Public FinanceWhy Study Public Finance?• Public Finance: is the study of the role of the government in the economy• Four Questions of Public Finance

• When should the government intervene in the economy?• How might the government intervene?• What are the effects of such interventions on economic outcomes?• Why do governments intervene in the way they do?

When Should the Government Intervene?• A trade is efficient if it makes at least one party better off without making the other worse off

• Total efficiency of economy is max. when the maximum number of efficient trades take place• This is very nice, but often there is a market failure

• In cases of a market failure => problem that causes the market economy to deliver an outcome that does not maximise efficiency => e.g. example of professor not getting a vaccine

• Problem that causes the market to deliver an outcome that does not maximise efficiency

• Redistribution:• Shifting of resources from some groups of society to others• Entails efficiency losses => individuals shift their behaviour away from efficiency-maximisng

point• Trade-off between size and distribution of the pie => equity-efficiency trade-off

How Might the Government Intervene?• Tax or Subsidise private sale or purchase

• Taxes: government intervenes by increasing the price for private sales or purchases of goods that are over-produced

• Subsidies: government intervenes by decreasing the price for private sales or purchases of goods that are under-prouced

• Restrict or Mandate private sale or purchase• It can directly restrict the private sale or purchase of goods that are overproduced• It can mandate the private purchase of goods that are under-produced and force individuals

to buy that good (e.g. health insurance in some countries)

• Public Provision• The government can provide the good directly in order to potentially attain the level of

consumption that maximises social welfare• Public Financing of Private Provision

• Governments may want to influence the level of consumption, but do not want to directly involve themselves in the provision of a good (e.g. Japanese rail)

• Introduce Regulation• Governemnts may want to influence the workings of markets through regulations and

legislations.

What Are the Effects of Interventions?• Direct Effects: The effects of government interventions that would be predicted if individuals did

not change their behaviour in response to the interventions• Indirect Effects: The effects of government interventions that arise only because individuals

change their behaviour in response to the interventions• So who assesses these effects?

• USA: The Congressional Budget Office => government scorekeepers• Provides Congress with objective, timely, nonpartisan analyses needed for economic and

budget decisions• Legislative spending proposals that are to become law must first have their costs estimated

by the analysts at the CBO• Example: Clinton’s failed plan to reform the health care

• Example: direct effects => it will cost 90 billion to insure the uninsured, indirect => yes, but thi will lead the people presently insured to opt for the free government insurance => increase in costs

Why do Governments Intervene the Way they do?• Political Economy: The theory of how political process produces decisions that affect individuals

and the economyFacts on Government in the US and Around the World:• Government spending (as a proportion of GDP) has steadily increased over time

• Decentralisation => the degree to which government spending is concentrated in local vs. federal levels

• Spending, Taxes, Deficits and Debts• Deficit: measures the year-to-year shortfall of revenues relative to spending• Debt: measres the accumulation of past deficits over time• Local governments tend to be very rarely in deficit

• Distribution of Spending:• Public Goods: goods for which the investment of any one individual benefits everyone in a

larger group => e.g. a missile• Social Insurance Programs: government provision of insurance against adverse events to

address failures in the private insurance market• e.g. insuring elders and the very poor

•• Payroll Taxes: taxes on worker earnings that fund social insurance programs• Sales Taxes: excise taxes on products such as cigarettes• Grants-in-Aid: redistribution of funds from federal gvt to lower levels of gvt• Property Taxes: taxes on the value of individual properties (mostly homes)• Graph on Next Page

• Regulatory Role of the Government => a critical role of the government is to regulate economic and social activities

• FDA => regulates the labeling, and safety of nearly all food products• 0.1% of gvt spending but its regulatory powers cover 20% of total consumer exp.

• Occupational Safety and Health Administration (OSHA) => regulates workplace safety => 115 million Americans, 7.2 million job sites

• Federal Communications Commission (FCC) regulates interstate and international communications => every appliance that communicates has such a EEC number

• Environmental Protection Agency (EPA) => charged with minimising dangerous pollutants in the air, water and food supplies (=> the ground you build the house on)

Policy Debates over Social Security, Health Care and Education• Social Security: single largest gvt expenditure program

• Financing Structure: young pay for the retirement benefits of the old• The babyboomers (75 million US people born between 46 and 64) put a strain

• The ratio will move from 8:1 (1950) to 3:1 (2050)• Funds will be insufficient in less than 30 years

• Solutions:↑ payroll tax (liberals) or everybody should fend for themselves (con.)• Health Care: there are 45.8 mill. Americans w/out health insurance (18% of non-elderly)

• Projections suggest that health care will consume half of our GDP within the next century• Solutions:

• Gvt intervention (liberals) => mandating/subsidising purchase of private health insurance• Gvt regulation to control costs (e.g. impose a limit on the price for medical services)

• Conservatives: bolster existing markets through tax subsidies => competition could keep prices down by promoting individual choice across health plans

• Mystery Graphs:

• Education: very dissatisfied (US scored relatively poorly on internaitonal tests)• Solutions:

• Liberals: ↑pay for teachers and ↑ resources to schools in disadvantaged areas• Conservatives: problem of educational system is that public schools are local monopolies

with no incentive to improve their performance• Increase competition and issue vouchers

Theoretical Tools of Public Finance• Theoretical Tools: set of tools designed to understand the mechanics behind econ. decision makin• Empirical Tools: set of tools designed to analyse data and answer questions raised by theoretical

analysis

Constrained Utility Maximisation:• Utility function: mathematical function representing an individual’s set of preferences, which

translates his well-being from different consumption bundles into units that can be compared in order to determine choice

• Constrained Utility Maximisation: the process of maximising the well-being (utility) of an individual, subject to his resources (budget constraint)

• Models: mathematical or graphical representations of reality• Indifference Curve: a graphical representation of all bundles of goods that make an individual

equally well off. • 2 Essential Properties (flowing from the non-satiability assumption)

• Consumers prefer higher indifference curves• Indifference curves are always downward sloping

• If they were upward sloping this would mean that an individual prefers bundles that have less of both (think through)

• Utility Mapping of Preferences:• Underlying the derivation of indifference curves is the notion that each individual has a well-

defined utility function

• Marginal Utility: additional increment to utility obtained by consuming an additional unit of good• Utilility function usually exhibit the principle of diminishing marginal utility: the consumption of

each additional unit of a good makes an individual less happy than the consumption of the previous unit

• Marginal Rate of Substitution: the rate at which an individual is willing to trade one good for another equal to the slope of the indifference curve = -MUM/MUC

• MRSXY: the amount of Y for which a consumer is willing to exchange 1 X locally = MUX/MUY• Budget Constraints:

• Budget constraint: a mathematical representation of all the combinations of goods an individual can afford to buy if he spends his entire income

• The slope of a budget constraint says how much of one good (y-axis) you can buy if you give up one unit of the other (x-axis)

• Opportunity Cost: the cost of any purchase is the next best alternative use of that money

• Y = PMXM + PCXC• Putting it All Together:

• If your MRSXY is greater than slope (px/py) you should buy more X and fewer Y• If your MRSXY is smaller than slope (px/py) you should buy fewer X and more Y• Maximisation: MRSXY=(px/py) or tangency• Think through the below graph:

• The Effects of Price Changes: income and substitution effect

• Substitution Effect: holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good

• The change of consumption of a good that can be seen by increasing the individual’s income to the extent that his budget constraint is on the same indifference curve as before

• Income Effect: a rise in the price of a good will typically cause an individual to choose less of all goods because his income can purchase less than before

• The rest of the change• Normal Goods: the income effect is negative (same direction to substitution)• Inferior Goods: the income effect is positive (opposite direction to substitution)

• Giffen goods are inferior goods where the income effect dominates the substitution effect• TANF and Labour Supply: studying the effect of a decrease in benefit guarantee

• Features of TANF:• Benefit Guarantee: baseline amount of money to which recipients are entitled• Benefit Reduction Rate: the rate at which the baseline amount is reduced if recipients have

other incomes (e.g. a reductino rate of 100% implies that TANF recipients are entitled to the guarantee if they have no other income, 50% implies that they loose 50 cents of the benefit guarantee for each 1 dollar they earn

• The amount of benefit she gets is: Guarantee - 0.5(wH)• If Guarantee = 5000 kink at 10,000, if Guarantee = 3000, kink at 6,000

• wH => wages*hours worked (essentially her non-Hartz IV income)• Joelle has a wage of $10 => every hour she works her effective wage is $5, since she

gains $10 but looses $5 due to the benefit reduction rate, ∴ slope is 5 (flatter)

• Figure 2-10: no substitution effect since the relative price of leisure has not decreased

Equilibrium and Social Welfare• Welfare Economics: the study of determinants of well-being in society• Demand Curves: a curve showing the quantity of a good demanded by individuals at each price

• Elasticity of Demand: the percentage change in quantity demanded of a good caused by a 1% change in price of that good

• Typically negative• Typically not constant along the demand curve• A vertical demand curve is one for which the Qd is perfectly inelastic• A horizontal demand curve is one for which the Qd is perfectly elastic

• Supply Curve: curve showing the quantity of a good that firms are willing to supply at each price• Marginal Productivity: the impact of a one-unit change in any input, holding other inputs

constant, on a firm’s output• Marginal Cost: the incremental cost to a firm of producing one more unit of a good• Profits: differences between a firm’s revenues and costs, maximised when MR=MC

• Equilibrium:• Market: the arena in which demanders and suppliers interact• Market Equilibrium: the combination of price and quantity that satisfies both demand and

supply, determined by the interaction of the supply and demand curves• Producer Surplus: the benefit that producers derive from selling a good, above and beyond the

cost of producing that good• Consumer Surplus: the benefit that consumers derive from consuming a good, at a price below

the one they were willing to pay• First Fundamental Theorem of Welfare Economics: the competitive equilibrium where supply

equals demand maximises social efficiency• Deadweight Loss: the reduction in social efficiency from preventing trades for which benefits

exceed costs• Social Welfare: the level of well-being in society => both by social efficiency and equitable

distribution of society’s resources => second fundamental theorem• Second Fundamental Theorem of Welfare Economics: society can attain any efficient

outcome by suitably redistributing resources among individuals and then allowing them to freely trade => society usually does not have this choice => equity-efficiency trade off

• Equity-Efficiency Trade-Off: the choice society must make between the total size of the economy and its distribution among individuals

• Social Welfare Function (SWF): a function that combines utility functions of all individuals into an overall social utility function => models the gvt’s equity-efficiency decision

• Utilitarian SWF: society’s goal is to maximise the sum of individual utilities• Utilities of all individuals are given equal weight (i.e. 1 util for a poor person = 1 util for rich)• Remember, sum of utility, not dollars=> 1 dollar to poor person does not have the same

utility as 1 dollar to a rich person• Because of diminishing marginal utility of income (richer people gain less utility from a

dollar than poorer people)• Transfer from people with a high MU to a low MU

• If individuals are identical, and there is no efficiency cost of redistribution, then utilitarian SWF is maximised with a perfectly equal distribution of income

• Rawlsian Social Welfare Function: maximise well-being of its worst-off members• SW = min ( U1, U2, … , UN)• Since social welfare is determined by the minimum utility in society, social welfare is

maximised by maximising the well-being of he worst-off person in society• If individuals are identical, and there is no efficiency cost of redistirbution, then this SWF

would call for an equal distribution

• So What is the Difference Between the Two?• Assuming that redistribution can entail efficiency costs

• Choosing an Equity Criterion:• Commodity Egalitarianism: principle that society should ensure that individuals meet a set of

basic needs, but that beyond that point income distribution is irrelvant• Equality of Opportunity: principle that society should ensure that all individuals have equal

opportunities for success but not focus on the outcomes of choices made• TANF Revisited with Social Welfare Models

• Given the large Equity gain, why not cut TANF benefits?• Citizens car enot only about efficiency but also about equity, the fair distribution of

resources in society• X is the efficiency maximising point, but not necessarily the welfare-maximising point

Empirical Tools of Public Finance• Empirical Public Finance: the use of data and statistical methods to measure the impact of

government policy on individuals and markets• Correlated: two economic variables are said to be correlated if they move together• Causal: two economic variables are said to be causally related if movement of one causes

movement of the other• Identification Problem: the problem in statistics referring to difficulty of determining whether

correlated variables are causally connected

Identification Problem• One must avoid the mistake of interpreting a causal relationship without sufficient thought to the

underlying process generating the data => Given A, B are correlated• A is causing B• B is causing A• Some third factor is causing both• It is purely coincidental

• This is the problem empirical economists face => you can’t immediately move form corr. to caus.

Randomised Trials as a Solution:• Randomised Trial: the ideal type of experiment designed to test causality, whereby a group of

individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not.

• Treatment Group: the set of individuals who are subject to an intervention being studied• Control Group: the set of individuals comparable to the treatment group who are not subject to the

intervention being studied.• Problem of Bias:

• Bias: any source of difference between treatment and control groups that is correlated with the treatment but is not due to the treatment

• e.g. the SAT example (treatment group => take classes, control group => don’t)• However, the groups differ in a way correlated to the treatment because the stupid ones

take classes while the clever ones don’t. However this correlation is not due to the treatment.

• Randomised Trials of ERT and TANF Context• Why We Need to Go Beyond Randomised Trials

• The sample may be different from the population at large => lack of external validity• e.g. Sample may attract people who are very ill and hence less risk averse

• Ethical Issues• Attrition: reduction in the size of samples over time, which, if not random, can lead to biased

estimates => e.g. half the group gets better, the other doesn’t (who then leaves). Experimenters conclude 100% improvement!

Estimating Causation with Observational Data:• Observational Data: data generated by individual behaviour observed in the real world, not in the

context of deliberately designed experiments• There are well-developed methods that often closely approximate the gold standard of

randomised trials• Time Series Analysis: analysis of the comovement of two series over time

• Problems with Time Series Analysis:• Although (as above) it can be very persuasive, when there is a slow-moving trend in one

variable through time, it is very difficult to infer its causal effects on another variable• Other factors: high economic growth over the period => favours work anyways

• So when is Time Series Analysis Useful?• When there are discontinuities in the data => sharp, simulatenous changes

• It is unlikely that another variable is causing those exact changes• Subperiods must also show fairly good variation

• Cross-Sectional Regression Analysis:• Statistical analysis of the relationship between two or more variables exhibited by many

individuals at one point in time• Regression Line: the line that measures the best linear approximation to the relationship

between any two variables

• An doubling in TANF is associated with a 110 increase in year labour supply• Each segment on the horizontal line represents a doubling of benefits

• Problems with Cross-Sectional Regression Analysis:• It could also be that high TANF benefits are causing an increase in leisure• It could be that single mothers have a high preference for leisure (wouldn’t work anyways)• Causal Analysis demands that two identical mothers are assigned different TANF

• But you are taking different mothers and compared their benefits and labor supply• BIAS!

• Control Variables: variables that are included in cross-sectional regression models to account for differences between treatment and control groups that can lead to bias

• e.g. a variable that comes in two categorical values: ‘Prefers Work’ ‘Prefers Leisure’• Allows us to divide the group and get rid of bias

• Not much use => the key variables we want aare usually impossible to measure• e.g. taste for leisure yes/no is an inaccurate proxy for actual tastes.

It is essential to all empirical work to ensure that there are no factors that cause consistent differences in behaviour across any number of groups and are also correlated with the independent variable• Quasi-Experiments: changes in the economic environment that create nearly identical treatment

and control groups for studying the effect of that environmental change, allowing economists to take advantage of randomisatino created by external forces

• e.g. Arkansas and Louisiana => Louisiana unilaterally cuts TANF guarantees• Randomisation has been done for us! (we have a treatment and a control group)• Must check the similarity

• Arkansas and Louisiana have similar culture and economic growth level (yay!)• Difference-in-difference estimator: the difference between the changes in outcomes for

the treatment group that experiences an intervention and the control group that does not

• Problems:• No certainty that we have purged all bias from the treatment-control comparison

• Statistical: to continue to use alternative or additonal control groups to confirm the bias has been removed

• They estimate the causal impact of a particular treatment (i.e. a 15% cut-but what about 30• We can’t necessarily extrapolate from a particular change in the environment to model

all possible changes in the environment• Tells us how they change, not why they change

Structural Modeling:• Structural Estimates: estimates of the features that drive individual decisions, such as income

substitution effects or utility parameters• Estimate the actual underlyng features of utility

• Reduced Form Estimates: measures of the total impact of an independent variable on a dependent variable, without decomposing the source of that pehaviour response in terms of underlying utility functions

Randomised or quasi-experimental estimates provide reduced form estimates

Externalities: Problems and Solutions• December 1997 => 170 nations met in Kyoto to attempt an international pact ot limit emissions of

CO2 because of global warming => very high costs in doing so, particularly for industrialised nations

• Externality: arise whenever the actions of one party make another party worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so

• Market Failure: problem that causes the market economy to deliver an outcome that does not maximise efficiency

• Negative Production Externality: when a firm’s productino reduces the well-being of others who are not compensated by the firm

• Private Marginal Cost: the direct cost to producers of producing an additional unit of a good• Social Marginal Cost: the private marginal cost to producers plus any costs associated with the

production of the good that are imposed on others

• Negative Consumption Externality: when an individual’s consumption reduces the well-being of others who are not compensated by the individual.

• Private Marginal Benefit: the direct benefit to consumers of consuming an additional unit of a good by the consumer

• Social Marginal Benefit: the private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others

•

• Positive Production Externality: when a firm’s production increases the well-being of others but the firm is not compensated by those others

• Positive Consumptino Externality: when an individual’s consumption increases the well-being of others but the individual is not compensated by those others

• Remember: MSC = MPC + EXTERNALITY_COST, MSB = MPB + EXTERNALITY_BENEFIT

Solution to Negative Externalities:• Internalising the externality: when either private negotiations or government action lead the price

to the party to fully reflect the external costs or benefits of that party’s actions• Private Sector Solution

• Coase Theorem (Part I): when there are well-defined property rights and costless bargaining, then negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity

• Coase Theorem (Part II): the efficient solution to an externality does not depend on which party is assigned the property rights, as long as someone is assigned those rights

• Problem with Coasian Solutions• Assignment Problem: depends on the nature of externality (global warming vs. loud stereo)

• Impossible to assign blame for externalities to one specific entity• Impossible to assign damage (i.e. how much are fishermen really suffering?)• Coasain solutions are more effective for small localised extern. rather than more global

• Holdout Problem: assume we have surmounted the assignment problem• Shared ownership of property rights gives each owner power over all the others• See fisherman example => all fishermen want to be the last to collect => breakdown of

negotiations• This effect is amplified where billions of people are potentially damaged

• Free Rider Problem: when an investment has a personal cost but a common benefit, individuals will underinvest

• Transaction Costs and Negotiating Problems• How can you make 100 fishermen negotiate with 1 entity => even more in global warming

• Bottom Line on Coase:• Gives us reason to suspect that the market may be able to internalise small-scale externaliti.

• Public-Sector Remedies of Externalities: EPA (1970) to provide public-sector solutions to environ• 3 Types of Remidies:

• Corrective taxation to discourage use• Subsidies to encourage use• Regulation to directly change use

• Corrective taxation: taxes that correct externalities are called Pigouvian after A.C. Pigou• Plays on the price

• Subsidies: gvt payment to an individual/firm that lowers the cost of consumption/production

T&S change the private marginal cost or benefit without affecting the social marginal cost or benefit

• Regulation: plays on the quantity• Governments prefer regulation but taxations is usually more efficient

• Remember, all of this is marginal (so think of it as the derivatives)• Currently we are at the point (0,0)

• For regulation you need to know the whole SMC curve• For taxation tax = MD, firms will pollute until SMC ? PMC

• Setting price requires only knowing MD => but if MD are unknown or not constant this is also hard

• The debate between taxation and regulation is especially useful in plants with different costs in reducing pollution

• Regulation requires each plant to reduce pollution by the same amount, but it would be more efficient to have low-cost plants reduce use by more => taxes can achieve this

• Multiple Plants with Different Reduction Costs:• Policy Option 1: quantity regulation

• For each plant, MC of reducing pollution is set equal to the SMB of that reduction (above)• Policy option 2:

• Pigouvian taxes raise the cost of input by the size of its external damage (one above the one above) => riase PMC to MD => in this way firms will arrive to the point where MC=MD (since they will always reduce more as long as MC<MD)

• Policy Option 3: Quantity regulation with Tradable Permits• Train of Thought

• Policy 1 requires a lot more information than policy 2 (i.e. gvt needs to know MC of individual firms) => does this mean Pigouvian taxation wins out?

• Permits: Allows the market to incorporate difference in the cost of pollution reduction across firms => a pseudo-Coasian solution that allows => provide property rights to pollution

•• Uncertainty About Costs of Reduction:

• If costs are high, then regulation could be expensive, since we will force plants to comply• Using a price mechanism avoids this problem since firms will adjust until cost of adjustment

= tax• But if costs are uncertain, then so is the amount of pollution reduction that a tax achieves.• Assume MD is downard sloping => diminishing marginal returns to reduction => the benefit

from the reduction of the first unit is quite high, but as production becomes more pollution-free subsequent decreases don’t bring the same benefit

• In Global Warming => additional decreases in CO2 has modest benefits, since global warming is affected by pollution in all societies and over a large period of time

• Nuclear Leakage => additional decreases in nuclear leakage have large benefits (in terms of lives saved

• Assume in both cases, that the gvt has an uncertain understanding of MC of firms• Could be MC1 or the higher MC2

• You understood: look over in book if unsure• Implications for Government’s Policy Choice:

• The choice depends on whether the government wants to get the amount of pollution right or whether it wants to minimise costs

• Quantity regulation ensures that the correct amount of pollution reduction is reached, regardless of the costs=> used whne firms are fairly homogeneous

• Price regulation through taxation (i.e. shifts the horizontal curve up) ensures cost reductions never exceed levels of taxation but the amount of reduction is uncertain

Externalities are the answer to the ‘when’ question in public finance: one party affects another party and doesn’t fully compensate it => market has failed and unless it is localised, the government must intervene => leads to the question of ‘how’ in public finance => i.e. quantity or price regulation

Externalities in Action: Environmental and Health ExternalitiesDamage of Acid Rain• Acid rain is a classic example of negative production externality• Rain that is unusually acidic due to contaminatino by emissions of Sulfur Dioxide and Nitrogen

Oxide• ⅔ of Sulfur Dioxide come from coal-fired power plant, mostly locate in Ohio River Valley• Types of Damage:

• Increased acidity of lakes and streams (e.g. fishing example in the book)• Forest Erosion: soil degradation, slower growth/damage/death of trees• Damage to property: e.g. car paints, buildings => 5 billion $ per year• Reduced Visibility => SO2 accounts for 50-70% of reduced visibility in Eastern US• Adverse Healt outcomes: not direct (walking in acid rain is like walking normal rain) but they

can bind with particles and cause heart&lung disease => 50 billion $ per year• Estimating Health Effects or Particles:

• Typical Approach: relate adult mortality in a geographical area to the level of particles• But areas with more particles may differ from areas with less for other reasons

• e.g. older plants are unsafer anyways, which increases morality• Chay and Greenstone => much more convincing (quasi-experiment, infant mortality)

• History of Acid Rain Regulation:• 1970: Clean Air Act federal legislation (congress) that regulated acid rain-causing emissions by

setting maximum standards for atmospheric concentrations of various substance（也SO2)• This regulation affected only new plants => encouraging the use of older, dirtier plants

• Exemplifies the problem of partial policy reform => LOOPHOLE• 1990: Attempted to rectify the ‘regulatory arbitrage’ present => amendments to Clean Air Act

• Granted plants permits to emit SO2 in limited quantities and allowed them to trade these permits => allowance system

• McCarthy => created a market for vice and virtue• Coalminers in the east complaine it was unfair (their coal was high in sulfur)

• Was it a Success: Yes, although it cost 600,000 jobs and $75 billion in polluting industries

Global Warming• Greenhouse effect: the process by which gases in the earth’s atmosphere reflect heat from the

sun back to the earth• Global temperatures are increasing more rapidly than at any time in the last 1000 years• Temperatures are projected to rise even more rapidly over the next century• Although developed countries have only 20% of world’s population, they are responsible for 80% of

the total greenhouse emissions

•

•

Distributing reductions from the high cost US to other parts of the world lowers price of reductions world wid (ST is flatter than both curves)

The Economics of Smoking: not all externalities are large-scale environemntal

• Negative health consequences do not, by themselves, mean smoking externalities• Externalities require that the smoker not bear all these costs

• Rational Smokers: who know the health risks, may internalise these costs• But there are reasons that the costs might not be internalised

Actuarially adjusted: changes to insurance premiums that insurance companies make in order to compensate for expected expense differences• Internalities: do they occur in smokers? Usually economists assume that smokers follow the

• The damage one does to oneself through adverse health behaviour• Rational Actor Model => they know the cost, posisbility of addiction => therefore no damage on

themselves. Is this reasonable?• But 75% of adult smokers begin smoking before their nineteenth birthday => can they assess

the substantive impact of their actions?• Indeed 8/10 smokers would like to quit but are unable• Average smoker tries to qui 8 ½ months• 54% of serious quit attempts fail within one week

• What is going on?• Self Control Problem: inability to carry out optimal strategies for consumption. Therefore, they

there is demand for commitment devices (their existence proves the presence of self-control problems)

• Commitment Devices: devices that help individuals who are aware of their self-control problems fight their bad tendencies => smokers who want to quit make public promises

• The irrationality of youth and the self-control problems of older people => internalities exist!• The government can curb this through taxation (a form of commitment device)

• 5-10$ per pack• The presence of internalities is a departure from microeconomic theory => requires more

research

Economics of Other Addictive Behaviours:• Drinking:

• Different to Smoking because:• Larger: than externalities associated with smoking

• Also when one considers the increased capacity for violence• Smaller: drinking in small quantities may impair one’s driving but may be good for long-run

health• Effects of Minimum Drinking Age:

• Carpenter and Dobking study this question using a regression discontinuity strategy• Quasi-experimental pretest-posttest design that elicits the causal effects of interventions

by assigning a cutoff or threshold above or below which an interventino is assigned• Compares health outcomes of people just above and just below their birthday• These people are likely to be similar so RDD estimates the causal effect of being able to

drink

• Illicit Drugs: most externalities associate with illicit drugs arise because of their illegality• Legal consumption of some illicit drugs is likely to have much lower externalities than

consumption of alcohol

• Obesity: has both externalities and internalities• Difficult to tax: while every cigarette is bad for you, some food consumption is good!• Major Policy Focus:

• Improve information about caloric/nutrition content• Targeting substance most closely linked to obesity => trans-fats

• Conclusion:• Carful analysis of public policy options requires

• Discriminating external costs from costs that are absorbed through the market mechanism

• Understanding the benefits and costs of alternative regulatory mechanisms to adress externalities

• Considering whether only externalities or also internalities should count in regulatory decisions

Public GoodsPublic Goods: A taxonomy• Example: Trash Collection in Dhaka

• No one wants to pay, but everyone wants someone else to pay• Private trash collection, financed by a voluntry fee by neighbourhood => free rider problem• Goods that suffer from free rider problem are known as eocnomic goods

• Pure Public Goods: goods that are perfectly non-rival in consumption and are non-excludable• Non-Rival: one individual’s consumption does not affect another’s opportunity to consume that

good• Non-Excludable: individuals cannot deny each other the opportunity to consume a good

• Impure Public Goods: goods that satisfy the two condition but only to some extent, not fully

• Optimal Provision of Private Goods (hehe opposite of Socrates’s way of proceding)• Consumers demand different quantities of the good at the same price => SUM

• Optimal Provision of Private Goods:• One person’s consumption does not reduce another’s, cannot tailor their own specific

consumption of missiles => each person is forced to choose a common quantity• Sum vertically, adding the prices each individual is willing to pay for the fixed market quantity

• Private Provision of Public Goods: Private Sector Under-Provision• Numaire Good: good for which the price is set at $1 in order to model choice between goods• Underprovision due to the free rider problem: when an investment has a personal cost but a

common benefit, individuals will underinvest• There is a positive externality which leads to underproduction

• Examples:• WNYC => 1 million people listen, but only 7.5% support the station

• BBC circumvents this by charging anybody who owns a set $230• When they find people that don’t, you are fined!

• File Sharing• 85% of Gnutella users of file program download files only from others• Kazaa gives download priority to users according to their ratings

• 1994: Cambridge tried with 350 bicycles => after 4 days not a single one could be found• Private providers can overcome the free rider problem

• Charge user fees that are proportional to their valuation of the public good (or scribd style)• e.g. Coase argued that lighthouses were used by private (as opposed to Stuart Mill)

• Example of Private Fighting Free Rider:• Quality of Streets: everybody wants clean streets, but you can’t really charge pedestrians

• By 1980 New York Times Square was dangerous and idrty => gvt tried but failed• 1992 => local businessmen started the Business Improvement District => legal entity that

privately provides local security and santitation services (funds from nearby businesses)• But How did they circumvent the free rider problem?

• NYC allows BIDs to levy fees on non-paying members, as long as the BID organisers could get 60% of local business community to agree to join

• Success: Budget of $5 million, 120 employees, sweepers, public safety • Business/tourism is booming BUT

• It hinges on whether it has the power to charge fees (i.e. depends on law/State)• When does Private Provision overcome Free Rider Problem?

• When some individuals care more than others

• When people are altruistic:• Altruistic: when individuals value the benefits and costs to others in making consumption

choices => laboratory experiments => 30-70% contribute to public fund (contr. tend to decline as more rounds are there

• Social Capital: the value of altruistic and communal behaviour in society• Measures how altruistic people are• Anderson => social capital determined by trust

• Attitudinal measure: can people be trusted?, Behavioural: do you trust your friends?• These measrues were related to contribution in public funds

• Warm Glow Model: • Indies. care about the total amount of public good and their particular contributions as well

• E.g. they get a plaque or something• Not like altruism because people don’t about just the amoutn of the public good

Public Provision of Public Goods: ‘naturally’ solves the free rider problem through coercion! YAY!• Several Challenges to this view:

• Crowd out: the more the gvt provides a public good, the private sector will provide less• Usually unintended => full crowd-out is rare

• Warm Glow: there may not be full crowd out if people continue to contribute due to Warm Glow• e.g. All I care is about how much I give, not ho much there actually will be (which would be

altruism)

•

Determining Crowd Out:• No evidence for full crowd-out• No consensus on the size of this important individual response to government intervention• Kingman (1989) => looked at how contributions vary as local gvts contribute different amounts to

public radio stations• $1 increase in gvt funding, private contributions fall by 13.5 c• Bias: areas with high gvt contribution could be high income, or have high taste for radio

• Laboratory evidence seems more convincing => Andreoni• Gave participants tokens => games was such that free riders should contribute 3 tokens

• Average contribution => 2.78 tokens• Then he introduced a 2-token tax on players => without warm glow they should have contributed

2 => but in fact each player cut contribution by 1.43 only (i.e. gave 1.35 token)• Crowd out was less than full => 1 gvt token crowded out 0.715 tokens of private contributions• This seems higher than in empirical studies => labs have their limitations

Measuring Costs and Benefits of Public Goods:• Difficult: e.g. highway => what is the cost? Not only wages, but also opportunity cost, i.e. would the

workers otherwise be unemployed?, Benefits=> what is the benefit for commuters, what is the value to society of reduced number of deaths

• How can we Measure Preferences for a Public Good?• Preference Revelation: tricky, people may not want to reveal their true valuation because the

gvt might charge them more for the good if they say that they value it highly• Preference Knowledge: but people may not know what their valuation is• Preference Aggregation: how can a gvt combine the preferences of millions of citizens?

Conclusion:• Major function of gvts is provision of public goods• Sometimes private sector can provide public goods, but not in the optimal amount• Gvt intervention can increase efficiency• Success Depends on:

• Ability of gvt to measure costs and benefits• Ability to implement optimal plan

Cost-Benefit AnalysisCost-Benefit Analysis: the comparison of costs and benefits of public goods projects to decide if they should be undertaken => used to evaluate potential public programs

Measuring Current Costs:• Cash-Flow Accounting: accounting method that calculates costs solely by adding up what the gvt

pays for inputs to a project, and calculates benefits solely by adding up income or gvt revenues generated by the project

• Opportunity Cost: the social marginal cost of any resource is the value of that resource in its next best use

• Imperfect Markets:• If labour in the economy is efficiently employed, then wages are a social cost• If some workers are unemployed, then we value their time at the value of leisure, not the wage• Payment of labour by the gvt consists of opportunity cost of the resource + transfer of rents

• Rents: payments to resource deliverers that exceed those necessary to employ the resource• E.g. if they are willing to work fo 10 and we give them 20, we give him 10 rent• Economic costs are only those costs associated with diverting the resource from its next

best use => i.e. in case of unemployed people them sitting in front of the TV• Therefore the $10 rents are not a true economic cost (although being an accounting cost)

• Measuring future benefits against current costs?• Use present discounted value, discounting at the social discount rate =>

• A dollar next year is worth (1+r) times less than a dollar now because it could have earned r% interest if invested => social discount rate: appropriate value of r to use in computing PDF for social investments

• In practice, the US uses a variety of dsiscount rate => Office of Management and Budge (OMB) suggested that gvt should use a discoutn rate of 7% = historical pretax rate of return

• Example: Highway, valuing the time saved • Market-Based Measures to value time: if time saved is spent at work, the value would be

the extra wage earned in that time. BUT• Individuals can’t freely trade leisure and hours of work => jobs have hours restrictions• Nonmonetary aspects of the job => e.g. maybe you value work more because there is a

working AC system => wage understates the value to me of saving time• Survey-Based Measures to value time:

• This is a contingent valuation: asking individuals to value an options they are not now choosing or do not have the opportunity to choose

• ADV: only feasible method for valuing a public good, straightforward, inexpensive• DISADV

• Revealed Preference: letting actions of individuals reveal their valuation• Market Prices: if people are willing to pay P for something, it is worth at elast P to them• E.g. price differences between houses close and far from downtown may reflect value of

commuting time• But treatments and controls may differ = bias

• Everett is 4 miles away Lexington 11 => E:345k, L:798k• Could control for house characteristics (e.g. lot size, bedrooms, square footage)

• but some features are very hard to observe (e.g. granite countertops)• Quasi-Experimetns:

• Deacon/Sonstelie look at how much people save by standing in line to buy price-controlled gasoline => $19/hour (v. close to average hourly wage)

• Valuing Saved Lives:• Single most difficult issue in cost-beneft analysis => some would say it is priceless =>

reprehensible activity; there is no way to put a value on such a precious commodity• But every possible inteventions has a chance of saving lives => to decide which to dinance

requires valuing lives• Valuing Life => Car Recalls:

• GM pickup trucks had a dangerous side-mounted gas tank (73-87)• 1993: Consumer groups demanded GM recall 5 trucks => recall would cost $1 billion and

save at most 32 lives, therefore cost per life saved => 1bln/32 => $31.25M• Valuing Life => Commuter train crash in Oct. 1999 (31 peope died)

• Safety advocates wanted measures that cost 3-9 bln & would save 1-3 lives for 30-50 years• At best: $20 million per life saved, $300 million per life saved• Train Protection and Warning System, European Train Control System

• Valuing Life => Wages: life’s value is the PDV of the lifetime stream of earnings• $3.685 million, on this analysis men have slightly higher value• Markets may not accurately reflect true value, life is more than wages & leisure, an individual

may internalise the enjoyment derived by others from him being alive• Valuing Life => Contingent Valuation: ask people what their lives are worth

• Provide a very wide range 963,000 to 26.0 million• Valuing Life => Revealed Preference: estimate how much indies are willing to pay for

something that reduces their odds of dying• Compensating Differentials: additional (or reduced) wage payments to workers to

compensate them for the negative (or positive) amenities of a job such as increased risk of mortality (or a nicer office) => life at $ 9.3 million

• Problems:• Strong information assumptions: we assume coal miner knows that he has 2% higher

chance of dying• Even when they have this information, individuals ar enot well prepared to evaluate these

trade offs• You need to control for other things (e.g. coal miner dies 2% higher prob. but also faces

injury with 30% higher probability)• Differences in the value of life => prob. not one size fits all

• Valuing Life => Gvt Revealed Preferences:• Look at existing gvt programs and see how much they spend to save lifes

Discounting Future Benefits:• Since projects have benefits that last long into the future, discount rates matter enormously

• Reducing global warming will bring benefits hudnreds of years into the future• Cost-Effectiveness Analysis:

• For projects that have unmeasurable benefits, or are viewed as desirable regardless of the level of benefits, we can compute only thei r costs and choose the most cost-effective project

• Avoids making judgements over the value of life saved

Issues in Cost-Benefit Analysis:• Counting ‘Mistakes’: sometimes by mistake, sometimes to ‘improve’ the figures

• Distributional Concerns: those living next to the highway have lost out (higher noise)• In theory it is possible to distribute from those who gain to those who lost out

• In practice this is hardly feasible => and discount rate is highly politicised (e.g. less if we are hurgin the rich)

• Uncertainty: Costs and benefits are often highly uncertain• Gvts should prefer projects that have more certain estimates of the gap between theory and

practice (i.e. those with less uncertainty)

Conclusion:• Turning abstract notions of social costs and beenfits into practical implications is challenging• What seems an accounting exercise becomes quite complicated• Economists have developed a set of tools that can take analysts a long way toward a complete

accounting of the costs and benefits of public projects

Political EconomyDirect Democracy: voters directly cast ballots in favour of or in opposition o particular public projectsRepresentative Democracy: voters elect representatives, who in turn make decisions on public projectsGovernment Failure: inability/unwillingness of gvts to appropriately address market failures

Unanimous Consent on Public Goods Levels:Lindahl Pricing: an approach to financing public goods in which individuals honestly reveal their willingness to pay and the gvt charges them that amount to finance the public good•Marginal Willingness to Pay: amount individuals are wiling to pay for the next unit of a good•This is an equlibrium

• Both are happy• Gvt has covered marginal cost of producing fireworks by charging each

individual his marginal willingness to pay• The principle corresponds to benefit taxation

• Taxation in which individuals are taxed for a public good according to their valuation of the benefit they receive from that good

• Does not require utility functions => citizens reveal their preferences

• Efficient Level of Public Goods Provision• Point at which the sum of the social marginal benefits of the public good is set equal to MSC

Problems with Lindahl Pricing:• Preference Revelation Problem: individuals have an incentive to lie about their willingness to pay,

since the amount of money they pay to finance the public good is tied to their willingness to pay• Preference Knowledge Problem: even if individuals are willing to be honest about their valuation,

they may have no idea of what the valuation actually is• Preference Aggregation Problem: even if the above problems don’t exist, how can the

governmen aggregate individual values into a social value?• E.g. is it feasible to ask 260M US citizens the amount of tanks, missiles etc, they want?

• Therefore, Lindahl is attractive in theory but not really feasible.

Methods for Aggregating Individual Preferences:• Referendum: a measure placed on the abllot by the gvt allowing citizens to vote on state laws or

constitutional amendment that have already been passed by state legislature• Voter Initiative: placeemnt of legislation on the ballot by citizens => e.g. petition for a

referendum w/enough signatures => not necessarily abrogative• Majority Voting: typical mechanism to aggregate indie votes into a social decision whereby

individual policy options are put to vote and the option that receives the majority of votes is chosen• Not as ‘efficient’ as Lindahl => as Lindahl equilibrium citizens were unanimously in agreement• The aggregation mechanism must satisfy three goals:

• Dominance: if one choice is preferred by all voters, the aggregatino mechanism must be such that this choice is made by society (DUH!)

• Transitivity: Choice must satisfy the property of transitivity => if a large statue preferred to medium, which is preferred to small, then large is preferred to small

• Independence of Irrelevant Alternatives: choices must satisfy the condition that if one choice is preferred to another, then the introduction of a third independent choice will not change that ranking

• Majority voting can produce a consistent aggregation of individual preferences only if preferences are restricted to take a certain form

•

• Majority Voting: When it doesn’t Work• Cycling: when majority voting does not deliver a consistent aggregation of individual

preferences => violation of the principle of transitivity!

Arrow’s Impossibility Theorem:• In the above example it is clear that no voting system will produce a consistent outcome

• Kenneth Arrow’s Impossibility Theorem: there is no social decision voting rule that converts individual preferences into a consistent aggregate decision without either a) restricting preferences or b) imposing a dictatorship

• Solving Impossibility Problem through Restricting Preferences• Single-Peaked Preferences: preferences with only a single local maximum so that utility falls

as choices move away in any direction from that peak (as opposed to multi-peaked preferences)• If preferences are single-peaked, majority voting will yield consistent outcomes• Single-Peakedness is a reasonable assumption to make about preferences

• But not reasonable if there is the possibility of a private substitute for a public good (Example no.2) => e.g. having a mediocre park is the worst options for all

• Median Voter Theorem: Majority voting will yield the outcome preferred by the median voter if preferences are single-peaked

• Median Voter: voter whose tastes are in the middle of the set of voters• In the first case => young couples => TRUE• In the second case => this has not been verified, as the preferences are not single-peaked

• Potential Inefficiency of the Median Voter Outcome:• Median voter outcome for majoirty voting is very convenient

• Implies that if single-peaked, the government need find only the one voter whose preferences for the public good are right in the middle of the distribution of social preferences and implement the lvel of public goods preferred by that voter

• But is may not be socially efficient => social efficiency requires that social marginal benefits of a public project equal its social marginal costs => median voter outcomes may not do this because they do not reflect the intensity of preferences

• If a small group of people derive enormous benefits from a public good, they should be taken into account

• Summary on Majority Voting => principally linked to direct democracies => if preferences are single-peaked, majority will consitently aggregate prefernces => but not intensity

• Therefore, while convenient, it may not be efficient

Representative Democracy:

• Median Voter Model: convenient way to describe the role of representative democracy, it does so by making a number of assumption

• Assumptions:• Single Dimensional Voting: voters are basing their votes ona single issue

• Stupid; voters are affected by a bundle of issues• Individuals may lie at different ends of the voting spectrum on different issues

• Only Two Candidates: there are only two candidates for office• If there are more, the simple predictions break down• There is no stable equilibrium with three or more candidates, because there is always

an incentive to move in response to the opponents’ positions• No Ideology or Influence:

• Politicians care only about maximising votes • Ideological convictions (or tangenti) could lead politicians to positions themselves away

from the center of the spectrum and the median voter• No Selective Voting:

• Median voter theory assumes that all people affected by public goods vote => but only a fraction of citizens vote in the US

• No Money: median voter theory ignore the role of money as a tool of influence in elections• If taking an extreme position maximises fundraising, even if it does not directly

maximise votes on that topic, it may serve the long-run interests of overall vote maximisation by allowing the candidate to advertise more

• Full Information: Median voter model assumes perfect information along three dimension:• Voter Knowledge of Issues• Politician Knowledge of Issues• Politiican knowledge of voter preferences

• Evidence on the Median Voter Model:• Median voter is a sensible starting point for modeling politician behaviour• However, don’t explain everything => the legislator’s own ideology and core constituency

• Washington argues the more daughters you have the legislator is more likely to vote in favour of women’s issues (e.g. reproductive rights) or women’s safety => ideology matters

• Lobbying: expenditure of resources by certain inndividuals or groups in an attempt to influence a politician

• Useful to politicians for two reasons• These groups can provide relevant information about an issue to uninformed politicians• This group will reward politicians who support their views by contributing to the politician’s

cambaing• Lobbying Serves 2 Useful Roles:

• Providing information and representing intensity of preferences• Given the potential inefficiency of the median voter outcome, some amount of lobbying is

probably optimal• Leads to inefficient outcomes

• Farm Policy in the US:• Direct Subsidies and Price Supports cost 25.5 Billion => 390$/American household

• Oh yeah, we’re supportin American family farms => But NZ got rid of its support and the same amount of people are employed in agriculture and live in rural areas

Public Choice Theory: The foundations of Government Failure• Emphasizes that the government may not act to maximise the well-being of its citizens• Government Failure: inability or unwillingness of the government to act primarily in the

interests of its citizens• Bureaucracies: organisations of civil servants that are in charge of carrying out the services of

government• Budget-Maximising Bureaucrat (Niskanen): bureaucrat’s salary is unrelated to efficiency

• Compensation (wages, benefits, status etc) is based on total measurable output of his bureaucracy

• The goal of the bureaucrat is therefore to maximise the size of agency he controls and thus maxmise the budget, not to choose the level of service that maximises efficiency

• Private vs. Public Provision:• Private is usually more efficient => when state companies are privatised, their efficiency

improves dramatically!• Problem:

• Natural Monopoly: A market in which, because of uniformly decreasing marginal cost of production, there is a cost advnatage to have only one firm provide the good to all consumers in the market => privatisation may cost more for consumers

• Contracting Out: the government retains responsibility for providing a good or service, but hires private sector firm to actually provide the good or service => middle-ground

• Competitive bidding => finds the most efficient producer => danger of corruption

• Leviathan Theory: Brennan and Buchanan• Voter cannot trust the government to spend their tax dollars efficiently and must design ways to

combat government greed• Explains many rules that tie the government’s hands in terms of taxes and spending in US

• Corruption: the abuse of power by government officias in order to maxmise their own personal wealth or that of their associates

• Electoral Accountability: ability of voters to throw out corrupt regimes• Why Does it Exist:

• Electoral Accountability: the more there is, the less corruption• Red Tape: the more red tape the more the more corruption

• Poor government structures can have long-lasting negative impacts on economic growth• Mauro 1995: however, high quality gvts (treatment group) may differ from the low

quality governments (control group) for other reasons as well => biases results • Wages of Bureaucrats: paying higher wages to bureaucrats makes them less willing to risk

losing their jobs by being caught in a corrupt act

FederalismOptimal Fiscal Federalism: the question which activities should take place at which level of government => although local provision allows communities to choose the package of services that best matches the tastes of their residents => higher efficiency, in some cases matching local interests may not be in the national interest

Fiscal Federalism in the US and Abroad:• Distribution of government spending has changed => local and state spending has declined• Much state and local spending is now supported by intergovernmental grants

• Intergovernmental Grants: Payments from one level of government to another

• Due to new Deal and Sixteenth Amendment (1913) => changed this distribution• Spending and Revenue of State and Local Governments

• State Governments: sales and income taxes• Local Governemnts: property taxes

• Propert Tax: tax on land and any buildings on it, such as commercial businesses or residential homes

• Abroad

• Fiscal Equalisation:policies by which the national governemnt distributes grants to subnational governments in an effort to equalise differences in wealth => US doesn’t do that

• Recent years have seen a move toward fiscal decentralisation around the globe• Shift of various things from national to subnational governments

What is the Optimal Fiscal Federalism:• Tiebout Model: he realised that what is missing in public goods is shopping and competition

• Shopping: individuals don’t debate whether a marginal missile is made by the federal gvt• Competition: who is to compete with the federal gvt when it provides goods?

• The situation is different for the local level in cities/towns => individuals vote with their feet• If they don’t like the level of public goods provision in one town they move to the next

• Less disruption than moving to a different country• Threat of exit ↑ efficiency in local public goods prod: mobility as preference revelation device

• Formal Tiebout Model:

• Problems with Tiebout Competition:

• Tiebout model assumes no externalities/spillovers• But many local public goods have such features => police, public works, education

• e.g. a beautiful park can be visited by citizens of other local areas• If there are spillovers => low-tax, low-benefit municipalities can free-ride off of high-tax,

high-benefit ones• Evidence on the Tiebout Model:

• Resident Similarity Across Areas:

•

• Capitalisation of Fiscal Differences into House Price: • House Price Capitalisation: incorporation into the price of a house the costs (inlcuding local

property taxes) and benefits (including local public goods) of living in the house• Areas with generous public goods should have higher house prices

• Tiebout does not require that all people vote with their feet, but that enough people are wiling to do so

Optimal Fiscal Federalism:• Tiebout model implies that three factors determine local public good provision:

• Tax-Benefit Linkages: the relationship between the taxes people pay and the gvt goods and services they get in return

• Cross-municipality spillovers in public goods• Economy of Scale in Public Good Provision

• If these conditions are bet, then local public good provision is close to optimal• But wait: most of the underlying differences is the actual values of taxed properties

• There is a difference in revenue bases!• Should We Care?

• In a perfect world, where Tiebout mechanism accurately describes reality => NO!• But, the Tiebout mechanism may fail for 2 reasons

• Zoning Rules: Forces certain people to underconsume public goods• Externalities: usual argument, gvt should subsidise spending in the communities providing

the (usually positive => think a nice park in Dahlem) externality

Tools of Redistribution: Matching Grants

• Matching Grant: a grant, the amount of which is tied to the amount of spending by the local community => e.g. 1:1 would provide 1$ of grant for every 1$ already spent on education

• If the goal is to encourage spending on public goods, matching grants will be most effective since they put both income and substitutions effects to work to increase town spending

• Help with externalities• Block Grant: a grant of some fixed amount with no mandate on how it is spent

• If the goal is to maximise the welfare of the lower level of gvt, block grants will be most effective => good for redistribution

Trade-off: block grant maximises the welfare, but it doesn’t raise public provision that much" Solution: Conditional Block Grants

• Conditional Block Grant: a grant of some fixed amount with a mandate that the money be spent in a particular way

• The effect of a conditional block grant differ from the effect of an unconditional one, only if the town receiving the grant would have spent less than the grant amount without the condition being imposed => otherwise, the local gvt merely reallocates existing spending to meet the mandate => crowd out

Redistribution in Action: School Finance Equalisation• School Finance Equalisation: Laws that mandate redistribution of funds across communities in a

state to ensure more equal financing of schools• Differs across states => Cali redistributes al revenues, NJ only towns with revenue in 85th%ile

• Tax Price: The amount of revenue a local district would have to raise in order to gain $1 more of spending => Cali => infinite (no matter how much revenue they raise through tax, they cannot spend more than 350 per person => incentive to cut taxes => reduction in per-pupil spneding) NJ => not sure, but it raised per-pupil spneidng

Conclusion:• When spending is on goods for which local preferences are relatively similar and where most

residents benefit from those goods, the Tiebout model suggests that spending should be local• When spending is for goodsthat benefit only a minority of the population, Tiebout suggests that

this might be difficult locally since the majority that does not benefit will ‘vote with their feet’ and go away

• This distribution is consistent with ‘division of labour’ => local takes care of schooling, natinoal takes care of redistribution

• The appropriate choice by national gvt depends on the goal (redistributing to offset Tiebout failures or to offset externalities)

EducationIntroduction:• In the US it is the single largest spending, and spends more than most countries but lags behind in

standardised test scores

There public benefits (positive externalities) to education that justify intervention:• Productivity: society benefits from the higher standard of living that comes with ↑ productivity• Citizenship: education may make citizens more infromed and active voters, improving the quality

of the democratic process• Educational Credit Market Failure: failure of credit market to make loans that would raise total

social surplus by financing productive education• Without public education, many families would have to borrow money for children’s education

• This market is unlikely to function well• Failure to maximise utility => parents may not choose an appropriate level of education for their

children• Redistribution: as long as education is a normal good, higher-income families would provide

more education for their children than lower-income families• But the government usually wants income mobility whereby low-income people have a chance

to raise their incomes, therefore it must get involved

How is the Government Involved in Education• Crowding Out:

• Model assumes that there is a link between spending and quality, and that there is a continuum of school prices (and hence quality)

•

•

• Solving the Crowd-out Problem: Vouchers• Educational Vouchers: a fixed amount of money given by the government to families with

school-age children who can spend it at any type of school, public or private• The curve is flat at first, because all public schools are of quality EF• Vouchers put private schools and public schools on equal footing

• Pros:• Consumer Sovereignty: By forcing individuals either to choose free public education or to

forgo this large public subsidy and choose private education, today’s system does not allow people to maximise their utility by freely choosing what makes them best off => solves crowd out

• Competition: educatino markets benefit from competitive pressures tha make private markets function

• Inefficient bureaucracy of present public schools would be reduced if private schools were more affordable

• Cons:• Excess Specialisation: if they are to only satisfy demand, schools like ‘football schools’ will

come up that ill neglect central elements of education => regulation• Segregation: the children of motivated children would move to higher-quality private

schools, while children of disinterested/uninformed => move to low-quality public schools• If the uniformedness is correlated to race/gender etc. => segregation• But vouchers may actually reduce present segregation as it allows some individuals who

would benefit from using vouchers to escape to higher-quality education• Mixed: it will increase segregation by student skill level or motivation

• It wil decrease by other dimensions (e.g. race)• Vouchers are an inefficient and inequitable use of public resources

• Total public-sector costs would rise, as the government would pay part of the private school costs that families currently pay

• Education may not be competitive:• Education market is described more closely by a model of natural monopoly, with

efficiency gains to having only one monopoly provider of the good• Special Education (=programs to educate disabled children): schools have an incentive

to avoid special education students, since they cost more, but bring the same voucher• Reduces options for special students => regulation very cumbersome and of

ambiguous success

Public School Choice: very little evidence• Some school district offer a variety of public choices e.g.

• Magnet Schools: special public schools set up to attract talented students/students interested in a particular subject or teaching style

• Charter Schools: schools financed with public funds that are not usually under the direct supervision of local school boards or subject to all state regulations for schools

Public School Incentives:• School Accountability:

• No Child Left Behind Act 2001 => made teacher accountable for results (carrot/stick)• Problems:

• Accountability induces teacher to “teach to the test”• Danger of manipulating the pool => e.g. reclassify low-skilled students as ‘special education’• Cheating by teachers

Measuring Returns to Education:• Returns to Education: the benefits that accrue to society when students get more schooling or

when they get schooling from a higher-quality environment• All agree that those with more education earn more => but there are differences in interpretation

• Education as Human Capital Accumlation: more education raises a worker’s stock of skills and allows him to ear more in the labour market

• Education as a Screening Device: education provides only a means of separating high- from low-ability individuals and does not actually improve skills (Hello Plato?)

• Why is interpretation important• If the former, gvt wants to support education and thus raise productivity• If the latter, gvt should not care => in this model returns to education are purely private, not

social => gvt should only support educational institutions if they are the best screening device• Result: most of the returns to education reflect accumulation of human capital, although high-

school and higher education may have some screening value• Effect of Education Levels on Other Outcomes:

• More education leads to => (More political participation, performing fewer criminal acts, have better health and healthier children, have better-educated children, have more productive coworkers)

Role of Government in Higher Education:40% of spending in education is for higher educationHigher education in US is viewed as an enormous success

• Current Government Role:• State Provision: Direct provision of higher educatino through locally and state-supported

colleges and universities• Pell Grants: subsidy to higher education administered by the federal government that provides

grants to low-income families to pay for their educational expenditures• Loans:

• Direct Student Loans: loans taken directly from the Department of Education• Guaranteed Student Loans: loans taken from private banks for which the banks are

guaranteed repayment by the government• For poor students => the gvt assures a low interest loan and allows deferring of payment

until graduation• Tax Relief: for college-goers and their families

• Tax Credits for families that send their children to college• Can deduct a certain amount from their income statement