximize their own utility.
- Most have their own constituency.
- Most recognize the importance of capturing control of larger budgets and staffs.
The budgeting process used by governments almost guarantees continuous expansion of expenditures.
- No level of government consistently uses "ZERO BASED" budgeting.

Rational Ignorance

Voters may choose not to acquire information when the cost of doing so exceeds the expected benefits. (Economists consider this to be a rational decision.) Voters invest little time or money to influence most decisions.

Special Interest Groups have a lot to gain or lose from government decisions. They invest heavily in obtaining information and trying to influence decisions.

Special Interest Groups

Special interest groups stand to receive large, direct benefits from special legislation. The costs, on the other hand, are spread over large numbers of tax payers.

Thus it pays special interest groups to organize but it is of little value to others to do so.

Special interest groups may time their actions to preclude any effective organization by their opposition.

Government Growth

Government may grow due to:
- Voter preferences
- Inefficient over provision

Voters tend to demand more government services as their incomes increase. (The income elasticity for government services is greater than one.)

If government programs are not working, new ones are created but old ones seldom die. Every government agency has its own "groupies."

Median Voter Theorem

The Median Voter Theorem states that political parties will pursue policies that appeal most to the median voter.
- This theorem attempts to explain why political parties in the U.S. frequently appear to promote essentially the same programs.
- Parties that promote policies that have few supporters lose power.

Excise Taxes: 1

An excise tax is a tax on the sale of a particular commodity.
- Cigarette tax
- Gasoline tax
Excise taxes work best when the price elasticity of demand for the commodity is low. In this case:
- tax revenues are higher
- more tax can be shifted forward to the consumer
- the deadweight loss is smaller

Excise Tax: 2

Excise taxes are usually levied to raise tax revenues -- not to discourage consumption.

Chapter 18 -- Review

What are the major changes in the Federal Government's role since 1930?
What is a public good?
What is the free rider problem?
Explain the concept of rational ignorance.
What is zero based budgeting?
What types of products are good candidates for excise taxes?

Chapter 19 Income Distribution

Income in the U.S. is far from equally distributed.
We use Lorenz curves to show the distribution of income & wealth.

Inequality & Time

From 1950 to 1967 the income distribution in the U.S. became more equal.
Since 1967, the rich have gotten richer and the poor -- poorer. The reasons include:
- loss of low skill jobs to other nations.
- technological change has increased the returns to education.
- lack of enforcement of anti-trust laws has resulted in consolidation of control over wealth.

High Incomes

High income groups include persons:
- with a college education
- white
- married
- age 45 - 54
- two children family
- living in the West
Low income groups:
- less than 9th grade education
- single
- female
- young (15 - 24) or old (over 65)
- black
- living in the South

Like Comparisons

If the value of "human capital" is included in wealth, the distribution of wealth is more equal.
- 30 year olds have more "human capital" than 70 year olds but less financial wealth
Should we use annual or lifetime income to measure inequality?
Should we count government transfer payments that affect household incomes?

Bequests

Bequests tend to make intergenerational transfers of wealth a source of increased inequality.
- Debts cannot be bequeathed
- Mating is assortative
Inheritance taxes have only a minor impact on wealth inequality.

Income Redistribution: 1

Income taxes can be
- progressive (reduce inequality)
- regressive (increase inequality)
- proportional (flat tax)
Income maintenance programs
- Social Security
  - Medicare
- Unemployment Compensation
- Welfare Programs
  - Supplemental Security Income
  - AFDC
  - Food Stamps
  - Medicaid
Subsidized Education

Income Redistribution: 2

When transfer payments are compared to tax payments, we find that 32 % of the population receive more from the government than they pay.

The poorest 20 % of families receive about two-thirds of their income from government transfer payments.
The richest 20 % of the families receive a third of their income from interest and dividends.

Redistribution Problems

Income maintenance programs create several problems. Many feel that such programs:
- discourage work
- break up families
- increase the number of illegitimate children
- create social tensions
- create unfairness
- create costly administrative structures.

Current Programs

Some feel that current programs discourage work because benefits fall as incomes increase. This is referred to as the "welfare trap".

Negative Income Tax

A negative income tax gives every family a guaranteed annual income and decreases the government payments as the family income increases.

Health Care Costs

Health care accounts for about 14 % of GNP.
The source of payments for health care are:
- 50 % Federal Government
- 30 % Private Insurance
- 20 % Individuals
Health Care Expenditures:

8 % of population account for 51 % of the total health care expenditures. (This group is mainly old, very young, or chronically sick.)

20 % account for 32 %
72 % account for 17 % of expenditures.

Distributional Justice

End-state theories focus on the fairness of the end results.
- From each according to his means.
- To each according to his needs.
Process theories focus on the fairness of the processes that lead to the end results.

There is concern that the process by which income is redistributed will lower incentives and result in less total output to redistribute.

Chapter 19 -- Review

Why is wealth inequality greater than income inequality?
What are the major characteristics of high income groups in the U.S.?
What is the welfare trap?
Explain the negative income tax concept.
Who pays and who spends health care dollars?
What is the difference between "end-state" and "process" theories of income distribution?

Chapter 20 Regulation

Government regulations affect almost all aspects of your life.

Among the most highly regulated industries are:

Banking
Communications
Utilities
Transportation
Agriculture

Antitrust Law

Antitrust law regulates and prohibits certain types of market behavior.
The Sherman Act -- 1890 -- was passed to discourage efforts to monopolize industries.
- Additional antitrust laws have been passed since 1890 which expand the scope of antitrust actions.
- Court interpretation of antitrust legislation has changed over time.
- The vigor of enforcement of antitrust laws depends to a large extent on the U.S. Justice Dept.

Political Equilibrium

The public interest theory argues that regulations are supplied to satisfy the demands of consumers and producers to maximize total surplus.

The capture theory is that regulations are supplied to satisfy the demand of producers to maximize producer surplus.

Scope of Regulation

The major regulatory commissions are:
- Interstate Commerce Commission 1887
- Federal Power Commission 1930
- Securities_ and Exchange Commission 1933
- Federal Communications Commission 1934
- FDIC 1934
- Federal Maritime Commission 1936
- Civil Aeronautics Board 1938
- Copyright & Royalty Tribunal 1976
- Federal Energy Regulatory Commission 1977

Regulatory Pricing

Among the approaches used by regulatory agencies to set prices are:
- Marginal Cost Pricing -- set prices equal to marginal cost.
- Average Cost Pricing -- set prices equal to average cost.
- Rate of Return Pricing -- set prices to provide a fixed rate of return on investment.
- Incentive Pricing -- set rates of return to encourage firms to cut costs.

Natural Monopoly: 1

A natural monopoly is a firm that can supply the entire market at a lower cost than two or more firms can.
Marginal cost pricing would result in a loss to natural monopolies.

Natural Monopoly: 2

Average Cost Pricing for a natural monopoly results in higher prices, lower output & no economic profit.

Natural Monopoly: 3

Under Average Cost Pricing regulation a natural monopoly has an incentive to inflate costs.

Oligopoly Regulation

Most regulatory commissions deal with industries in which there are a small number of competitors.
Public interest theory suggests that regulators will set the best price for consumers.
Capture theory suggest they will set the best price for producers.

Antitrust Law

The major antitrust laws are:
- 1890 Sherman Act
  - Monopolization
  - Attempts to Monopolize
- 1914 Clayton Act
  - Price Discrimination
- 1936 Robinson Patman Act
  - Price Discrimination
- 1950 Cellar-Kefauver Act
  - Acquisitions
  - Tying Contracts
  - Interlocking Directorships

Antitrust Actions

Antitrust actions can focus on the structure, conduct, or performance of industries.
Most antitrust laws assume that there is a relationship between structure, conduct & performance.
Most cases are concerned with conduct that may affect the structure and/or the performance of an industry.

Antitrust Cases

1911 American Tobacco
- Guilty of monopoly -- broken up
1911 Standard Oil
- Guilty of monopoly -- broken up
1920 U.S. Steel
- Not Guilty of monopoly
- Rule of Reason
1945 ALOCA
- Guilty of monopoly -- too big
1961 General Electric
- Guilty of price fixing
1982 IBM (Case dropped)
1983 AT&T (Deregulation)
1994 Microsoft ????? ?????

Chapter 20 -- Review

Which industries are most highly regulated?
What are the key antitrust laws?
What are the main approaches used by regulatory agencies to set prices?
Explain the differences between MC and AC pricing for natural monopolies.
What are the relationships between the structure_, conduct, and performance of industries.

Chapter 21 External Costs

Who pays the cost when
- Hog farm waste pools fail and pollute rivers ?
- Industrial wastes are blown into the air around Mexico City ?
- Automobile owners fill up with leaded gasoline ?
- Oil tankers run aground ?
- Your best friend smokes ?
- A lumber company clear cuts timber ?

Environment Problems

Environmental Problems
- are not new.
- are not restricted to rich nations.
- will not go away.
- will continue to change.
- create property rights problems.
- are seldom analyzed in economic terms.

Environment Demands

The increased demand for a better environment are the result of:
- Higher Incomes.
- Increased knowledge of environmental problems.
- Increased ability to shift the cost of environmental problems to others. (Primarily through legislation.)
- The vested interest of environmental bureaucrats.

Air Pollution

The sources of air pollution are:

Solid waste disposal 4 %
Other fuel combustion 12 %
Electric Utilities 16 %
Industrial processes 25 %
Road transportation 43 %

Air pollution has been reduced in the United States during the past 20 years.
- The reductions have been particularly dramatic in some cases -- particularly lead.

Water Pollution

The primary sources of water pollution are:
- Industrial waste.
- Sewage.
- Fertilizer run-off.
- Oil spills.
- Nuclear waste disposal.

Land Pollution

The sources of land pollution are:
- Dumping of toxic waste materials.
- Land fill seepage.
The solutions to some land pollution problems can result in air or water pollution.
- Incineration of garbage can create air pollution.

Coase Theorem

Externalities exist because of an absence of property rights.

The Coase Theorem is the proposition that if property rights exist and transaction costs are low, private transactions are efficient.

It does not matter who has the property rights. The property rights create markets and the markets eliminate the externalities.

The markets will not develop, however, if the transaction costs are too high.

Marketable Permits

Potential polluters are given a permit that allows them to create a fixed amount of pollution. These permits can be resold.
- If you can sell a permit for more than it is worth to you -- you do so.
- If you can buy a permit for less than it is worth to you -- you do so.

Thus, firms either buy the permits they need or invest in technology to reduce emissions -- whichever approach saves them money.

Economics of Knowledge

Knowledge frequently results in external benefits.

Without Government intervention, individuals will buy knowledge up to the point where marginal private benefits (MPB) equal the marginal cost of producing knowledge.

Government can encourage the purchase of more knowledge with
- subsidies
- below-cost provision of knowledge
- patents
- copyrights.

Knowledge does not seem to show diminishing returns.
- Probably because we know so little.

Chapter 22

The Balance of Trade is the value of exports minus the value of imports.
Two thirds of U.S. international trade is trade in goods. One third is trade in services.

In 1950 the U.S. exported about 5 % of GNP and imported about 4 %.
- We now export and import more than twice as much as we did in 1950.
- The importance of fuel imports has increased dramatically.
- Most of our trading is with Asia, Western Europe and Canada.
- Japan is the country with which we have the largest trade deficit.
- Our trade deficits increased dramatically beginning in 1982.

U.S. is a major exporter of:

1. Agricultural goods

2. Capital goods (other than autos)

3. Industrial supplies

U.S. is a major importer of:

1. Consumer goods

2. Petroleum

3. Capital goods

4. Industrial supplies

5. Automobiles

If there is a difference in the opportunity costs of producing the same item in different countries, the countries will be better off by trading.

Suppose that Iowa would have to give up 100 tons of soybeans in order to produce 1 car.
Japan, on the other hand, would have to give up 50 tons of soybeans to produce 1 car.
The opportunity cost of an additional car produced in Iowa is 100 tons of soybeans.
The opportunity cost of an additional car produced in Japan is 50 tons of soybeans.

Soybeans are twice as expensive in Japan compared to Iowa in terms of cars. In other words, Iowa has a comparative advantage in the production of soybeans. With 100 tons of soybeans, you could buy 2 cars in Japan or 1 car in Iowa.

Both Japan and Iowa would benefit by trading Iowa soybeans for Japanese automobiles.

As trade takes place production patterns will change and prices will adjust accordingly. In the previous example, the price of cars would fall in Iowa and increase in Japan. The price of soybeans would increase in Iowa and fall in Japan. This process continues to the point where Iowa's import demand for cars equals Japan's export supply of cars.

If the trading ratio with Iowa is 1 car for 70 tons of soybeans, Japan can obtain any combination of cars and soybeans on its Trading Ratio Curve. Trade will be beneficial.

As trade takes place, the domestic price of soybeans in Japan will fall and that of cars will increase.

Where the price will end up depends on the strength of the demands for the products in Japan relative to the strength of the demands for the traded products in Iowa.

In general, the "Terms of Trade" measured by the trading ratio favor the nation with the relatively weaker demand for the other country's product.

In other words, a country gains the most from trading when the trading ratio is close to the other country's opportunity cost ratio.

As long as opportunity costs are different between countries, everyone has a comparative advantage in something.
Thus, even if a country has an absolute advantage in the production of everything, it can still benefit from trade.

Why do we export and import wheat?
- Different types of wheat are needed for different types of bread. We don't produce all types of wheat.
Imports provide a wider variety of products.
We promote exports to take advantage of economies of scale.

Individuals

Exports can create new jobs.
Imports can cost jobs.

Thus, nations usually try to promote exports and discourage imports.

Congress sometimes passes laws authorizing payments to workers displaced by foreign competition. This slows down the adjustment process -- -- but makes life a bit easier for displaced workers.

Economists usually suggest wage subsidies for displaced workers who find employment in other industries.

The General Agreement on Tariffs and Trade (GATT) was signed in 1947.
Under this agreement, nations work to reduce tariffs and non-tariff barriers to trade.

In addition to the multilateral agreements under GATT, the U.S. is a party to several bilateral trade agreements. (Ex., Canada)

Tariffs shift the export supply curve upward which reduces trade and increases prices.

The tariff
- 1. Increases prices from Pw to Pt
- 2. Reduces imports
- 3. Increases domestic production

A QUOTA is a quantitative restriction on the import of a particular good.

Quotas cost consumers and benefit domestic producers.
Foreign producers who obtain quotas benefit from higher domestic prices.

Tariffs are collected by the Government.

Quotas benefit the companies that have the right to import under the import-quota regulations.

VERs benefit companies in the exporting country.

Countervailing duties are tariffs that are imposed to enable domestic producers to compete with subsidized foreign producers.

Job Protection

1. You need to protect U.S. workers from cheap foreign labor.
2. This argument ignores differences in productivity.

Tariffs are Bargaining Chips

1. You need to be able to impose tariffs if necessary to discourage other nations from imposing trade barriers.
2. Everyone knows that tariffs do more harm than good and that nations are hurting themselves by imposing tariffs.