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Under Ideal Market Conditions

Almost no role as long as society only cares about efficiency Define and enforce private property rights Outcome will be efficient
That state of the world in which all opportunities to make someone better off without making anyone worse off are exhausted

Efficiency means not wasting resources

all resources allocated so that no more of one type of good can be produced without having to produce less of another type of good. This concept of production efficiency can be illustrated with a Production Possibilities Curve

Production Possibilities Curve

Capital Goods



Consumption Goods

More generally, we can illustrate efficiency with Supply/Demand

efficiency means maximizing societys net benefits from producing/consuming supply curve reflects societys marginal cost of producing a good (MSC) demand curve reflects societys marginal benefit of consuming a good (MSB) societys net benefits are maximized where MSC=MSB

Efficiency in Perfect Markets $ S = MSC

At Q1 MSB>MSC so society can gain this much extra net benefit

At Q2 MSB<MSC so society can gain this much extra net benefit


Q1 Qe



In the Real World

Conditions are not ideal
market failures
externalities public goods monopolies

business cycle
recessions economic booms

Society cares about more than efficiency

cares about economic fairness
whatever that is!

wants to impose certain paternalistic requirements on consumption

merit/demerit goods

The Roles of Government

correcting market failures merit/demerit goods

redistributive tax structure redistribution in cash and in kind

fiscal policy monetary policy


Correcting market failure

externalities public goods monopolies merit and demerit goods

Negative externality
costs not accounted for by economic decision maker

Positive externality
benefits not accounted for by economic decision maker

Externalities (both + and -) in production and consumption

Causes divergence between market supply and MSC or market demand and MSB Thus, market equilibrium not efficient
that is, the market fails to achieve an efficient state society stands to gain from government correction of the market failure

Happens because of failure to define a property right Air pollution

lack of private property right to the atmosphere factory uses the atmosphere as an input for which it does not pay society incurs a cost not accounted for by the factory too much of good produced

Negative Externality From Pollution $ MSC S


External cost

ABC = welfare loss triangle = net social gain from reducing output to Qeff


Qeff Qmarket

students receive private benefits from education others receive benefit of associating with educated person student cannot capture this public benefit
i.e., lacks property right needed to charge for this service to others

causes too little education to be consumed

Positive Externality From Education $ S=MSC


ABC = welfare loss triangle = net social gain from increasing output to Qeff


Qmarket Qeff

Externality Policies
Pigouvian taxes
tax factory
shifts S up to MSC how to measure value of pollution/amount of tax not common gas tax tax the product works in short run but no incentive to find less polluting technology tax the pollutant better long run incentives

command and control

require pollution reducing capital, clean fuels, etc.
e.g., stack scrubbers lacks long run incentive to find better technology same rules for all firms regardless of costs easier to administer and politically more acceptable
past reluctance to adopt market-based solutions like taxes

pollution rights
1990 Clean Air Act
radical market-based departure from traditional reliance on standards power generating firms issued rights to pollute
these rights were for a level of pollution much lower than then-current levels

these rights are auctioned on the Chicago Board of Trade

firms able to reduce pollution at lower cost than the price of a pollution right will sell firms for which the cost of pollution reduction is higher will buy

more pollution reduction by allowing firms that can reduce at lowest cost to reduce the most incentive to find new ways to produce power with less pollution anyone can buy, including environmental groups
want to rid the Earth of a ton of S02 each year? Itll cost you about $200!

Public Goods
an apple is a PRIVATE good national defense is a PUBLIC good What distinguishes private goods from public goods?
private goods are EXCLUDABLE public goods are NONEXCLUDABLE
an apple is a private good because a consumer who does not pay the price can be excluded from consuming it no one can be excluded from consuming public goods -- can anyone not be protected?

private goods are RIVAL in consumption public goods are NONRIVAL in consumption
if I eat an apple, you cannot when I consume national defense, its still there for you to consume
therefore, it costs nothing to provide to additional consumers therefore, the efficient price is zero

since no one can be excluded from consuming a public good, and since the efficient price is zero, the private sector would ordinarily not be able to provide it

WARNING! A good is public or private because of these characteristics, not because the government provides it or doesnt
governments provide all sorts of things, including private goods
e.g., electricity, steel

private sector sometimes finds ways to provide public goods

e.g., TV broadcasting

Government provides public goods at zero price Funding out of general budget
we pay taxes based on income, consumption, etc., not on the amount of public goods we consume
for example, a household earning $100,000 pays more tax than a household earning $10,000 but both consume the same national defense

Quantity determined through political process

Mixed Goods
Mixed goods have characteristics of both private and public goods
sometimes characteristics depend on circumstances
highways are nonrival as long as few drivers are on them but become rival with congestion

sometimes a nonexcludable good becomes excludable when technology changes

city streets

Perfectly competitive firms produce efficient output
efficient output where P=MC

Monopolies restrict output and drive up price

monopoly output not efficient because P>MC society suffers a welfare loss

Monopoly MC
Monopoly welfare loss

$ PM

PM = monopoly price Peff = efficient price

QM = monopoly quantity Qeff = efficient price




Qeff MR

Two Types of Monopoly

requires some kind of barrier to entry
legislated barrier, sole access to input, etc. Microsoft???
What is Microsofts barrier to entry?

very high fixed costs must be spread over whole market
breaking up makes no sense as it would raise average fixed costs that would be passed on to consumers

Monopoly Policy
break up
prohibit collusion
anti-trust law

two possibilities
regulate to force firm to act as if it were a perfectly competitive firm
the usual response to natural monopoly

state provision
the usual response everywhere else

Merit and Demerit Goods

Goods provision of which society wants to encourage (in the case of merit goods) or discourage
education housing health care

tobacco alcohol

Various subsidies and taxes used to encourage or discourage consumption

housing allowances sin taxes on tobacco and alcohol

Direct provision

Society cares about equity or fairness as well as efficiency Thus a role of government is to create a more fair distribution than the market produces
distribution of income distribution of opportunity
education health

What is Fair?
We know what an efficient allocation is We have no idea what a fair distribution is
equal income for all?

Redistribution creates inefficiency

distorts returns to productivity drives wedge between cost and value

Mechanisms to Redistribute
Via the tax structure
progressive taxation negative income tax

cash in-kind

Progressive Taxation
A progressive tax makes the aftertax (disposable) income more equal Burden of tax rises as income rises
as income rises, proportion of income paid as tax rises
in U.S., Federal Personal Income Tax

A proportional tax has no redistributive effect

as income rises, proportion paid as tax stays the same
property taxes more or less proportional

A regressive tax makes after-tax income less equal

as income rises, proportion paid as tax falls
Social Security tax, sales taxes (USA)

Redistributive Effect of Tax Structure

In overall tax structure is proportional

Negative Income Tax

Proposed from time to time
a variant of NIT is used

Cash assistance through income tax Structure of a negative income tax

define income guarantee (IG) define rate at which transfer phased out (t) if transfer is T,earned income is IE, and disposable income is ID,
T = IG - t I E ID = IE + T

NIT Advantages/Disadvantages
simple and straightforward
would be administered through income tax

could replace myriad of cash and in-kind programs

either t has to be high or IG low or NIT gets to be very expensive

Earned Income Tax Credit

Like an NIT but only for workers
takes the form of a tax credit on Personal Income Tax that increases tax refund

Credits depend on income, children, and other factors affecting living expenses

Transfers to the Poor (Welfare)

Two major forms of cash transfers to the poor funded by Federal government
Temporary Assistance to Needy Families (TANF) Supplemental Security Income (SSI)

States also have general assistance programs for singles or childless couples

Several in-kind transfers

Medicaid food stamps housing assistance other
employment and training social services
child care, rehabilitation, legal aid, etc.

energy assistance

Temporary Assistance to Needy Families (TANF)

State administered Federal government makes block grants to states to fund TANF
block grant set amount that increases each year for inflation only
if a state spends less it can keep difference if it spends more, it has to fund difference
incentive for states to get poor off welfare

Key elements of TANF

recipients must eventually work, be seeking work, or be in training or school
recipient who has children over the age of five and who declines an offer of work arranged by caseworker loses benefits recipients lose benefits after two years without work
only those with children under one year of age exempt

states receive grants to support child care so parents can work

maximum lifetime benefit of five years states may waive above requirements for disabled and others unable to work
no more than 20% of caseload

teen mothers on TANF required to live at home with responsible adult and attend school unmarried mothers who do not help establish paternity lose 25% of benefits
funds available to help enforce child-support laws states that reduce out-of-wedlock births the most receive bonus from Federal government

Each state responsible for establishing its own rules within Federal requirements
Florida cuts payments for additional children born to those on TANF Massachusetts limits support for two years in any five-year period Wisconsin exempts virtually no one from work requirement Mississippi has very low benefits and urges churches and charities to play greater role

Supplemental Security Income

Federally administered Provides assistance to the poor who are aged, blind, or disabled States can supplement SSI

Health care for the poor under 65 Jointly funded by Federal governments and states Eligibility determined by states
generally eligible if on TANF or SSI

Medical services billed directly to state

states determine reimbursement rates

Food Stamps
Federally funded and state administered Recipients receive coupons that can be redeemed for food and related items Varies with income and household size

Housing Assistance
Subsidized housing for the poor Public housing at low rents that vary by income Subsidies for private housing

% Total

Federal Program


Spending 6.35 1.57 0.42 0.54

Medicaid $105B Food stamps 26 Social services 7 Child nutrition 9

Cash versus In-Kind Transfers

More than twice as much spending in-kind than cash
although most of in-kind is Medicaid

Why not just give cash to spend as they like?

equivalent cash would make them better off than in-kind from THEIR perspective but donors are better off dictating consumption to the poor

Minimum Wage
Government legislation requiring firms to pay workers no less than a minimum wage
currently $5.15 per hour

Purpose to assure workers receive a living wage Makes low-skilled workers less employable

Effects of Minimum Wage

Increased unemployment

SL I: Better off - working at higher wage II: Worse off unemployed III: Want to work at higher wage but cannot find work DL







Distribution of Income in U.S.

11.8% lived in poverty in 1999
poverty defined as income equal to three times that needed to buy an adequate diet
arbitrary definition but gives us a benchmark to make annual comparisons

Percent poor fell steeply from 1960 (22.2%) to 1973 (11.2%), rose to new high in 1983 (15.2%) and fell to 13.8% in 1995, 12.7% in 1998, and 11.8% in 1999

Ratio of rich to poor has risen steadily, however In 1947 ratio of richest fifth to poorest fifth of households was 8.6 In 1997 ratio was 13.7

Lorenz Curves
Graphical representation of distribution of income Table shows distribution by quintiles for 1968 and 1992

We can plot these data to construct a Lorenz Curve

The diagonal represents perfect equality The more unequal, the more bowed out from the diagonal Good way to visualize, but not good when quantification needed

Gini Coefficient

Percent income

Gini Coefficient = Area A (Area A+Area B) A

Lorenz Curve

Households ranked by income


Gini coefficient takes value of zero with perfect equality and 1 with perfect inequality Gini coefficient makes it easy to plot distribution of income over time, as in the following graph

Increasing equality until late 60s followed by increasing inequality Table and graphs on Lorenz curve and Gini coefficient from
http://www.panix.com/~dhenwood/ Gini_supplement.html

Social Security
Several programs all funded through payroll taxes
government-provided pension
what most think of by the term Social Security

disability payments health care for the elderly unemployment compensation

The most expensive of all government programs in U.S.

surpassed national defense in 1993

Social Security Web Sites

The official SSA site:

The Heritage Foundation:

http://www.heritage.org/library/keyissues/social security/

http://www.brookings.org/es/research/areas/soc ial/socsec.htm


Social Security Retirement

Pensions funded by payroll taxes of 7.65% paid by both employees and employers on first $72,600 of wages (in 1999)
self-employed pay 15.3% maximum wage base indexed to inflation

Basic pension available at retirement at age 65

retirement at 62 with reduced pension available

Essentially a pay-as-you-go system

private retirement systems are fully funded
contributions build a fund from which earnings pay benefits

Social Security not fully funded

benefits paid from taxes collected
essentially a transfer from workers to retirees because of baby-boom tax revenues exceed pension payments so a fund is building up currently will reach its max sometime during the next twenty years as baby-boomers retire fund will then shrink until it is gone unless tax rates go up, retirement age is increased, or some other adjustment is made

Pension amount a function of past earnings, age, marital status, number of dependents, etc.
must have paid Social Security taxes for at least forty quarters to qualify

Pensions also paid to dependent spouses over 65 at one-half the workers pension
widows/widowers get what the spouse would have gotten

Strong redistributional element

gross replacement rate (ratio of benefits to pre-retirement wages) falls as preretirement income rises
worker earning 45% of average wage earnings would have a GRR of almost 60% average wage earner a little over 40% worker earning at the maximum wage tax base around 25%

Social Security pensions are tax-free

average wage earners 40% GRR is more like 50% on an after-tax basis

Incentive effects
obvious disincentive to work past 65
many opt to retire at 62 when Social Security becomes available at a reduced rate

savings and capital formation

reduces need to save for retirement disincentive to work past 65 increases need to save for retirement
net effect may be a wash

Health Insurance For The Elderly

Two parts Part A is hospitalization insurance for the elderly
Financed by 2.9% tax on all wages paid by both employers and employees covers only medically necessary care in hospitals and is subject to a deductible

Part B is voluntary medical insurance available at highly subsidized rates

premiums cover only about a fourth of costs subject to deductible of 20% and maximum payments for each medical procedure

Medicare spending amounts to over 11% of total federal spending or 2.4% of GDP

Unemployment Compensation
Income support for workers temporarily out of work
temporarily laid off lost job through fault not of their own
does not cover loss of job through misconduct does not cover work loss due to labor disputes

worker must be full-time and have worked a minimum time to qualify for benefits

Funded by Federal tax on payrolls

first $7,000 of wages tax levied on employer only tax rate varies by each firms employment record
firms that lay off workers frequently pay higher taxes

Each state levies own tax to supplement Federal fund

base and rates vary by state base always equal to or greater than Federal base

Benefits vary widely by state

high of about two-thirds of lost wages plus dependent allowance average only about 35%
has been declining in recent years

Benefits normally last only for a maximum of 26 weeks Benefits extended 13 weeks in recessions Congress may extend even further Average worker uses only 8 weeks

Incentive effects
availability of unemployment compensation makes the period of unemployment easier to take both negative and positive effects
reduces incentive to look for a job
increases unemployment rate one study estimates that a ten percentage point increase in replacement rate increases unemployment by 1.5 weeks

allows worker to extend job search

potentially more fruitful job search