Slide public economics

1/17/2013 PART 1- CHAPTER 3: PUBLIC GOODS Introduction    Some markets not work very well because the good in question has public good characteristics to it For example, in Dhaka, Bangladesh, public trash collection is fairly inefficient, but attempts at privatization have not fared any better The key problem with private collection of garbage is the free rider problem–with a private, voluntary system, each resident could simply sneak his garbage into his neighbor’s garbage and avoid making payments Introduction   Eventually, everyone would figure this out, and no one would be willing to pay trash collection voluntarily In fact, most residents have figured out the incentive to “free ride.” Only 50 of 1,100 neighborhoods have private garbage collection, however 1/17/2013 Introduction   This lesson explores the role of government in providing goods like this, and shows that the private sector tends to underprovide them It also explores the notion of “crowd-out” where public provision simply substitutes for already existing private provision of a good WHAT ARE PUBLIC GOODS  Pure public goods have two traits:    They are non-rival in consumption: The marginal cost of another person consuming the good is zero, and does not affect your opportunity to consume the good They are non-excludable: There is no way to deny someone the opportunity to consume the good Table gives some examples If a Ice good Icecream cream is both isisrival, rival also and because excludable, excludable, This my Cable Some It is table excludable, TV goods shows is non-rival, are examples since “impure” because theof public cable pure my consumption because aofprivate simply it precludes good not share you public company goods from myconsumption goods, because canimpure simply they of itpublic refuse are in no non-rival, way goods, to hook Table it Iiscan Yet For Other itexample, is non-excludable goods asame are crowded “impure” because sidewalk public Finally, It The itis National is isalso pure non-excludable, defense public goods is a extent) classic because are both consuming icethe cream with iceyou cream diminishes but they and upare private the your (tosystem some consumption goods Defining pure and impure public goods goods rival clearly because because very difficult they your are enjoyment torival, prohibit but example not area It excludable is and isnon-rival protected, non-excludable because everyone my only way for you to consume itonce isisnon-rival to an pedestrians reduced asfrom excludable moreusing pedestrians the sidewalk also consumption “consumes”ofthat national protection defense make ice cream Is the good rival in use the same sidewalk protection does not diminish your consumption of it consumption? Yes Is the good excludable No ? Yes No Ice cream Cable tv Crowded city sidewalk National defense 1/17/2013 • Examples of public goods: • national defense • fireworks • radio and television broadcast signals • clean air WHAT ARE PUBLIC GOODS  It is helpful to think of public goods as goods with a large, positive externality Optimal Provision of Private Goods   Consider a private good, like ice cream Figure shows the market for ice cream cones, assuming that the alternative use of the money is buying cookies at $1 each  This makes cookies the numeraire good 1/17/2013 Adding up Ben’s and Jerry’s At a price Ben ofhas $3, an neither individual, person Adding up Ben’s and Jerry’s S=SMC individual demands at each demands downward-sloping ice cream demand individual demands give Jerry alsomuch has an individual, pricecurve givesfor society’s demand ice cream society’s demand at $3 downward-sloping demand curve for ice cream At a price of Adding $2, Leading bothup people to Ben’s a competitive and Jerry’s demand more equilibrium individual ice cream atdemands $2 Ben give & Jerry consume society’s different demand quantities at $2 There is a market supply curve Price of ice cream $3 associated with producing ice cream $2 DJERRY Figure QJERRY QBEN QTOTAL DBEN SMB =DBEN+JERRY Quantity of ice cream Demand for a private good 10 Optimal Provision of Private Goods   In this figure, as price adjusted, each person changed his quantity consumed For a private good, consumers demand different quantities at the same market price 11 Optimal Provision of Public Goods   Now consider the tradeoff between a public good, like missiles, and a private good like cookies Figure shows the market for missiles, assuming that the alternative use of the money is buying cookies at $1 each 12 1/17/2013 Price of missiles $6 $4 $3 Adding Adding up Ben’s up Ben’s andand Jerry’s Jerry’s willingness willingnesstotopay pay gives for each society’s quantitydemand gives society’s for missile demand As does Jerry There is a market supply curve Leading to a competitive associated with and producing Adding up Ben’s Jerry’s equilibrium at missiles Ben & tomissiles willingness pay gives society’s Ben hasJerry a downward consumesloping the same Q demand for the 5th missile While Ben’s Jerry’s willingness willingness to pay for to pay the S=SMC demandDcurve for missiles forJERRY the firstfirst missile missile is $2 is $4 While Ben’s Jerry’s willingness willingness to pay for to pay the for the fifthfifth missile missile is $1 is $2 SMB=DBEN+JERRY $2 $2 DBEN $1 Figure Quantity of missiles Demand for a public good 13 Optimal Provision of Public Goods   Unlike the case of private goods, where aggregate demand is found by summing the individual demands horizontally, with public goods, aggregate demand is found by summing vertically That is, holding quantity fixed, what is each person’s willingness to pay? 14 PRIVATE PROVISION OF PUBLIC GOODS: Private-sector Underprovision  In general, the private sector underprovides public goods because of the free rider problem 15 1/17/2013 The Free Rider Problem The fundamental problem of all public goods is I’d rather someone else paid for the public goods I consumed This is called the free-rider problem 16 Prisoners’ Dilemma in Action Imagine it costs £4 to provide a clean street outside my house Either I or my neighbour can pay for it We both value clean streets at £3 If one of us pays £4 we are both better off He Pays He Doesn’t Pay I Pay I Don’t Pay 17 The Free Rider Problem in Practice  There are some interesting examples of the freerider problem in practice   Only 7.5% of public radio listeners in New York contribute to the stations–that is, there is a lot of freeriding In the United Kingdom, the BBC charges an annual licensing fee for all television owners Many users of file sharing services never contribute uploaded files; they only download files Some of these services, like Kazaa, give download priority to those who contribute 18 1/17/2013 Other Examples of Free Rider Problems In the USA people pay voluntary subscriptions for the public broadcasting service – less than 10% so (In the UK it is mandatory to pay the TV licence fee.) The town of Cambridge distributed 350 bikes around the town for people to use free of charge (You had to return the bike to a special stand after using it.) Within days they had all gone 19 When Is Private Provision Likely to Overcome the Free Rider Problem?   While the free-rider problem clearly exists, there are also examples where the private market is able to overcome this problem to some extent But the private market may still fall short of the socially optimal amount 20 Can Private Providers Overcome the Free Rider Problem?  Examples of private provision of a public good:   Privately financed fireworks displays Privately owned British lighthouses until 1842 21 1/17/2013 Business Improvement Districts  A final example concerns business improvement districts (BID)    The quality of city streets is a public good During the 1980s, New York City’s Times Square had high crime and many social problems The city had given up on cleaning up Times Square In 1992, local businessmen started a BID–a legal entity to provide security and sanitation, with fees collected from local businesses   New York law makes participation of businesses compulsory if BID organizers can get 60% of local businesses to join, allowing the organizers to overcome the free-rider problem The BID was a clear success in New York City 22 Business Improvement Districts    On the other hand, Massachusetts law allows businesses to “opt-out” of a BID within 30 days of the BID approval by the local government This deters formation of BIDs in the first place, because there are fixed costs of doing so As a consequence, only BIDs have been formed in Massachusetts 23 When Is Private Provision Likely to Overcome the Free Rider Problem?  Under what circumstances are private market forces likely to solve the free rider problem?    Intense preferences Altruism Utility from one’s own contribution to the public good 24 1/17/2013 Some individuals care more than others   When some individuals have especially high demand for a public good, private provision may emerge (but not necessarily provide efficiently) The key intuition is that the decision to provide a public good is a function of the enjoyment that the individual gets from the total amount of the public good, net of cost  If a person gets a lot of enjoyment, or has a lot of money, he will choose to purchase more of the public good even though it benefits others 25 Some individuals care more than others  Olson and Zeckhauser (1966) studied the financing of NATO, which was a voluntary organization at the time   Although countries had an incentive to free-ride on the contributions of others, the largest nations (such as the United States) did contribute Higher incomes or stronger tastes can mitigate the free rider problem to some extent, but are unlikely to solve it completely Thus, underprovision is still likely to occur 26 Altruism  Another reason is that there is evidence that many individuals are altruistic, caring about the outcomes of others as well as themselves 27 1/17/2013 Altruism    Laboratory experiments are becoming more popular in the economics profession Some experiments examine the incentive for college students to contribute to a pool of money, where the dominant, self-interested strategy should be to not contribute The experiments suggest that between 30% and 70% of participants contribute to the public good  As the experiment is repeated in multiple rounds, contributions fall, but rarely reach zero contributions 28 Private Provision of Public Goods: When is private provision likely to overcome the free rider problem ?  Of course, these experiments may be of limited applicability to the real world:    Individuals may behave differently in a contrived laboratory setting The stakes are often small, so the cost of being altruistic is low College undergraduates may not be representative of the population more generally 29 Private Provision of Public Goods: When is private provision likely to overcome the free rider problem?  On the other hand, some real-world evidence is consistent with altruism in private support of public goods  Brunner (1998) found that the number of public radio listeners who contribute decreases only modestly as the total number of listeners increases 30 10 22/09/2015 Majority Voting: When It Doesn’t Work   This creates the problem of the agenda setter, the person who decides the sequencing of the votes In the second situation, he can affect the outcome   For low spending to win, for example, first set up a vote between H and M H wins Then a vote between L and H means L will win Any outcome can win with appropriate ordering 25 Arrow’s Impossibility Theorem   In fact, there is no voting system that will produce a consistent outcome here Arrow’s Impossibility Theorem states that there is no social decision (voting) rule that converts individual preferences into a consistent aggregate function without either restricting preferences or imposing a dictatorship 26 Restricting Preferences to Solve the Impossibility Theorem  One way to solve this problem is to restrict preferences to “single-peaked” preferences     A “peak” in preferences is a point that is preferred to all its immediate neighbors Utility falls in any direction away from this point Multi-peaked preferences means that utility may first rise, then fall, then rise again If preferences are single peaked, majority voting will yield a consistent outcome We can visualize our earlier examples See Figure 27 22/09/2015 (a) (b) Utility Utility Elders Young marrieds Private parents Parents Young marrieds Public parents M H Private Their utility parents goesare in indifferent either direction in the second from M case And young marrieds The elderly are single peaked are single at “M” peaked at “L” L Figure Parents are single peaked at “H” H M School spending L Voting rules School spending 28 Restricting Preferences to Solve the Impossibility Theorem   The failure of these preferences for the “private parents” in this second case is what leads to the inability of majority voting to consistently aggregate preferences Fortunately, single-peakedness is a reasonable assumption in most cases 29 Suppose that there are voters with preference rankings for projects(A, B, C, D) as follows:   B A C A D  C D B C B  D C D B C  A B A D A a, Draw the preference rankings graph of voters b, Find the voters with single peaked preferences c, With majority voting, direct elimination pair wise voting, which project will win? Which project will win with simultaneous pair wise voting? 30 10 22/09/2015 Logrolling   Logrolling or voting trader: a mechanism by which voters can buy, sell or exchange the bill saying “yes” from other voters Objectives: to be winner in majority voting 31 Logrolling => increase SW Voters X Y Z Total Net benefit Hospital 200 - 50 -55 95 School -40 150 -30 80 Library -120 -60 400 220 Projects 32 Analysis   Find the winner project and social welfare without logrolling If there is logrolling by exchanging bill between voters, which project (s) could be passed? And the SW = ? 33 11 22/09/2015 Logrolling => decrease SW Voters X Y Z Social net benefit Hospital 200 - 110 -105 -15 School -40 150 -120 -10 Libary -270 -140 400 -10 Projects 34 Analysis   Find the winner project and social welfare if no logrolling If there is logrolling by exchanging bill between voters, which project (s) could be passed? And the SW = ? 35 Median Voter Theory   When preferences are single-peaked, then majority voting will deliver a consistent aggregation of preferences of the individual voters Even stronger, the median voter theorem states that majority voting will yield the outcome preferred by the median voter if preferences are single peaked  The median voter is the voter whose tastes are in the middle of the set of voters, so an equal number of other voters prefer more and prefer less of the public good 36 12 22/09/2015 Potential Inefficiency of the Median Voter Outcome   Thus, the voting would suggest that the government only needs to find the preferences of the median voter, and implement that level of public goods This does not account for intensity of preferences, however, so it does not follow that the social marginal benefits equal the social marginal cost  For example, if small numbers of individuals derive enormous benefits from the public good, this should be accounted for in the total social marginal benefits 37 Potential Inefficiency of the Median Voter Outcome  For example, imagine that there are 1,001 voters in a town, who are considering building a monument that costs $40,040 ($40/person)   Assume all 1,001 voters have single-peaked preferences, so the median voter will determine the outcome If 500 citizens value the monument at $100 each, and the other 501 value it at $0, then the social marginal benefit is $50,000, far greater than the cost However, the monument doesn’t get built 38 CHAPTER 2: REPRESENTATIVE DEMOCRACY AND POLITICAL ECONOMY  Keywords:      Representative politician Group of interests Public choice theory Lobby Corruption 39 13 22/09/2015 REPRESENTATIVE DEMOCRACY: Vote-Maximizing Politicians   In reality, voters elect representatives, who are supposed to aggregate their preferences and take them into account when they vote on the appropriate level of public goods If politicians care about maximizing the number of votes they get, they choose the outcome preferred by the median voter 40 Vote-Maximizing Politicians    The public good in question is defense; the key question is what fraction of the budget (0% to 50%) should be spent on defense? Voters are uniformly distributed on this continuum Two politicians, John and George, are running for office and vying to maximize their votes Figure illustrates this 41 Figure (a) 0% John is trying to appealIn tothis case, the candidates split the voteWhile George chooses a those who don’t want much higher level of equally much defense, so he defense, G1 places himself at J1 Voters for John Voters for George By But doing nowso imagine he gets that the Defense majority John changes of the votes his spending position to J2 25% J1 G1 50% Voters for George ByIndoing response, so, George George now Defense lowers gets ahis majority position ofto the G2 spending G1 50% votes Voters for John (b) 0% J2 Voters for John (c) 0% J2 Voters for John (d) 25% Voters for George This process will continue until the median voter’s G2are arrived at 25% preferences Defense spending 50% Voters for George Defense spending 0% J3 = G3 = 25% 50% 42 14 22/09/2015 Assumptions of the Median Voter Model  The median voter model is a powerful tool, but relies on a number of assumptions worth mentioning:  Single-dimensional voting: Voters only care about one issue rd  Only two candidates: With a candidate, there is no stable equilibrium  No ideology or influence: Assumes politicians only care about votes, not ideological positions  No selective voting: All citizens actually vote  No money as a tool of influence  Perfect information along three dimensions: voter knowledge of the issues, politician knowledge of the issues, and politician knowledge of voter preferences 43 Lobbying   The issues of money and information make it likely that elected officials will be lobbied by highly interested and informed subgroups Lobbying is the expending of resources by certain individuals or groups in an attempt to influence a politician 44 Lobbying  Lobbyists can:    Inform politicians Reward politicians The problem with lobbying arises when an issue benefits a small group and imposes small costs on a larger (perhaps even a majority) group  In this case, politicians might support socially inefficient positions 45 15 22/09/2015 Lobbying   The key point to remember is that large groups of people with small individual interest on an issue suffer from a free rider problem in trying to organize politically Small groups with large interest overcome the freerider problem 46 Farm policy in the United States    Even though only 2.5% of workers are employed on farms, this sector receives $25 billion in direct support from the federal government This comes in direct subsidy payments to farmers, and price supports (guaranteed minimum prices for crops) These subsidies costs each American household about $360 per year on average, and the average recipient of a subsidy receives $18,000 per year 47 Farm policy in the United States  The 2002 farm bill was estimated to cost $190 billion over the following decade Although it motivated by preserving “family farms,” this motivation is completely at odds with the facts    Only of 400 crops are eligible for the subidy Subsidy increases with productions, so large farms benefit more than small farms Two-thirds of all subsidies accrue to 10% of recipients, most of who earn over $250,000 per year 48 16 22/09/2015 Farm policy in the United States    How such expensive, and poorly targeted subsidies end up surviving? The total cost per American family is modest ($360), and dwarfed by the enormous gain to the typical farm ($18,000) The small group of farms are able to effectively organize and lobby, while the much larger group of taxpayers hurt by the programs are not able to so 49 Evidence on the Median Voter Model  While the median voter model is a potentially powerful tool, does it have predictive power?  The empirical evidence is mixed It certainly does not completely explain legislator behavior There is strong evidence that legislators consider their own ideology, and that of their core constituency, when they vote on policies 50 Testing the median voter model   Stratmann (2000) found that redistricting, which changes the nature of the district’s median voter for largely exogenous reasons, affected the voting preferences of legislators He asked: When districts become more conservative through redistricting (as measured by the vote for the Republican presidential candidate in 1988 and 1992), but were represented by the same politician, did the politician start to vote more conservatively  The answer: Yes 51 17 22/09/2015 Testing the median voter model   There is also evidence that “core constituencies” matter as well Levitt (1996) compared two senators from the same state but different political parties Median voter theory suggests they should take the same position on legislation, yet he found that the senators vote very differently   The senators vote very similarly to senators from other states who are in their party He found that legislators care roughly equally about the median voter, voters in their own core constituencies, and the “party line.” Yet most of the voting pattern is explained by individual ideological differences 52 Cycling in Representative Democracies   An issue that arises in direct democracy, cycling, can also arise in representative democracy if legislator preferences are not single peaked There is some evidence that such cycling has occurred in Congress from time-to-time 53 The Political Business Cycle  Another issue that arises in representative democracy is the “political business cycle.” Pocketbook issues matter    Bill Clinton’s mantra – “It’s the economy, stupid!” Ray Fair has developed models relating the fraction of the vote for the incumbent to the economy’s growth rate and inflation rate Figure shows the results 54 18 22/09/2015 Figure 55 The Political Business Cycle   On average, predicted share of the vote for the incumbent party is within 2.6 percentage points of the actual vote received It has done a pretty good job at predicting winners in presidential elections 56 The Political Business Cycle   That fact that voters respond to economic conditions close to the Presidential election has led some to posit the existence of a political business cycle, where politicians attempt to manipulate economic conditions Although the actual business cycle may or may not exist, it is clear that incumbents use government powers of taxation and spending to try to win voter favor 57 19 22/09/2015   PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT FAILURE The analysis in most of this course assumes a benign government intent on maximizing social welfare Public choice theory questions this assumption by noting that governments often not behave in an ideal manner, so that traditional assumption of a benevolent social-welfare maximizing government may be inappropriate 58  PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT FAILURE Government failure is the inability or unwillingness of the government to act primarily in the interest of its citizens Reasons include:    Size maximizing bureaucracy Leviathan theory Corruption 59 Size-Maximizing Bureaucracy    Niskanen (1971) developed a model of the budget maximizing bureaucrat In this model, the bureaucrat runs an agency that has a monopoly on the government provision of some good or service Bureaucrat’s salary typically unrelated to efficiency His compensation consists of salary, but also perks like the size of his office and support staff The larger government tries to rein in the bureaucrat 60 20 22/09/2015 Size-Maximizing Bureaucracy  A key question is then whether goods and services are more efficiently provided by the public or private sector    For most goods and services, it is abundantly clear that private provision is more efficient In a review of the literature, Mueller (2003) finds that only of 71 studies found state-owned companies outperformed their private counterparts For some goods, such as social services, public provision may be superior, especially when there is a market failure  Hart, Shliefer, and Vishny (1997) compared public and private prisons Private prisons were 10% cheaper, through lower wages to guards The low pay led to more violence, however 61 Leviathan Theory   Leviathan theory sees individual bureaucrats and the larger government as one monopolist that simply tries to maximize the size of the public sector This view would help explain rules that explicitly tie the government’s hands in terms of taxes and spending 62 Corruption  Finally, corruption is where government officials abuse their power in order to maximize their own personal wealth or that of their associates 63 21 22/09/2015 Government Corruption   Former Illinois governor George Ryan was indicted in December 2003 for selling state contracts to his friends in exchange for cash, gifts, loans, and trips for his family The case is still pending This was uncovered as part of “Operation Safe Road,” which investigated bribes that many truck drivers had given to officials at then Secretary of State Ryan’s office to obtain a driver’s license   At least 20 people had died in accidents involving drivers who had bribed officials for their licenses The investigation resulted in 70 indictments and over 60 convictions of many people who were close friends and allies of the former governor 64 The Implications of Government Failure    There is clear evidence that governments fail in some instances to benevolently serve the interests of their citizens Can citizens “undo” these harms through actions like direct democracy? Some evidence suggests that government failures can have long-lasting negative impacts on economic growth 65 Government failures and economic growth  Acemoglu, Johnson, and Robinson (2001) examined two sets of nations that were similar when they were colonized by European powers, yet colonization took very different forms  Treatment group: Nations in the Caribbean, Central America, and Africa   The colonizers were focused solely on extracting natural resources, and not interested in setting up institutions to foster economic success Control group: Nations in North and South America, Australia, and New Zealand  The colonizers moved to these nations in large numbers and set up institutions to foster economic success 66 22 22/09/2015 Government failures and economic growth  Why the lack of “hands-on” governing in the treatment group?    The odds of colonists dying from locally infectious disease was much higher This exogenously affected settlement patterns of colonizers Despite their precolonization similarity, the treatment nations have grown much more slowly post colonization than have the control nations The treatment nations continue to suffer from the long-run detrimental effects of inefficient government 67 Recap of Political Economy     Unanimous consent on public goods levels Mechanisms for aggregating individual preferences Representative democracy Public choice theory: The foundations of government failure 68 23 ... 1/17/2013 Qpc Q Economics - Hoang Phu LY - FTU (b) Industry Public equilibrium under monopoly 34 Monopoly Public Policy Toward Monopolies 1/17/2013 Public Economics - Hoang Phu LY - FTU 35 5.1 Public. .. 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