CHAPTER 4 - SUPPLY AND DEMAND FOR THE PUBLIC SECTOR
"Public Choice analyzes the motives and activities of
politicians, civil servants and government officials as people with
personal interests that may or may not coincide with the interest of the
general public they are supposed to serve." page 87.
Civil servants are neither.
The role of government in the economy is very large, and has grown
dramatically this century. Therefore we need to understand the role of
government and see how government solutions can either increase or
decrease the efficiency of the market. Public Choice economics looks at
public decision making using econ analysis. In this chapter, we look at
1) possible Market Failures and 2) possible Government Failures.
To compare public-sector policies/outcome to private-sector
policies/outcomes, we need some standard of comparison. We can use the
standard of Economic Efficiency, which is the idea that we want to
Maximize Net Benefits, or Minimize Net Costs. All actions involve Cost
and Benefits, and we want to engage in economizing or maximizing behavior.
At a given level of costs, we want to get the Max benefit possible. Or
given a certain level of benefits, we want to achieve it at the lowest
The Rules of Economic Efficiency are:
1. Only engage in activities where the Benefits are greater than the
Costs. Increases welfare.
2. Avoid activity where the Costs outweigh the Benefits.
Counterproductive results. Reduces social welfare.
When Rule 1 or 2 is violated, Economic Inefficiency results.
In most cases, a market economy results in economic efficiency, because
market prices and market forces guide the economy to efficient outcomes.
Or stated differently, in most cases government intervention would lead to
economic inefficiency, compared to the market. In most cases, there would
be "Government Failure" if the government intervened because the
government could not improve on Market outcomes.
But what about the cases where the market outcome is inefficient? In some
cases, perhaps a government outcome can increase efficiency, or decrease
inefficiency. Example: pollution.
WHY MIGHT THE INVISIBLE HAND FAIL?
1. Lack of competition -
1) prevents sellers from taking advantage of buyers, keeps prices low,
sellers compete with each other.
2) prevents buyers from taking advantage of sellers,
competition for buying keeps prices up.
Example: what if GM, as a buyer of
labor services, offered starting salaries of $12,000 for engineering
graduates? Competitive pressure from other buyers, Ford, Chrysler, would
prevent that from happening. Buyers compete against other buyers.
Bidding in auction markets. Baseball card for $400,000. House for sale.
Sellers don't always like the competitive pressure of the market. Competition
is good when the other guy faces it. We would all like less competition
sometimes. Very competitive to get into college, competitive to get into
grad school, it is competitive to make the team, the dating market is competitive,
job market is competitive, etc.
See graph page 91. Sellers restrict supply and actually increase
revenue, but produce less. Optimal output/price for society is P1 and Q1.
Optimal price for sellers might be P2/Q2. How can sellers reduce
competition in a free market?
Traditional view: We need government intervention to maintain competition
in the market, prevent big companies from monopoly, restraint of trade.
How can a private firm prevent entry in a free market?
What about using the government to reduce competition? How?
Tariffs, occupational licensure, regulation, ADA, zoning, etc.
2. Externalities - spillover effects, either positive or
negative, of actions that affect the well being of second parties.
Example: pollution of the water, air or land by suppliers, who do
not have to pay the full cost, or maybe not any of the cost to society of
polluting. The reason that pollution can take place is that property
rights are not clearly defined, allowing the polluter to damage common
property. Tragedy of the commons, again.
See page 93. S1 represents the supply curve when negative externalities
are ignored. P1 and Q1 represent the actual amount supplied and the actual
price. S2 represents the supply curve taking into account the costs of
pollution. Q2 is optimal output from society's viewpoint. If producers are
able to shift some of the cost of production onto society by polluting,
they want to produce more than the optimal amount. Market will overproduce
goods by imposing external costs on nonconsenting parties.
Not really a market failure, it is failure to establish property rights.
3. Public Goods - jointly consumed, nonexcludable goods. No way
to exclude nonpaying users. If the market provided the goods and collected
voluntary contributions for something like national defense, people would
have an incentive to be "free riders" - they would know
would get the benefits whether they paid or not. Because of the
non-excludability of certain goods and the free rider problem, people
wouldn't voluntarily pay for the goods or services and the market may not
provide the socially optimal amount of certain goods. Like national
defense, the legal system, law enforcement, national highway system,
national parks, the monetary system, fire departments, lighthouses, etc.
National defense benefits everybody, you can't provide it for some and not
others. Market relies on voluntary behavior. Really a failure of people,
not market. Market would provide it, it just wouldn't be able to collect
for it. We might have to coerce people and force them to pay for courts,
national defense, etc.
Page 572 - Example of the private provision of public goods. Wildlife
is a form of a public good. But since no one owns wildlife, we don't always
personally have an incentive to protect them. Market may not provide as
much wildlife privately as is socially optimal. Market might underprovide
wildlife. But the government doesn't always do a good job either. Earlier
this century, hawks in PA and sea lions in Oregon were considered to be
nuisances. Hawks killed chickens and sea lions ate coastal salmon. Government
paid a bounty for people to kill them. In PA, a woman was upset and organized
a group to privately buy the property where the hawks nested and lived,
and ended the killing. Created a sanctuary.....
In Oregon, a private company owned a section of the coast and they created
a natural habitat for sea lions and opened a tourist attraction - Sea Lion
Caves - and provided protection and a sanctuary for sea lions. Ended the
bounty hunting.... Didn't own the sea lions, but they created a habitat
for them..... there is government failure as well as market failure....
4. Economic Instability - economic stability, or monetary
stability, is a form of a public good. It is possible that the market may
not provide stable money as well as the federal government. Stabilization,
through fiscal and monetary policy, may be provided better or more
efficiently through the government. Because of the underprovision by the
market of public goods and the free rider problem, some of our resource
allocation and decision-making gets done collectively in the public sector
instead of the private sector. Thus the name of the book, Macro; Private
and Public Choice. And just like market failure, we also have government
PUBLIC CHOICE analysis: the use of economics to study the
using insights and tools of economics to study politics. Links economics
and political science. Lets looks at some important issues and discuss
the differences and similarities between the public sector and the private
SUPPLY AND DEMAND FOR PUBLIC-SECTOR ACTION-Using standard supply
demand framework to analyze public sector activity.
- Competitive behavior is present in both sectors. Politicians compete
to get into office, bureaus and agencies compete for funding, special interest
groups compete to get funding or regulation or deregulation. Private and
public sectors are both competitive. Public sector is not profit/loss though,
so the competition can be different. See page 98.
- Public sector breaks the
- you pay for what you consume. Public sector not the case.
Everybody pays for library, not every one uses. vs. Blockbuster...
All prop owners pay school taxes, not everyone has children, or has children
in public schools, not everyone has the same number of children...
Everybody pays taxes for roads/highways, not everybody uses the same
- Scarcity still exists, so that the aggregate
consumption - aggregate payment link
will remain. We still have to pay as a group/state/country for what we
consume. There are still no free lunches.
- Compulsion/coercion exists in the public sector. GM might be economically
powerful, but they can't force anybody to buy their cars, or work for them,
or lend them money or sell them products or buy their stock, etc. Can't
put people in jail for not buying their products. Rely on voluntary action
and behavior. Government has the exclusive right to use force and coercion,
it can put people in jail if they don't pay taxes or follow federal laws,
etc. Compel payment.
- When collective decisions are made legislatively, voters have to chose
among candidates who represent a bundle of positions. We can choose a legislator,
but we have no direct control over how they vote on individual bills. We
have very little control to express our preferences on each issue. We make
a "bundle purchase" and have no decision-making power after that.
- Political power is different than power in the marketplace. Political
connections and knowledge of the political process are rewarded. Success
in politics is different from success in the private sector.
Supply of Public Sector Action - Vote-seeking politicians have a
incentive to appeal to politically active constituents (special interest
Legislators also may cooperate with regulatory agencies to supply the
desired public services. Example: Dept of Agriculture supervises price
supports, FDA supervises food and drugs, EPA regulates pollution, etc.
Demand for Public Sector Action - Special interest groups.
IRON TRIANGLE: 1) special interest groups, 2) legislators and 3)
regulators and bureaucrats who administer the programs.
What is it that special interest groups desire, what exactly do they
DEMAND from the SUPPLIERS of public sector action?
1. Regulation - pollution, food and drug, trade protection
(tariffs), banking and
finance, FDIC, anti-trust, safety (airbags, seatbelts, etc), etc.
2. Income redistribution - welfare, general assistance,
compensation, social security, farm subsidies, tariff protection, transfer
payments, Medicare, Medicaid, subsidized housing, etc.
Reasons that income redistribution may lead to economic inefficiencies
reduce our standard of living:
a. Rent seeking - potentially wasteful spending of time, money and
resources devoted to trying to influence the political process to produce
political outcomes favorable to special interest groups, resulting in
redistribution of income toward the narrowly focused special interest
group. Examples: AMA, teachers, farmers, manufacturers, green
domestic producers, etc. spending money on lobbying in an attempt to
influence political action.
b. reduction in productive activity - if punitive taxes are imposed
generate revenues to redistribute, then individuals may engage in less
productive activity, engage in tax avoidance, tax shelters, etc.
An increase in rent-seeking activities and income redistribution may
provide: 1) disincentives for productive work and 2) increased
incentives to protect income by either hiding income or working less,
resulting in less total output.
Rent-seeking and the accompanying income redistribution, may therefore
reduce economic efficiency, lower output/production, and lower the
standard of living of the economy.
Problems with Collective Decision Making
- Political decision making is binary - either/or, yes/no.
can result in 51% of the people imposing their wishes on 49% of the people,
so that everybody has to accept what only 51% of the people want. In a
market you get proportional representation, where everybody gets exactly
what they want. If 51% of the people want to buy domestic cars and 49%
of the people want to buy foreign cars, everybody gets exactly what they
want. It is very hard politically to set up a system where 51% of the people
get what they want and the minority gets what they want. In the market
it is easier to give everybody what they want. Collective decision-making
finds it hard to satisfy minority groups
Example: BBC in UK, vs cable TV. Post office.
- Rational Ignorance Effect - Voters might make a rational
decision to be politically ignorant, and either not vote or not get
involved in politics. Voters may engage in a cost benefit analysis,
compare the costs of voting vs. benefits of voting.
Costs of voting intelligently? vs. Benefits of Voting? Costs may
outweigh benefits. Rational conclusion: Don't invest a lot of time to
make an intelligent vote and don't become well informed on critical
economic and political issues. People accept the views of politicians and
media, don't think critically about issues like tariffs, min wage, rent
Rational ignorance effect explains why political outcomes very often
violate economic efficiency, meaning that the Costs > Benefits, lower our
standard of living, reduce prosperity, etc.
- Special interest groups - Tyranny of the Status Quo. Special
groups are very organized and concentrated. Usually the suppliers who get
Example: sugar industry. World sugar is 7 cents vs 21 cents for US
sugar. Assume $500m extra cost
to consumers for domestic sugar vs imported sugar, $2/person/year in
extra cost. Assume 10,000 U.S. sugar growers. $50,000/grower/year in
additional income. Much
easier to organize 10,000 sugar growers than 250m people. They have a lot
more at stake per person/farm. Seek protectionist legislation. Hire lobbyists.
They provide a strong voting block. Concentrated in a few states. 5 states,
2000 farmers per state. Each farmer gets 5 votes by influence. Each senator
and US rep will now have a guaranteed voting block of 10,000 votes and
he/she hasn't lost any. How many regular voters changed their vote based
on sugar quotas or tariffs? None. So the politician doesn't lose any votes
from sugar consumers, but gains 10,000 votes.
Compare Cost vs Benefit of Sugar protection:
Costs (to consumers in the form of higher prices, and lost jobs in other
industries): hidden, diffused over
250m consumers, delayed
Benefits (producers): visible, concentrated, immediate
Tyranny of the status quo - Iron Triangle (politicians, special interest
groups, and bureaucrats).
- Shortsightedness effect - because politicians want to get
there will be a bias in favor of programs that have immediate benefits,
even if the long run costs are much greater that the benefits. Short-run
solutions and outcomes will be favored over long run outcomes. Programs
or solutions with long run benefits to society will be ignored, like ending
sugar subsidies. Inherent bias for short term results, and a bias to ignore
long run solutions. Example: budget deficit.
Because of 1) special interest groups and 2) the
shortsightedness effect, 3) the rational ignorance effect,
and 4) rent-seeking,
the invisible hand of the political system will not work to promote the
public interest. Conspiracy against the consumer.
Democracy - 2 foxes and a chicken taking a vote on what to eat for lunch.
Career class politicians.
Growth of Gov Expenditures:
Until 1929 (and for 150 years) Fed spending as a percent of GDP was
never more than 3 percent, except during wars. State and local spending
was about 7%, so that total gov spending at all levels was about 10%. If
10% is good enough for God...
Now Fed spending is over 23% of GDP, an increase of 7x, or about 700%
State, local spending is only at about 11%. Growth in gov has been at
fed level. And so this can explain the emergence of the Career Class Politician.
SUMMARY OF INSIGHTS FROM PUBLIC CHOICE:
1. Democratic process can result in economic inefficiencies, such as
rational ignorance, shortsightedness effect, rent-seeking, special
interest groups, etc. that result in the general interest not being
2. Properly constructed constitutional rules can improve economic
efficiency by aligning interests of all parties. Point: Incentives
matter, political rules must promote the
general welfare and economic prosperity of the country.
Examples: term limits, balanced budget amendment, expiration dates
legislation, make people pay income tax monthly, move voting day to April
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