Govt Sector

The entity that has a monopoly over the legitimate
use of force to modify the actions of adults.
An institutional process through which individuals

collectively make choices and carry out activities.
Differences and Similarities in Public and Private

Decision-Making
Competitive behavior is present in both the market and public
sectors.
Private sector action is based on voluntary choice; public
sector is based on majority rule
Copyright (c) 2000 by Harcourt Inc.
All rights reserved.
The most fundamental function of government is the

protection of individuals and their property against acts of
aggression.
Involves the provision of a limited set of goods that are
difficult to supply through the market
Involves the maintenance of a legal structure within which

people interact peacefully and provision of a mechanism for
the settlement of disputes while maintaining a competitive
market.
May Fail to Allocate Resources

Efficiently:
3. Public Goods
1. Monopoly
2.Externalities
4. Asymetric Information
INEFFICIENCY OF PURE MONOPOLY

P An industry in pure competitionS = MC
sells where supply and
demand are equal
At MR=MC
A monopolist
will sell less
units at a
higher price
than in
competition
Sellers
may gain
by
P
restrictin m
g output P
c
and
raising
price. Too
few units
will be
produced
D
MR
Qm
Qc
Q
Externalities exist when the market fails to

register fully costs and benefits.
External Costs:
Present when the actions of an individual or group harm
the property of others without their consent.
The Problem arises because property rights are
imperfectly defined and/or enforced.
External Benefits:
Present when the actions of an individual or group
generate benefits for nonparticipating parties.

Because costs are not fully registered, the supply

curve understates the true cost of production.
Units may be produced that are valued less than
their cost.
From the viewpoint of efficiency, too many units
are produced.
Pollution problems are often a side effect.

Consider the market to the right.

Under initial supply and demand
conditions an output of Q1 and a
price of P1 exist.
If, though, all costs are fully
identified and measured . . .
Then the new supply curve (S2 )
would result in an output of Q2 ( <
Q1) and a price P2 ( > P1).
The result of an externality with
external costs (a negative
externality) is that too many units
are produced at a price below that
which would prevail if all the
costs of the production, provision,
and consumption of the good were
identified and factored into it.
Price
Ideal
output
S2 (includes
external costs)
S1
P2
Actual
price and
output
P1
D
Q2 Q1
Quantity /
Time

Demand curve understates total value

of output.
Units that are more highly valued than

costs may not be produced.
From the viewpoint of efficiency, too
few units may be produced.

Consider the market to the right.

Under present supply and demand
conditions an output of Q1 and a
price of P1 exist.
If, though, all benefits are fully
identified and measured . . . then
the new demand curve (D2 ) would
result in an output of Q2 ( > Q1)
and a price P2 ( > P1).
The result of an externality with
external benefits (a positive
externality) is that too few units
are produced at a price below that
which would prevail if all the
benefits of the good were
identified and factored into it.
Price
Ideal
output
S
P2
Actual
price and
output
P1
D1
Q1 Q2
D2 (includes
external benefits)
Quantity /
Time

Goods that are :

jointly consumed
Individuals can simultaneously enjoy
consumption of same product or service
non-excludable
Consumption of the good cannot be
restricted to the customers who pay for it

If a public good is made available to one

person, it is simultaneously made available to
others.
Because those who do not pay cannot be

excluded, no one has much incentive to help
pay for such goods. Each has an incentive to
become a free rider
a person who receives the benefits of the good

without helping to pay for its cost.
But, when a lot of people become free riders,

too little is produced.

It is the characteristics of the good, not the sector in

which it is produced, that distinguishes a public good.
Examples of public goods:
national defense
radio and television broadcast signals
clean air.
Markets often develop ways of providing public

goods (e.g. use of advertising to support provision
of radio and television). Nonetheless, public goods
often cause a breakdown in the harmony between
self-interest and the public interest.
Either the potential buyer or potential

seller has important information that
the other side does not have.
Major problems of conflicting interests and

unhappy customers can arise when goods
are either
difficult to evaluate on inspection and

seldom repeatedly purchased from the same
producer, or,
potentially capable of serious and lasting
harmful side effects that cannot be predicted
by a lay person.
The consumers
information problem is
minimal if the item is
purchased regularly.
Brand names, franchises,
and product warranties are
helpful ways of dealing
with information problems

The Relative Size

and Extent of
Government

The Size of Government

Sweden
66.1
Denmark
60.8
Netherlands
58.1
Germany
56.0
France
54.7
Belgium
54.5
Italy
52.7
Austria
52.7
Greece
49.4
Canada
Government Expenditures
as a % of GDP (1996)
46.4
United Kingdom
43.7
Ireland
37.7
Australia
37.5
Japan
36.9
United States
34.4
Singapore
23.7
South Korea
22.8
Thailand
20.3
Hong Kong
17.6
20
40
60
80
The U.S. spends about a third of GDP on local, state, and federal government.
This is 3 times what it was in 1930, but not as much as many of its trade partners.
The Extent of Government

20
20
Health Care
Income Transfers
15
15
3.8
6.3
5.0
10.4
10
10
8.7
6.3
2.7
6.5
1.3
4.3
11.4
11.8
1980
1990
13.7
8.1
5.6
0
1960
1970
1980
1990
1997
(a) Defense expenditures as a % of GDP
1960
1970
1997
(b) Expenditures as a % of GDP
Defense spending as a % of GDP has declined sharply since 1960.

As was seen before, during this period federal government spending increased.
The increase in income transfers and health care spending during the past 4
decades has more than offset the reduction in defense expenditures.
How Government Spends:

Federal spending: $1752 billion
State & local spending: $983 billion

Insurance
trusts
8%
Defensea
18%
Social Security
23%
Net interest
15%
Highways
3%
Other
7%
Public welfare
and health
22%
Income
security
14%
Medicare
and health
20%
1997
Police
and fire
protection
4%
Highways
6%
Utilities and
liquor stores
7%
Education
28%
Administrative
and other
expenditures
21%
Interest on debt
4%
1994
The way that the respective levels of government spend money differs significantly.

How Government Taxes:

State & local taxes:
Federal taxes:
Property
15%
Payroll
34%
Personal
income
46%
Other
3%
Customs
duties 1%
Excise taxes
4%
Corporate
income
12%
1997
User charges a
24%
Payroll
12%
Sales and
excise
17%
Personal
income
10%
From
federal
government
16%
Corporate
income
2%
Other
4%
1994
The way that the respective levels of government tax differs significantly.

Taxes
Progressive
Proportional
Regressive

Ability
to Pay
Benefits Received

The Opportunity
Cost of
Government

Opportunity cost of resources

used to produce goods supplied
through the public sector.
Cost of resources expended in the

collection of taxes and the
enforcement of government mandates.
Excess burden (deadweight loss) of
taxation.

Overview
of Collective
Decision
Making

-- applies the tools of economics to the political

process in order to provide insight concerning
how the process works.
Self-interested behavior is present in both market and

political sectors.
Political process can be viewed as a complex exchange
process involving:
voter-taxpayers
politicians
bureaucrats

The Voter-Consumer:
Voters will tend to support those candidates

whom they believe will provide them the most
government services and transfer benefits, net of
personal costs.
Rational Ignorance Effect:
-- Recognizing their vote is unlikely to be
decisive, most voters have little incentive to
obtain information on issues and alternative
candidates.
Because of the rational ignorance effect, voters
will be uninformed on many issues; such issues
will not enter into their decision making process.
The Politician-Supplier:
Political officials are interested in winning
elections. Just as profits are the lifeblood of the
market entrepreneur, votes are the lifeblood of
the politician.
Rationally uninformed voters often must be
convinced to want a candidate.
Legislative bodies are something like a Board
of Directors

Civil Servants (Government Bureaucrats) as Political Participants:
Bureaucrats (persons that handle day-to-day operations of

government) seek promotions, job security, power, etc.
The interests of bureaucrats are often complementary with
those of interest groups they serve. This is called the
CAPTURE problem.
Bureaucrats can usually expand their own interests, as well
as that of their constituents, by working for larger budgets
and program expansion.

When Voting Works Well
Other things constant, legislators will have a strong

incentive to support political actions that provide
voters with large total benefits relative to costs.
If a government project is really productive, it will always be

possible to allocate the projects cost so that all voters will gain.
When voters pay in proportion to benefits received, all voters will
gain if the government action is productive (and all will lose if it is
unproductive.) Under these circumstances, there is a harmony
between good politics and economic efficiency.

Benefits Derived by Voters from

Hypothetical Road Construction Project
TAX PAYMENT
Voter
Adams
Chan
Green
Lee
Diaz
Total
Benefits
Received
(1)
Plan A
(2)
Plan B
(3)
$20
12
4
2
2
$40
$ 5
5
5
5
5
$25
$12.50
7.50
2.50
1.25
1.25
$25.00
Consider the government program above. As with many such

programs, individuals receive varying levels of benefits.
If tax plan A is adopted to fund this program, it may be simple and
seem fair, but even as Adams is getting a real deal (values the
program at $20 and only pays $5) Green, Lee, and Diaz do not even
receive the value of their taxes paid in benefits.
When each voter pays in proportion to benefits received (tax plan B),
each receives more in benefits than it costs them in taxes. If tax plan
B is used, all voters gain and the program would pass unanimously.
This example shows that harmony between good politics and economic
efficiency can exist.

When Voting
Conflicts with
Economic Efficiency

When Voting Conflicts

with Economic Efficiency
Special Interest Effect
- generates substantial personal benefits for a
small number of constituents while imposing a
small individual cost on a large number of other
voters.
Interest group members will feel strongly about
an issue that provides them with substantial
personal benefits. Such issues will dominate
their political choices.
Politicians have a strong incentive to favor
special interest even if action is inefficient.
Logrolling and pork-barrel legislation
strengthen the special interest effect.
Vote Trading and Passing

Counterproductive Legislation
Net Benefits (+) or Costs (-) To Each Voter in District
Voters of
District *
A
B
C
D
E
Total
Construction of
Post Office
In A
+ $10
- $03
- $03
- $03
- $03
- $02
Dredging
Harbor
In B
- $03
+ $10
- $03
- $03
- $03
- $02
Construction of
Military Base
In C
- $03
- $03
+ $10
- $03
- $03
- $02
Total
+ $4
+ $4
+ $4
- $9
- $9
- $6
*We assume the districts are of equal size.
Consider a composite bill in Congress that would build a post office

in district A, dredge a harbor in B, and construct a military base in C.
The benefits to A, B, and C voters vary by project. In total, A, B,
and C voters come out ahead despite the costs involved in paying
taxes for activities in other districts if they agree to vote together.
With this bill, there are no direct benefits to district D and E voters.
In total, the sum of benefits for the group of all voters come out
negative despite the positive benefits for district A, B, and C voters.
In a majority rule voting system, the majority can pass counterproductive
legislation benefiting themselves but creating negative net benefits for
the whole.

Shortsightedness Effect
-- Issues that yield clearly defined current benefits

at the expense of future costs that are difficult-toidentify.
Political process is biased toward the

adoption of such proposals even when they
are inefficient.


Rent Seeking
-- Actions by individuals and interest groups designed to

restructure public policy in a manner that will either
directly or indirectly redistribute more income to
themselves.
Widespread use of the taxing, spending, and

regulatory powers of government that favor some at
the expense of others will encourage rent seeking.
Rent seeking moves resources away from productive
activities. The output of economies with substantial
amounts of rent seeking will fall below their
potential.


Lack of Incentive for Operational Efficiency
In the public sector, the absence of the profit motive

reduces the incentive of producers to keep costs low.
Neither is there a bankruptcy process capable of
weeding out inefficient producers.
Public-sector managers are seldom in a position to
gain personally from measures that reduce costs.
Because public officials and bureau managers spend
other peoples money, they are likely to be less
conscious of cost than they would be with their own
resources.

There is nothing in positive economics that

indicates one distribution of income is
better than another.
A large and growing part of government is

devoted to transferring income.

There are three major reasons why

large-scale redistribution will reduce
the size of the economic pie:
When taxes take a larger share of ones income, the

individual reward derived from hard work and
productive service is reduced.
As public policy redistributes a larger share of income,
more resources will flow into wasteful rent seeking
activities.
Higher taxes to finance income redistribution and an
expansion in rent-seeking will induce taxpayers to focus
less on income-producing activities, and more on
actions to protect their income.

External costs and benefits

Lack of competition
Public goods
Poor information
Public Sector Vs. Market Sector:

A Summary
The power of special interests
The shortsightedness effect

Rent seeking costs
Lack of signals and incentives to
promote operational efficiency

Implications of Public Choice:
Getting More From Government
Both bad news and good news flow

from public-choice analysis:
The bad news:

For certain classes of economic activity,
unconstrained democratic government will
predictably be a source of economic waste and
inefficiency.
The good news:
Properly structured constitutional rules can
improve the expected result from government.

Structure of Budget & Accounts:
Government Account
Consolidated Fund of India
Revenue Account
Receipts
Contingency Fund of India
Capital Account
Receipts
Tax Revenue
Non-Tax Revenue
Grants-in-aid &
Contributions
Expenditure
General services
Social Services
Economic Services
Grants-in-aid & Contributions
Public Account of India

Small savings
Expenditure
General Services
Social services
Deposits &
Advances
Reserve Funds
Suspense &
Misc.
Economic Services
Remittances
Grants-in-aid &
Contributions
Cash Balance
Public Debt
Loans & Advances
Head
In Crore of Rupees
Tax Revenue
8,84,078.32
Non Tax Revenue 1,72,252.38
Capital Receipts 6,08,966.62
Grand Total1
6,65,297.32

Head
In Crore of Rupees
Interest Receipts
17,764.39
Dividends and Profits
73,866.36
Fiscal Services
General Services
Social Services
Economic Services
87.82
12,254.71
2,684.42
62,972.64
Grants
1456.13
Non Tax Rev of UT
1165.91
Grand Total
172252.38

Head
In Crore of Rupees
Recoveries of
Loans & Advances
10,654.00
Misc. Capital
Receipts
55,814.00
Net Borrowings
Net Securities
against Small
Savings
State PF Net
503,844.46
5,797.52
10,000
Other Receipts
12,296.54
External Debt
10,560.10
Net Market
Stabilisation
Scheme
20,000.00
We have been talking about deficit for some time here, and
Grand Total
628,966.62
if you look at these numbers above 36.6% of the total
revenues are capital receipts, and 80% of those capital
receipts are borrowings. So, effectively we borrow 29.3% of
what we have to spend. Thats just too high, and has to be
brought under control. When you look at it from this context,
widening the tax base and better compliance is inevitable if
you have to get this number under control.

Govt Sector

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The entity that has a monopoly over the legitimate

use of force to modify the actions of adults.

An institutional process through which individuals

Differences and Similarities in Public and Private

The most fundamental function of government is the

Involves the maintenance of a legal structure within which

May Fail to Allocate Resources

INEFFICIENCY OF PURE MONOPOLY

Externalities exist when the market fails to

Copyright (c) 2000 by Harcourt Inc.

Because costs are not fully registered, the supply

Copyright (c) 2000 by Harcourt Inc.

Consider the market to the right.

Copyright (c) 2000 by Harcourt Inc.

Demand curve understates total value

Units that are more highly valued than

Copyright (c) 2000 by Harcourt Inc.

Consider the market to the right.

Copyright (c) 2000 by Harcourt Inc.

Goods that are :

Copyright (c) 2000 by Harcourt Inc.

If a public good is made available to one

Because those who do not pay cannot be

a person who receives the benefits of the good

But, when a lot of people become free riders,

Copyright (c) 2000 by Harcourt Inc.

It is the characteristics of the good, not the sector in

Examples of public goods:

Markets often develop ways of providing public

Either the potential buyer or potential

Major problems of conflicting interests and

difficult to evaluate on inspection and

Copyright (c) 2000 by Harcourt Inc.

The Relative Size

Copyright (c) 2000 by Harcourt Inc.

The Size of Government

The Extent of Government

(a) Defense expenditures as a % of GDP

(b) Expenditures as a % of GDP

Defense spending as a % of GDP has declined sharply since 1960.

How Government Spends:

State & local spending: $983 billion

Copyright (c) 2000 by Harcourt Inc.

How Government Taxes:

Copyright (c) 2000 by Harcourt Inc.

Copyright (c) 2000 by Harcourt Inc.

Copyright (c) 2000 by Harcourt Inc.

Copyright (c) 2000 by Harcourt Inc.

Opportunity cost of resources

Cost of resources expended in the

Copyright (c) 2000 by Harcourt Inc.

Copyright (c) 2000 by Harcourt Inc.

-- applies the tools of economics to the political

Self-interested behavior is present in both market and

Copyright (c) 2000 by Harcourt Inc.

Voters will tend to support those candidates

Copyright (c) 2000 by Harcourt Inc.

Civil Servants (Government Bureaucrats) as Political Participants:

Bureaucrats (persons that handle day-to-day operations of

Copyright (c) 2000 by Harcourt Inc.

When Voting Works Well

Other things constant, legislators will have a strong

If a government project is really productive, it will always be