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The Economics of the Public Sector

Introduction

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Main ReadingsStiglitz, J., Economics of the Public Sector, Parts 1-3 (2nd

Edition), Norton.

Carneiro, P. and J. Heckman, Human Capital Policy, in J. Heckman and A. Krueger, Inequality in America: What Role for Human Capital Policies, MIT Press, 2003.

Cunha, F., J. Heckman, L. Lochner and D. Masterov, Interpreting the Evidence on Life Cycle Skill Formation, National Bureau of Economic Research Working Paper no. 11331, May 2005.

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Overview of the Course1. Why do Governments Exist? What do Governments Do? – Efficiency and Equity

2. Efficiency – Public Goods, Externalities, Market Failures; Government Failures

3. Equity – Redistribution and Social Insurance; Political Economy, Paternalism

4. Human Capital Policy

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We should think of the government as an entity that levies taxes on individuals and firms, spends the proceeds of taxation, and regulates several aspects of economic activity.

Why do governments intervene in economic activities? Why can’t we leave it all to private interactions among individuals (markets)? Economists usually think of two main motives:a) Efficiencyb) Equity

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In economics, efficiency has a very precise meaning. An allocation of resources is said to be efficient if “there is no rearrangement of resources (no possible change in production or consumption) such that someone can be made better off without at the same time, making someone else worse off”. (Stiglitz)

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Equity is a much more vague term. There is no best definition of equity. Each individual has his or her own definition of equity. Ideally, governments should be able to aggregate the different visions of equity in the population and provide a solution agreeable to all. As we will see this is an impossible endeavour.

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Therefore, it is much easier for economists to discuss efficiency issues than equity issues. Efficiency can be discussed without resource to any moral or philosophical principle. This is not the case with equity.

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EfficiencyIt is possible to prove, mathematically, that under certain conditions, competitivemarkets produce efficient outcomes. Under these conditions one could not argue for government intervention in the economy on the grounds that it promotes efficiency.

This assertion is stated in the Two Fundamental Theorems of Welfare Economics.

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First Theorem of Welfare EconomicsUnder certain conditions, competitive markets produce an efficient allocation of resources.

Second Theorem of Welfare EconomicsUnder certain conditions, any efficient allocation of resources can be achieved with competitive markets.

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There are two crucial expressions in the statement of the theorems:i) under certain conditionsii) competitive markets.

Failure of either one, or both, can result in inefficient outcomes, and provide reasons for government intervention in the economy.

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Failure of CompetitionA market is competitive if all sides of the market behave competitively, i.e., take prices as given when making their decisions.

In general, in order to have competition we need to have a large number of agents transacting in either side of the market, so that no single party is large enough to influence prices substantially.

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When competition does not exist, either in the supply side of the market (ex: Monopoly) or in the demand side (ex: Monopsony), one or both sides have market power which they can exploit to extract rents at the expense of the other side and at the expense of efficiency.

Another case of inexistence of competition is the inexistence of markets altogether. One example is communism, but there are many other examples. It is possible that communism generates efficient outcomes, but it is also very unlikely.

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Failure of Other Conditions

Public Goods

Externalities

Other failures, such as information asymmetry or credit constraints.

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There are many types of failures that can occur in markets. However:

i) Can the market correct itself, and has it done so already?

ii) Can the government do better? Will the government do better?

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There are several problems that hamper the actions of governments:i) Information – Does the government have the information needed to correct market failures?ii) Distortions – Is the government introducing new distortions in the market when acting to correct and existing distortion?iii) Incentives – What are the incentives of public bureaucrats? How well are incentive schemes designed in public bureaucracies?

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EQUITY

Why is the allocation of resources resulting from the market operation inequitable?

Why is equity a problem of the government?

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There are two important aspects to consider:i) Achieving a more equitable allocation of resources than the one produced by the market may or may not be desirable. It depends on the values of each person.ii) If we think that the market outcome is efficient but not equitable and the government needs to intervene, then very often this implies that the new more equitable allocation of resources is also less efficient – equity is costly.

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Equity has Efficiency CostsMost government interventions in the market imply some kind of distortion in incentives. If incentives were conducive of efficiency to start with, then distorting them is likely to produce inefficiencies. It is important to acknowledge and quantify these distortions in order to understand the costs of redistribution programs, which can be very high. For example, progressive taxation distorts incentives to work at the top of the income distribution, while welfare programs distort these incentives at low income levels.

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Different Individuals have Different Views on Equity

Then, which one should we adopt? How equitable is equitable enough? How much inefficiency are we willing to trade-off for a given increase in equity?

Different individuals have different preferences. We need a mechanism to aggregate preferences of individuals into a social preference (social welfare function).

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There are two extremes we can think of: tyranny and direct democracy. However, there are many other ways to aggregate preferences, that do not even correspond to a particular political system.

Even if we can construct such a social welfare function, do we usually think of the government as exercising the will of society (maximizing the social welfare function)?

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Merit Goods

These are goods that the government believes individuals should consume more of (or less of) what they currently consume. The reason individuals do not consume adequate quantities of these goods is because, even though they are good for them, they do not know better and make bad decisions. This may be one reason (but not the only one) for compulsory schooling. In these cases we say that the government acts paternalistically.