Chapter 1 – Fundamental Principles of Public Finance Topics: 1. Difference between private and public economies 2. Market failures and the role of Government.

Chapter 1 – Fundamental Principles of Public Finance

Topics:1. Difference between private and public economies2. Market failures and the role of Government3. Privatization and the distinction of Provision and Production4. Problems with determining the “public good” and the aggregation of individual preferences5. Layers of Government in the US, fiscal responsibilities and limits

How is Public Finance different from Private?

1. Resource Constraints Government has the ability tax to increase

resources. Private organization can only borrow or increase equity by “selling” ownership rights.

2. Ownership Who owns private resources is clearly defined.

Public interests include a wide range of stakeholders who have legitimate interests in the decisions by governments.

3. Objectives Private firms seek to increase value for a firm.

Governments have a wide range of goals, from supporting equity and individual rights, to providing services broadly to a population, to maintaining public legitimacy and getting elected.

How are Private Economies different from Public Economies?

What is the mechanism that makes private markets work?

Why does that not work for providing public services?

What is the mechanism typically used for providing public services?

Are there others?

Market Failures and the Functions of Government

1. Public Goods

- some types of goods and services have characteristics that lead to under-production in the private market.

- Involves resources where some aspect of consumption is shared

Market Failures and the Functions of Government

Two Characteristics of Public Goods:

1. Non-rivalry = when a good can be consumed without reducing the consumption of others

2. Excludability = inability to exclude non-payers from consuming the good

Public Good Typology

Excludability

Easy Difficult

Rivalry

Low

High

Toll goods Pure Public Goods

Private good Common pool resources

Market Failures and the Functions of Government

2. Externalities = a cost or benefit created by the market exchange of two parties that affects a third party not part of the exchange.

Costs are “negative”. Examples?

Benefits are referred to as “positive externalities”. Examples?

Market Failures and the Functions of Government

3. Failures of Competition

Monopolies = if a single firm is able to control a market and receive excess profit.

Natural Monopolies = when there are economies of scale to providing some kinds of goods.

Market Failures and the Functions of Government

3. Failures of Competition (continued)

Incomplete Information = when an individual consumer does not have complete information on the value of good.

Information Asymmetry = when one party in an exchange has important private information

Market Failures and the Functions of Government

3. Failures of Competition (continued)

Information Asymmetry leads to:

Adverse selection – asymmetric information distorts market exchanges

Moral hazard – asymmetric information creates an incentive that distorts market exchanges

Market Failures and the Functions of Government

4. Non-market Goods = some items of value are not provided by market exchange.

Ex: Equity, Justice, Morality, etc.

Redistribution = the general idea that there should be some concern for disadvantaged members of society

Who provides public goods – Privatization

Privatization is based on the idea that private markets will increase efficiency (lower costs) of public good delivery to citizens.

Includes:1. Transfer of public sector organizations to the private sector

2. Contracting out of service delivery by a private organization to the public

Smaller Government – philosophical position. Does not usually examine the full roll of the public section

Operating efficiency and responsiveness to client needs – economic position. Private firms are more flexible and better able to match need with service.

As a means of raising revenues

Arguments Supporting Privatization

Goods and services provided by a government because of market failures, do not necessarily need to be directly produced by government. Provision refers to intervention to ensure a good is produced at a desired quantity or quality. Whereas production refers to the actual creating and distributing of the good.

The Production / Provision Distinction

Govt. provision/Govt. Production- Police provide security during a parade

Govt. provision/Private Production - A police department sends forensic samples to

a private laboratory

Private provision/Govt. Production - A stadium pays for extra police during an event

Private provision/Private Production - A stadium hires its own security for the event

Examples of Production / Provision

Aggregating Individual Preferences into Social Decisions

How do we know what is good for “society” as a whole (what goods to provide) when we are composed of individuals with different preferences?

Example: Three public projects we could build

1. More parking2. Outdoor park with whitewater kayaking, climbing

wall and ice skating3. Music concert stadium

Which do you prefer?

Aggregating Preferences

The theory and methods used to aggregate preferences assume three things:

1. Individuals are generally the best judges of their own well-being and act to improve their well-being as they see it.

2. Well-being of a community depends on the well-being of the individuals within that community.

3. “Pareto criteria”, if at least one person is better off, and no one is worse off, then the community as a whole has been made better off.

Example 1 (p. 15)

Individual benefits from a project

Individual: Benefit:A $8,000B 7,000C 6,000D 9,000E 6,000Total Benefit to Society: $36,000

Total Costs to Build: $20,000

Example 2 (p. 16)

Indiv Indiv Benefit Cost Share Indiv gain

A 5,000 4,000 1,000B 5,000 4,000 1,000C 2,000 4,000 -2,000D 1,000 4,000 -3,000E 6,000 4,000 2,000

Total 19,000 20,000Total costs: 20,000

Example 3 (p. 17) Cost Indiv Share Ben. Ben. Share gain of Bens. based

A 3,000 2,500 500 15% $1,875B 5,000 2,500 2,500 25 3,125C 8,000 2,500 5,500 40 5,000D 3,000 2,500 500 15 1,875E 1,000 2,500 -1,500 5 625

Total: 20,000 12,500 100% 12,500

Project costs = 12,500

Politics, Representation and FinanceProblems with relying on government to provide the

optimal level of public goods:

1. Information is costly, and politicians don’t necessarily know what is in the public’s best interest

2. Politicians are vote-seeking and interested in personal goals rather than “public interests”

3. Some individuals are better able to influence political decision-makers than others

4. Those in power have an incentive to use position for personal gain (rent-seeking)

5. Voters are “rationally ignorant”6. Different constituents have different intensity of

preferences

Layers of Government

Some countries have Unitary systems – central government is the primary responsible agent for raising revenues and making decision on spending.

Others have Federal systems – responsibilities are shared

Three primary layers of relatively independent government units in terms of US fiscal relationships:

National, State & Local

Revenues and Spending by Governments

Sources Major

of Revenue: Expenditures:

Federal Personal income tax National Defense

Payroll tax for SS RetirementCorporate profit tax Health Care

State Personal income tax Highways

Sales tax Education (~higher) Health Care

Local Property Tax Education (~primary)

Sales Tax Public safety

Fiscal Relations between layer of Govt.Responsibilities and Limits are outlined in

ConstitutionFederal Government:

To lay and collect taxes, duties, etc.; pay the debts and provide for the common defense and general welfare of the United States; where all taxes, duties, etc. are uniform across states

Regulate commerce with foreign nations, among states, and with Indian tribes

Print money and regulate its value, and standards and weights

To establish post-offices and roads Raise and support Armies, but no appropriation to

that use shall be for a longer terms than two years

Restrictions on powers of the States

(Generally Outlined in Article I, Section 10) Prohibition against printing money Commerce clause prevents state interference

with international commerce and that among states. Places a limit on taxing power and regulatory authority.

Due process and equal protection of all state laws

Tenth amendment – “Powers not delegated to the US by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people”. Residual power resides with states – implies that a state can act when an action is in question even if not explicit in Constitution.

Local Governments Local governments are generally

considered subject to the authority of states, unless explicit authority has been delegated. “Dillon’s Rule”.

“Home rule” charter powers are one means of giving local govts. residual powers.

Fiscal authority is often severely limited. Exceptions tend to be large

municipalities