1. PUBLIC SECTOR ECONOMICS
Lecture 1: The Foundations of Public Sector Theory

2. Two Watershed Elections in 20th Century
Franklin Delano Roosevelt
32nd President of the United States ( )
“True individual freedom cannot exist without economic security and independence.”
→ Elected during Great Depression
→ Signed Social Security Act of 1935 to provide public insurance against poverty
→ A ‘Liberal’ President
Franklin D. Roosevelt (1940)
Source: Franklin D. Roosevelt Library

3. 40th President of the United States (1981-1989)
Ronald Reagan
40th President of the United States ( )
“Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”
→ Elected during stagflation of late 1970s
→ ‘Conservative’ response to FDR
→ Proposed largest tax cut in history and drastic spending cuts to social programs
Official Portrait of President Reagan (1981)
Source: Ronald Reagan Library

4. How much did social spending change during and after Reagan?
Not much
Through the following presidents (Republican & Democratic) spending as % of GDP changed little
So what is difference between Liberals and Conservatives?
Not as great as might be suggested in popular press
Differences are more normative than positive
Federal Outlays, 192 to 2001
(As a percentage of GDP)
Source: Congressional Budget Office

5. Three Normative Aspects of Public Sector Economics
Public expenditure theory
What government expenditures do we expect, and why?
How should government carry out its desired functions?
Theory of taxation
What principles should guide design of government tax policy
Theory of fiscal federalism

6. Fiscal Federalism Refers to multi-tiered system of government
Questions
Which tiers should provide which government functions?
How do people sort themselves across tiers?
Federal - 1
State - 50
Local - 89,000+

7. What are the Legitimate Economic Functions of a Government?
Depends on chosen economic system…
Least
individual
freedom
Most
Centrally Planned Socialism: Government owns all resources and makes all important economic decisions
Decentralized Capitalist Economy: Limited government; individuals and firms make all important economic decisions

8. Where do Current Economies Fall?
Least
individual
freedom
Most
China
Often referred to as “communist” economy
52.8 % free according to Heritage Foundation’s Index of Economic Freedom (126th freest in world)
United States
Often referred to as ‘capitalist’ economy
Gov’t spending 30% of GDP
80.6% free in 2008 according to Heritage Foundation’s Index of Economic Freedom (5th freest in world)
 Modern economies all lie well within bounds

9. What Economic Functions Should Government Provide?
Should honor consumer and producer sovereignty (humanism)
Gov’t should intervene in cases of market failure
Functions that government cannot perform at all or performs sufficiently badly to merit gov’t intervention
The correct definition of market failure is the main issue over which Liberals and Conservatives disagree
Both sides do agree that gov’t should not intervene in markets that are functioning well

10. Two Goals of Economies 1: EFFICIENCY
Efficiency is mainly a positive concept
Economists measure efficiency as Pareto Optimality
Definition: An economy-wide allocation of resources is efficient if in order to increase one person’s utility at least one other person’s utility must be decreased
Example
An allocation in which I have everything and you have nothing is an ‘efficient’ allocation (Pareto Optimal)
The only way to make you better off is to take some away from me

11. (Efficiency continued…)
Consider all ‘efficient’ points given our existing resources
Called the Utility Possibility Frontier
Must be downward sloping
To increase 1’s utility we must take utility away from 2
Points below line are attainable but not efficient
Could give some to both 1 and 2 and make them both better off (Pareto Superior moves)
Points beyond line are unattainable
Would require giving more utility to both 1 and 2 which is impossible

12. Two Goals of Economies 2: EQUITY (FAIRNESS)
Equity is mainly a normative concept
End-results equity
Asks whether outcomes are fair.
For example: Is it fair that over half of income in U.S. goes to 20% of households? If not, what should be done to correct it?
Process equity
Asks whether rules determining process are fair, regardless of allocation.
For example: Do children of wealthy families start with an advantage due to their family’s wealth? If so, then what should be done to level the playing field?

13. How Should Government Carry Out Its Desired Functions?
In general, government should act as agent for individuals
Implies that elected officials do not make decisions on own behalf
Ignores that elected officials are individuals interested in their own personal welfare

14. Public Choice Theory (1)
Credited to James Buchanan (Nobel Laureate 1986)
Believed individuals self-interested in both private and public economic affairs
Gov’t just another venue through which to pursue economic self-interest
Buchanan’s Public Choice Theory adds political content to concept of individual decision-making
Argues that gov’t is efficient only if it establishes rules that allow people to get what they want from gov’t

15. Public Choice Theory (2)
Therefore, what would be an efficient (Pareto Optimal) decision rule?
Unanimity: only way to make at least one person better off without making anyone worse off
Problem: Unanimity is impractical
As number of citizens increases what are chances anything passes?
Solution: Buchanan argues that unanimity should only be required when gov’t first agrees on its decision-making process
After that all decisions can be made by different rule (i.e. majority rule)

16. How do Mainstream and Public Choice Theories Compare?
Similarities: Both argue that democracy is process that is most consistent with decentralized market economy that honors consumer sovereignty
Differences:
Public choice
Mainstream
Adds political content
Ignores political content wherever possible
Focuses on process
Focuses on outcomes
Assumes narrow self-interest in private and public affairs
Assumes narrow self-interest in private affairs only

17. Pros and Cons of Public Choice Theory
More desirable aspects
Less desirable aspects
Better able to explain and predict actual gov’t behavior
Has a thin normative base which makes correct decisions on gov’t intervention in cases of market failure difficult to determine
Focuses more on process than outcomes
Belief in self-interest in all aspects of life appealing to economists
Ignores possibility that individuals have sense of community

18. And Finally…
Recent experiments (Behavioral Economics) suggest that individual behavior is often more consistent with Mainstream view
Individuals appear more self-interested in market experiments than in public good experiments