week 3 handout

PART 1 ■ INTRODUCTION

3 0

DISCUSSION QUESTIONS

CHAPTER 2

1. "The state-local government sector stopped growing relative to the size of the economy in the late 1970s because of a decline in the amount of federal aid to states and localities." Do you think this is correct and why?

2. The recent growth (since 1999) in state and local spending relative to income, population, and prices is still not as fast as growth that occurred in the 1952 to 1975 period. Discuss the reasons why state-local spending increased so fast in the earlier period and consider what might be different in the recent period of growth.

3. Although the diversity of subnational governments means that the notion of "typical" behavior is often not meaningful, it is still common in presentations of data, news reports, and political debate to compare a state or locality to the "national average." How does the state-local sector in your state compare to that average in terms of (1) the structure of localities, (2) the level of expenditure, (3) the pattern of services provided, and (4) the mix of revenue sources? Do you know of any reasons why your case might differ from the national average?

4. Some surveys show that citizens usually are aware of services provided by local governments, but often not certain of the services provided by state governments. Make a list of five services provided by your city/township and five provided by your state that directly benefit you. After thinking about how you directly pay for those services, do you believe you get your money's worth?

SELECTED READING

Bahl, Roy. "The Growing Fiscal and Economic Importance of State and Local Governments." In Financing State and Local Governments in the 1980s, 7-32. New York: Oxford University Press, 1984.

Giertz, J. Fred and Seth Giertz. "The 2002 Downturn in State Revenues: A Comparative Review and Analysis." National Tax Journal 57,1 (March 2004): 111-132.

Oates, Wallace. "An Economic Approach to Federalism." In Fiscal Federalism, 3-30. New York: Harcourt Brace Jovanovich, 1972.

Rivlin, Alice. Reviving the American Dream: The Economy, the States, and the Federal Government. Washington, DC: Brookings Institution, 1992.

Sjoquist, David L., ed. State and Local Finances Under Pressure. Northampton, MA: Edwa Elgar, 2003.

MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

The economic function left to state and local govern- ments in the United States system is the allocation function, i.e., the determination of the amount and

mix of local public services to be offered.' —ROY BAHL

HEADLINES

FROM THE DAYS OF ADAM SMITH, ECONOMISTS HAVE RECOGNIZED THAT A SYSTEM OF PER-

FECTLY COMPETITIVE MARKETS ENHANCES ECONOMIC WELL-BEING IN SEVERAL WAYS: BY PER -

MITTING RESOURCES, PRODUCTS, AND SERVICES TO GO TO THOSE WHO VALUE THEM MOST; BY

PROVIDING INCENTIVES FOR COST SAVINGS AND INNOVATION IN THE PRODUCTION AND DISTRI-

BUTION OF GOODS AND SERVICES; AND BY FOSTERING LOW PRICES. YET, LIKE ADAM SMITH,

Y E S ECONOMISTS ALSO RECOGNIZE THAT UNDER SOME LIMITED BUT IMPORTANT CIRCUM-

CES, MARKETS DO NOT ALWAYS ACHIEVE THESE DESIRABLE ENDS. WHEN THEY DO NOT,

OPRIATE GOVERNMENT ACTION CAN IMPROVE MARKETS' FUNCTIONING AND SO INCREASE

OMIC WELL-BEING... .

ADAM SMITH PUBLISHED THE WEALTH OF NATIONS IN 1776, THE SAME YEAR THOMAS

RSON WROTE THE DECLARATION OF INDEPENDENCE. SINCE THAT TIME . . . GOVERNMENT

ORKED IN PARTNERSHIP WITH THE PRIVATE SECTOR TO PROMOTE COMPETITION,

RAGE EXTERNALITIES, AND PROVIDE PUBLIC GOODS. 2''

g State and Local Go melds in the 1980s. Oxford, England: Oxford University Press, 1984, 25. the President.

p

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PART I ■ INTRODUCTION

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

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33

An important issue of microeconomics is when and why collective action, such as that by government, may be preferable to separate economic decision making by individual consumers and producers, usually referred to as the private market. In short, what is the economic rationale for government provision of some goods and services, and how can microeconomic tools be applied to eval uating the relative merits of government and private provision? As noted in Chapter 1, Richard Musgrave has argued that government's economic role may include attaining a more efficient use of society's resources, altering the distrib- ution of resources, and achieving macroeconomic stabilization. However, the focus of microeconomic analysis and research concerning state and local governments has been on the first role—their effectiveness in directly providing goods and services.

Before the potential for government provision can be evaluated against society's goals, you must understand the nature of economic efficiency and the reasons why government intervention may improve upon the results of private-market provision. This chapter reviews the basic microeconomic principles of market operation and economic efficiency, including why private markets may be effi- cient, the conditions under which private markets will not generate efficiency, the potential distributional concerns from private provision, and the ways govern- ment involvement generally in an economy (and not just state-local government) may improve efficiency or resource distribution compared to private markets.

The concept of economic efficiency most often used in economics is called Pareto efficiency or optimality (named after the Italian economist Vilfredo Pareto [1848-1923] who proposed the definition), which states that an economy is efficient if it is not possible to make at least one person better off without making someon else worse off. This concept of economic efficiency is broader than the everyda use of the word efficiency. Economic efficiency includes the idea of technical o engineering efficiency, requiring that goods be produced at lowest cost, while al requiring that the type and quantity of goods and services are consistent wi society's desires.

The test for efficiency, then, is to search for changes to the current economic s uation that can improve the welfare or economic conditions of some people, b not decrease the welfare of any others. The efficiency definition requires only it be possible to make some consumers better off without hurting anyone and d not address the issue of how any change actually is to be accomplished. If, in f no one will be hurt by a change, then those who gain from that change have compensate those who lose. This requires that the aggregate benefit be greater the aggregate cost, so the net benefit can be used to compensate anyone wh hurt initially.

If such changes are possible, the economy is not efficient; if those changes are no

possible, then the original situation is efficient. If the gain to society from one sr(' change is called the marginal social benefit and the cost of the change is

marginal social cost, then a general efficiency rule for evaluating changes can be stated as follows:

If marginal social benefit equals marginal social cost, then the economy is efficient because there is no net gain from any change. If marginal social benefi t is greater or less than marginal social cost, the economy is not efficient, and the proposed change would improve economic efficiency.

Suppose, for example, that it is possible to produce more goods with the same resources by changing to a different (more efficient) production process. With more goods, the welfare of some (or even all) consumers could be improved at no cost to society. That economy was not producing goods efficiently. By "welfare," economists mean the utility or satisfaction consumers receive from consumption. Because a con- sumer's utility depends on preferences—individual likes and dislikes—each con- sumer is the sole judge of his or her own welfare. To put it another way, more goods will not improve a consumer's welfare if that consumer does not like those goods.

As another example, suppose that society decides to allocate fewer resources to the military and to use the freed-up resources to produce more education. If con- sumers in aggregate value the increased amount of education more than the reduced military structure, the economy was not producing an efficient mix of consumer goods. The marginal benefit from providing more education is greater than the mar- ginal cost. At least some consumers are made better off by the change, and any con- sumers who might be made worse off by the loss of military service could be com- pensated (and thus not hurt) because the gain to consumers in aggregate is positive.

This notion of economic efficiency has several advantages and one apparent weakness. The advantages are that value judgments about how much society "cares" for different types of consumers are not necessary and that no consumer need be opposed to changes to an inefficient economy. These both follow from the fact that if an economy is not Pareto efficient, no one need be hurt by a change to an efficient situation. The weakness of the definition is the narrow view of ineffi- ciency. If a potential economic change must hurt even one consumer while making

others better off, by the Pareto definition that situation is efficient. Because of at narrowness of definition, achieving Pareto efficiency would not resolve all

al issues, but there appears to be no shortage of situations that could be proved even by this narrow definition.

ow do competitive markets satisfy this definition of efficiency? Although ele- athematics is required to "prove" the efficiency of competitive equilibrium, erlying principles are easily demonstrated. The long-run equilibrium of a

ye market is depicted in Figure 2.1a. The market demand for the product ates the marginal benefit to consumers consuming this good or service; if act to maximize profits, the market supply corresponds to the marginal

oducing the good or service. At the market equilibrium, the marginal cost cmg one more unit equals the marginal benefit—all the possible aggregate

from producing this good or service have been achieved. The equilibri- P* is equal to both the marginal cost and the marginal benefit. e point of view of a typical firm in this competitive market, the equilib-

lso equals the lowest possible production cost per unit—that is, the

THE EFFICIENCY OF THE MARKET

Efficiency requires

equal marginal

social cost and

benefit

Price

($)

Supply or marginal social cost

Quantity of product 100 200

35

Figure 2.2

10

8 Demand or marginal social benefit

F

34

Figure 2.1

A

Price

($)

Competitive mar-

ket equilibrium

Demand or marginal social benefit

Market output q .

(b) Typical firm

Price

Supply or ($) marginal social cost

P"

Firm's production Q

(a) Market

Marginal cost

Average cost

PART I ■ INTRODUCTION

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

minimum of the average cost function (Figure 2.1b). At that price, firms are earn-

ing normal profits—that is, rates of return equal to those available elsewhere in the

economy. Because investors are doing exactly as well in this business as they could

in any other, there is no incentive for changes in output or prices.

The dollar magnitude of the gains to society from producing this good or service

also can be approximated in Figure 2.1. Consumer's surplus is defined as the

difference between the marginal benefit to consumers from a unit of the product and

the market price they actually pay, which is represented by area ABP* in Figure 2.1a. Producer's surplus is defined as the difference between the price charged for the

product and the marginal cost of producing a unit of the product, which is similar-

ly represented by area CBP* in Figure 2.1a. The net gain to society from producing Q* units of this good or service can be measured by the sum of the producer's and

consumer's surplus. This is nothing more than the difference between the marginal

cost and marginal benefit for each unit, summed for all the units produced.

If marginal social cost does not equal marginal social benefit for the amount of

a good or service provided, then the outcome is not efficient, as depicted in Figure 2.2. If 100 units of this product are produced and consumed, the marginal

benefit or gain to society from unit 101 is $10, whereas the cost to society of

producing unit 101 is only $5. Producing one more unit of this product (beyond

100) would provide society a net gain in welfare worth $5. Conversely, if th

market fails to provide that unit 101, society effectively loses or foregoes tha

potential $5 welfare gain—the outcome is not efficient. Similarly, the margin

benefit is greater than the marginal cost for all the potential units of outp

between 100 and 200. If output and consumption is restricted to 100 units rath

the efficient quantity of 200, the welfare loss or welfare foregone by society can

measured by area DEFG, the sum of producer's and consumer's surplus. 3

3 Area DEFG is approximately equal to $250. DEFG is approximately a triangle, the area of which is SS (base)(ileiO t N (5)(100) in this case.

The results in a competitive market when producers act to get the highest

possible profits and consumers act to get the greatest possible satisfaction are as

follows:

1. Marginal cost equals marginal benefit, with both equal to price.

2. Price equals the lowest possible production cost and producers earn normal

profits.

3. Because price equals both marginal cost and marginal benefit in all

competitive markets—that is, PA. = MCA = MBA and PB. = MCB = MBB—it follows that the relative prices of different products reflect the relative

production costs and relative marginal benefits in consumption or

PA• MCA MBA Pir MCB MBB

WHEN MARKETS ARE NOT EFFICIENT

might prevent provision through the private-market system from achieving

mic efficiency? One possibility is that the marginal cost faced by producers of reflect all the costs to society from additional production or that an indi-

consumer 's marginal benefit does not equal society's benefit. If benefits other than the direct consumer or if private production costs do not

tal social costs, then the competitive market choices may not be socially oices. Although the competitive market sets marginal cost equal to mar-

efit, the costs and benefits are not properly measured. A second possibil- -a lack of competition, such as if economies of scale are present or entry

PART INTRODUCTION

36

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

37

of firms is blocked, may prevent the market from reaching the "marginal cost equals marginal benefit" equilibrium.

Externalities One problem arises if consumption or production causes external effects—that is, if one person's consumption or one firm's production imposes costs or benefits on other consumers or producers. In essence, an externality exists if one economic agent's action (consumption or production) affects another agent's welfare outside of changes in market prices or quantities. For instance, in the course of production, one firm (a steel mill) may discharge pollutants into a river, thereby increasing production costs for a downstream firm (a brewer) who must clean the water before using it in production. The pollution is an external effect because it is out- side of the steel market—that cost is involuntarily transferred from the steel pro- ducer and consumers to the beer producer and consumers. In essence, no market or other mechanism exists to assign a price for river pollution to be paid by the polluter.

Externalities create an efficiency problem because the external costs or benefits usually are not taken into account by the consumer or producer causing the exter- nal effect. If an activity creates external costs, then the producer or consumer underestimates the social cost of the activity and chooses too much of that activity from society's viewpoint. If consumption or production generates benefits for oth- ers that are not considered, then the consumer or producer underestimates social benefits and chooses too little of that economic activity.

This issue is illustrated in Figure 2.3, which shows an individual's marginal benefit (demand) and marginal cost (price) from consuming a particular good or service. Constant marginal cost is assumed only to simplify the illustration. The quantity selected by consumers who equate marginal cost to marginal private benefits (their benefits) is Q 1 . Because each unit of this good purchased by one consumer generates benefits for others as well, the marginal benefit to society is greater than to the direct consumers alone. In that case, the efficient amount o consumption is Q*, where marginal private cost equals marginal social benefit. Because the direct consumers underestimated benefits, an inefficiently low amount of consumption is selected from society's viewpoint. When externalities are present, private choices by consumers and firms in private markets generally will not provide an economically efficient result. In this particular case, the benefits to other than direct consumers as a result of increasing consumption from Q 1 to Q* are represented by area I-IIJK. The net gain to society from increasing consumption from Q1 to the efficient amount is represented by the area HDK, which is th difference between marginal social benefit and marginal cost.

Government may be able to intervene and create incentives so that privat choices of consumers and firms will be efficient in the presence of externalities however. If there are external costs, a tax equal to the marginal external cost w force the consumer or firm to include all costs in the economic decision, and th the efficient quantity will be selected. Similarly, inefficiencies caused by exte benefits can be corrected by a government subsidy equal to the marginal extern

Figure 2.3

Price ($)

Market efficiency

with externalities

P* S J

Marginal private benefit

Marginal private cost = Marginal social cost

Marginal social benefit

Q I Q* Quantity of consumption

(a) External benefits

Price ($)

Marginal social cost

1 Marginal external cost Marginal private cost Marginal private benefit

Q Q l

(b) External costs

Quantity of consumption

it. If a consumer underestimates benefits by not considering those that accrue ers and thus chooses too little consumption, the subsidy will reduce private d induce an increase in consumption to the efficient amount. Returning to 2.3, if marginal costs are reduced to P* — S by a subsidy of $S per unit, then

onsumer is induced to choose consumption level Q*. The externality has been ated, and the private market choice of the consumer is efficient. 4

recisely the rationale for many intergovernmental grants, to correct the externality that arises when state or y

provided public services provide benefits to nonresidents as well.

PART I ■ INTRODUCTION

Externalities are common among the goods and services provided by state and local governments. Education, police and fire protection, transportation, and sani- tation services all have benefits that accrue to those who are not direct consumers and to nonresidents of the communities providing those services. Negative exter- nalities also are important for state and local governments because tax payments do not respect political boundaries. Nonresidents not only enjoy the benefits of ser- vices provided by a local government but also may pay part of that local govern- ment's costs through taxes.

Public Goods The term public goods is used classically to refer to goods or services that exhibit two properties. Public goods are nonrival, meaning that one additional person can consume the good without reducing any other consumer's benefit; after the good or service is produced, the marginal cost of an additional consumer is zero. Public goods often are also said to be nonexcludable, meaning that it is not possible (at least at reasonable cost) to exclude consumers who do not pay the price from consuming the good or service. The traditional example of a good said to exhibit both proper- ties is national defense. After a region is defended, there is no extra cost from adding one person to that region nor can any individual in the region be excluded from pro- tection. Another example is a lighthouse. After a lighthouse is operating, an addi- tional ship can be guided by the light while others are using it, and it could be very expensive to enforce a "lighthouse use fee" on ships that come in view of the light. 5

If a good is nonrival, the marginal social cost of adding another consumer is zero, so efficiency requires a zero price. A zero price obviously does not provide revenue to cover any fixed costs, so these goods are not provided in an efficient amount by private firms. Examples of nonrival goods include several usually pro- vided by state—local governments, such as an uncrowded street, bridge, or park. If a park is not crowded, then another person can enter and use the park withou reducing the enjoyment or benefit of any other user. To charge a fee to enter a park in that case is not efficient because the fee might induce some people not to use the park. Because the resources (mostly land) for the park already have been set aside use of that resource at less than capacity is wasteful or inefficient from the view- point of the entire society. Of course, the problem remains of deciding on the amount of park services to provide and paying for acquiring those services.

The potential for government involvement in providing nonrival goods seem obvious. The task is to collect revenue to cover the fixed costs of a service (the cost of acquiring and operating the park) while maintaining the price for each use of the service equal to zero, that is, equal to the marginal cost. Government can us general taxes to pay the fixed costs, and because those general taxes do not depe on a taxpayer's use of the service, the price for each use is zero.

It is worth noting that nonrival or public goods may be thought of as a s externality case. A nonrival good for which another consumer may be added a

5Coase (1974) provides evidence contradicting this example, suggesting that lighthouses are not good examples of nonexcludable goods. As discussed in the application at the end of this chapter, the possibility of market fail is only one aspect of potential government involvement in an economy.

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

39

cost to others is simply a good with a substantial benefit externality. Everyone can benefit if only one consumer provides a nonrival good, so the external benefits are large compared to the private benefits that go only to the buyer. From this view- point, the major difference in an efficiency sense between a nonrival good and an external benefit is the degree of public impact as compared to private impact.

If a good exhibits the nonexclusion property so that it is not feasible to charge a price for consumption, then private firms also are unable to collect revenue to cover costs. The tax power of government is needed to finance provision of these goods. If a commodity is both nonrival and nonexdudable, then individual con- sumers have no incentive to reveal their true demand for that good. Instead they can be free riders, benefiting, without paying, from the amount of goods pur- chased by others. Because all individuals have this incentive to understate their true demand, the quantity of these goods provided usually is inefficiently low. Even if the efficient quantity of these goods can be determined, efficient use of the goods may require prices that preclude private provision, as noted previously.

Increasing Returns to Scale A final efficiency problem for competitive markets occurs if production of some commodities exhibits increasing returns to scale—that is, if a proportional change in all production inputs causes a greater than proportional change in output. For instance, if doubling the labor, land, and capital cause output to more than double, then average production costs decrease as output increases. If

Total Cost = (Prices b o ) Labor + (Priceu nd)Land + (Pricec apitai) Capital

and

Average Cost – Total Cost Output

and the amounts of labor, land, and capital are doubled, then total cost doubles; but if twice as much of each input causes output to more than double, average cost falls.

A cost function reflecting increasing returns to scale is depicted in Figure 2.4. If average cost is decreasing, then marginal cost must be less than average cost at all out- put amounts (because average cost is decreased by more production if the extra cost of producing one more unit is less than the existing average cost). The usual explana- tion for this type of cost structure is the existence of fixed costs that are large compared to variable costs. Because fixed costs must be paid regardless of the level of output, a ;larger output allows those costs to be spread over more units, causing a decrease in

ost per unit. This situation often applies to public utilities, induding communica- ons, electricity, natural gas, water, sewer, or transit services, all of which have large

quirements even to serve a few customers. Industries with increasing scale are often called natural monopolies because it makes sense to have producer rather than multiple producers duplicating the required infra-

. Why have two separate but parallel water pipes if one is sufficient? creasing returns to scale exists, producers cannot earn a positive profit

qual to marginal cost (which is required for efficiency). With the

Figure 2.4

Qt Output

Increasing returns

to scale

Price

($)

13 1

Average cost

Marginal cost

Demand

P"

PART 1 ■ INTRODUCTION

4 0

CHAPTER TWO ■ MICROECONOMIC ANALYSIS- MARKET EFFICIENCY AND MARKET FAILURE

4 1

demand for the product as shown in Figure 2.4, efficiency requires a price equal to P. However, at that price and the resulting output Q 1, cost per unit is greater than revenue per unit, so the producer earns negative profits (that is, losses), and no firms would stay in business. In contrast, a price equal to average cost of 132 allows producers to earn a normal profit or rate of return on investment, but output Q 2 is not efficient because too little of society's resources are applied toward producing this good. The inescapable problem is that with increasing returns to scale, a price equal to marginal cost cannot generate enough revenue to cover total costs.

Government intervention may resolve this difficulty. One option is to have government become the producer. This is often done for water, sewer, and transit ser- vices, but less often for communications or electricity and gas production. The gov- ernment can charge consumers a price equal to marginal cost and make up the revenue shortfall with general tax receipts. Also, sometimes more complicated pric- ing schemes can be used to cover the production-cost deficit while allowing the marginal price to equal marginal cost. This topic is expanded on in Chapter 8 by discussing how governments can set efficient user charges. An alternative to govern- ment production of goods with increasing returns to scale is regulated monopoly production, with government as the regulator. In that instance, government grants a firm a monopoly in the sale of the good and attempts to regulate the price so that the producer earns normal profits. In either case, the outcome cannot be efficient because the taxes or regulation create other efficiency problems, so the preferable choice depends on whether government production or regulation works better practical'

supplied by individuals determine the resources available for market consump- tion by each individual. If society values highly the ability to pass a football effec- tively and that skill is in short supply, then individuals with the skill will earn high wages and be able to enjoy substantial consumption. Of course, the same argument applies to other types of (more ordinary) skills as well. If individuals have different abilities and if the financial resources for and incentives to acquire skills are not the same for all, then substantial differences in income and welfare can arise.'

If society is not satisfied with the distribution of resources that results from that process, the alternatives are either to alter it directly through transfer payments or subsidies or to reject the market as a means of allocating consumer goods either by altering prices or substituting an entirely different allocation mechanism. Of course, governments do all these things. State governments coordinate major transfer programs, such as Medicaid and food stamps, whereas the national gov- ernment coordinates others, such as social security Many states subsidize higher education services through public colleges and offer scholarships to needy stu- dents. In some states, nonmarket, public systems provide health-care services for lower income individuals.

These distributional concerns with the outcome of markets provide another rea- son for government activity. If society is unhappy with the resource distribution (income or wealth) among individuals, then the efficient prices for commodities may not be attractive. Theoretically, efficiency concerns should not dominate equi- ty considerations, so the efficiency criterion may be relevant only if the socially desired distribution is achieved. The traditional economic solution is to transfer resources among individuals to attain the desired resource distribution and then allow markets to allocate goods. If the process of redistribution does not have any costs, then that path may be preferable. Redistribution is not without cost, howev- er, because the taxes used to generate revenue and the receipt of transfer payments may alter behavior and create inefficiency, and because the institution for redistri- bution, usually government, is costly itself.

An alternative is to have the government provide these goods and services and to alter their prices. As Peter Steiner (1983) has noted, even if it is practical to charge fees for park use, school bus transportation, and school lunches, it may not be desirable if society desires to alter the pattern of consumption as well as increase

e level of consumption for some individuals. In addition to these equity reasons, e society may want to alter the pattern of consumption for efficiency reasons

ause of the externalities involved.

DISTRIBUTIONAL CONCERNS

The standard competitive market analysis also can be used to explain the distri ution of resources. The markets determine the prices of various types of labo land, and capital goods, and those prices together with the quantities of the inPu

le

EFFICIENT PROVISION OF PUBLIC GOODS

for efficient provision of goods is that the marginal social cost should e marginal social benefit. For externalities or public goods, social costs and

ill differ from the costs and benefits of the direct consumers. Because all s consume a pure public good simultaneously, the efficiency rule for

Efficient quantity

of a public good

Person A

($)

Marginal benefit to A

PART 1 ■ INTRODUCTION

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

4 2

43

Qo

Quantity of public good

Price

($)

Z+ 2Y

iSum of marginal benefits Marginal cost he

Z- 17 8 h

Q 1 Quantity of public good

public goods is that the marginal costs to society should equal the sum of the mar ginal benefits of all consumers, which is the marginal social benefit.

To illustrate the application of this rule, consider a society with three differen individuals (or groups of consumers), each with a different demand for the publi good, as shown in Figure 2.5. Person A represents a small demand, Person B medium demand, and Person C a high demand for this public good. A deman function for an individual shows the quantity demanded of every price, given th individual's tastes and income and the prices of substitute and complement goals. The benefits to society equal the benefits to all three consumers together. the bottom part of Figure 2.5, the marginal benefits of individuals A, B, and C ha

been added together to give the sum of marginal benefits for all three, labeled /;MB;, which means MBA + MBB + MBc.

In calculating this aggregate marginal benefit function, the individuals' margin- al benefits are added vertically. For example, the demand by Person A shows that the marginal benefit of the first unit is $Z; the first unit of national defense, police protection, or whatever provides $Z worth of benefit to Person A. Similarly, the marginal benefit of the first unit of public good is $Y for both Persons B and C. The marginal benefit of the first unit to all three individuals (that is, society) is therefore $(Z + 2Y). The aggregate marginal benefit curve is calculated in that way for every unit of the public good. Although all three consumers receive the same level of public good, only Person C values additional units between Q° and Q 1 .

The efficient amount of this public good is Q*, for which the marginal cost to society equals the sum of individuals' marginal benefits. It is implicit in this rule that the marginal cost includes all the costs to the society, including opportunity costs generated by production (such as pollution). This rule is often called the Samuelson rule or Samuelson public goods equilibrium, reflecting economist Paul Samuelson's work in deriving the condition. Although the rule was illustrated for a pure public good, the rule also applies to any good involving externalities (recall that public goods are just special cases of external benefits). If consumption of a good by an individual imposes costs on or creates benefits for other individuals, those costs and benefits must be included to satisfy the efficiency rule that mar- ginal social costs must equal marginal social benefits.

Methods ob Government Provision An important topic of this book (and one to which we will return often) is how government might be able to achieve or provide for an efficient use of resources. Government can intervene in private markets in at least three ways: (1) by directly providing goods and services, (2) by creating incentives to alter economic decisions through the use of taxes and subsidies, and (3) by regulating private economic activity. Government in the United States, including state and local overnment, uses all three methods. Government is essentially the sole producer f some goods and services such as streets and highways and a parallel producer ith the private sector of other services such as education, police and fire protec- on, and waste collection and disposal. A variety of taxes and subsidies are used

an attempt to curtail or expand different activities in view of their external ffects. For example, intergovernmental grants, offered by states to localities and y the federal government to the state—local sector, are subsidies in the state—local ovemment arena. In other cases, regulations are imposed on activities of the rivate sector, such as state regulation of public utilities or private schools, or on

el activities agencies

c tivitiie iecsos o of a local

level government, such as state regulation of local

Every attempt by subnational governments to improve economic efficiency, ever, may not be successful. Government provision involves substantial

cti on costs, including the administrative costs of the government structure the compliance costs to taxpayers and voters of making economic decisions

Figure 2.5

Person B

Person C

Marginal Marginal benefit to C benefit to B

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE PART I INTRODUCTION

44 45

collectively through government; and the information problems facing govern- ment in discerning the "public interest." As Peter Steiner (1983) and Richard Nelson (1987) have argued, the fact that private markets fail to provide goods or services efficiently may be of little relevance if government also cannot provide them efficiently. In that case, a different or at least broader analytical framework than the basic microeconomics reviewed in this chapter is necessary to evaluate the role of government. Society would select government to provide some goods and services if government could better serve the public interest, which is not defined solely by economic efficiency. Private provision may be selected for some goods even though the market is inefficient if government provision would be too costly or create other problems; government provision may be selected in other cases even if private-market inefficiencies are insignificant or nonexistent if society seeks another objective, such as fairness or security.

Given these cautions about the emphasis on efficiency, one special government fiscal structure may generate the efficient outcome. At the efficient amount of out- put shown previously in Figure 2.5, Q*, the marginal benefits to Persons A, B, and C are labeled hA, hB, and hc, respectively. If these individuals were charged a "price" for this public good equal to hA, hB, and hc, the amount of public good demanded by each individual is Q*, the efficient amount. Every consumer demands the same amount of government service, which is the efficient amount.

The particular characteristic of this situation that generates the efficient result is that each consumer is being charged a price equal to marginal benefit at the effi- cient quantity. Although user fees equal to marginal benefits could perhaps accom- plish this, it is more common in the provision of government goods for the "price" to be the taxes a consumer pays. In that case, each consumer's taxes must equal marginal benefit, or at least the share of taxes paid by each individual should equal that person's share of marginal benefits. The shares for each consumer are

SA = hA/ (hA + hB + hc)

SB = hB/(hA + hB + hc)

Sc = he/ (hA + hB +

SA + SB Sc = 1.

These tax shares are much like prices because they show the amount each per- son must pay to increase government spending by $1. For example, if hA = 20 per cent, hB = 30 percent, hc = 50 percent, and spending is to increase $1, taxes mus also increase by $1, with Person A paying $.20 more, Person B $.30 more, an Person C $.50 more. The price to Person C for another dollar's worth of gov ment service is $.50. If the shares equal marginal benefits, then each is willin pay the price up to the efficient amount. This situation, with charges or tax s equal to marginal benefit shares, is called a Lindahl equilibrium after the Sw economist Erik Lindahl (1919-58). If consumers' marginal costs reflect marginal benefits, then the efficient amount of public good will be demanded course, it is not a simple matter to implement that solution.

First, marginal benefits must be measured and assigned to individuals or at groups of individuals. This may be an impossible or expensive task in part

consumers have little incentive to reveal their true demand. What, for instance, are the marginal benefits by income class of increasing police service spending by $1? Second, as previously noted, it may not be appropriate to charge marginal prices if the marginal cost of another user is zero. Third, it may not be feasible to exclude consumers from use if they refuse to pay the price set by the government. The Lindahl equilibrium does offer the possibility of efficiency by converting taxes into a form of user charge with tax shares determined by benefit. This idea of benefit taxation and its efficiency properties is raised again in Chapters 5 and 14 concerning property taxes and in Chapter 8 with a more complete discussion of user charges.

The problems of public goods, externalities, and increasing returns to scale provide reasons for government action to improve the efficiency of the economy, and many, although certainly not all, state-local government activities can be explained by these reasons. On the other hand, state and local government intervention is not used for all local goods or services that involve externalities or public-good prop- erties. Redistribution of society's resources also can be a legitimate and explicit objective of government policy, and although state and local governments may be limited in carrying out redistribution programs, it seems clear that distribution and equity concerns influence many (if not most) state-local government fiscal decisions.

Despite these qualifications, the framework outlined in this chapter offers some explanation for the common fiscal activities and behavior of many state-local gov- ernments. Why is government, particularly state and local government, deeply involved in the education business? (As explained in Chapter 1, education is by far the largest subnational government budget category) First, education produces external benefits such as the gains to all from a literate and educated populous and

e information generated by research at educational institutions (which is usual- nsidered a public good). Second, education has the potential to be an impor-

echanism for income redistribution by affecting earnings potential. Third, tion benefits cannot generally be confined to a particular geographic area or trial sector, so intergovernmental arrangements may be called for. The edu-

case also may illustrate reasons for government provision other than the economic efficiency arguments. Public education may be a way of imple- g a basic notion of fairness—equal opportunity for all—and it has been a

way society transmits social values and informal rules of behavior. ar arguments can be made about police and fire protection. These services a large degree, nonrival and to a somewhat lesser degree, nonexcludable. hal interjurisdictional externalities (or spillovers) also occur in the provi- these goods. Accordingly, almost every municipality or township in the States provides services of this type. These services also are provided

however, in the form of private security guards at businesses, private trols in some neighborhoods, and privately purchased and owned uch as locks, burglar alarms, smoke detectors, and fire extinguishers.

APPLICATION TO STATE AND LOCAL GOVERNMENTS

PART I ■ INTRODUCTION

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

46 47

Application 2.1

Yet all these activities also generate external effects. Largely for the economic reasons, government takes a central but not an exclusive role in providing these services (see Application 2.1).

Transportation provides a final illustration. State and local governments finance, own, and operate transportation facilities such as streets and highways, airports, and public-transit systems. The economic efficiency arguments again provide some explanation. If uncrowded, these goods are nonrival, requiring a zero price for efficiency. Benefit spillovers among different jurisdictions providing the facili- ties also are common, requiring some coordinating mechanism. Although state and local governments provide these facilities, they seldom produce them; rather, gov- ernments usually contract with or buy from private firms, thereby taking advan- tage of any economies of scale in production.

PUBLIC AND PRIVATE PROVISION OF PUBLIC SAFETY

Application 2.1—Public and Private Provision of Public Safety

Although the discussion in this chapter may

seem to suggest that goods and services

are provided either privately or by the public

sector, in fact, it is more common for indi-

viduals and firms to purchase goods or

services in the private market to comple-

ment services provided by government. In

some cases, state and local governments

purchase services from private firms to aug-

ment similar services the government

produces directly. Public safety or police

service is one area where joint public-private

action is common.

Public provision of police services is usual-

ly called for because of substantial social (as

opposed to private) benefits from the service

(externalities), the difficulty of forcing con-

sumers to pay for public safety benefits

other than through goCiernment taxes

(nonexclusion), and economies of scale in

producing services. Certainly all these factors

are important and help explain why most

local and state governments in the United

States provide police and other public safety

services.

Some forms of public safety services do not

meet these conditions; rather, the benefits are

mostly private, exclusion is direct, and scale

economies are minor, if they exist at all. Thus,

individuals and firms privately purchase locks,

safes, security lights, and alarm systems, all of

which are private goods, providing benefits to

the direct consumers.That doesn't mean there

is no connection between these goods and

publicly provided police services, however, as

they seem to complement each other. A

security alarm is not likely to deter illegal entry

or theft unless the criminal believes that the

alarm will attract public safety officers with the

power to make an arrest. On the other hand,

locks, safes, video surveillance equipment

private neighborhood patrols, and other

security devices may reduce the demand for publicly provided police service, freeing up

resources for other public safety matters o even other government responsibilities. 6

The relationship between public police

and private security workers is one important

aspect of this issue. In fact, private security

forces seem to outnumber public law

enforcement staff (Sklansky, 1999). Based on

2002 Census data, approximately 575,000 pri-

vate security guards worked in companies

that specialize in providing security services

and another 75,000 people worked as private

investigators and employees of armored car

services. In addition, there are an estimated

450,000 to 500,000 "in-house" security

guards—workers hired solely for that purpose

by firms or property owners—and about

120,000 employees of firms that install and

monitor security and alarm systems. In con-

trast, the Department of Justice reported a

total of about 700,000 state and local govern-

ment police officers in 2000. So, the number

of private security guards (1.2 to 1.3 million) is

at least 70 to 80 percent greater than the

number of public police officers.

Private security services may both comple-

ment and substitute for public safety services,

depending on type. For instance, uses of pri-

vate security guards to guard specific build-

ings or parking lots is similar in effect to locks

and alarm systems installed by private own-

ers, providing mostly private benefits to the

direct users of the service. These uses com-

plement but do not really replace public

lice.

Increasingly, however, private security rces are being used to substitute for or aug-

nt public police services, as well. In some ses, groups of individuals or businesses are ntracting with private security firms to pro- e services in addition to those of local ice.

Such services commonly include oiling, monitoring behavior, and provid-

nformation to public police, but usually

do not include arrests or criminal investiga-

tion. For instance, businesses in Philadelphia's

commercial downtown did just that in 1991.

Similarly, homeowners in some neighbor-

hoods (often through a neighborhood associ-

ation) hire private guards to patrol the neigh-

borhood or staff entry centers, a trend that

seems to be increasing partly due to the

growth of gated communities. Sklansky

(1999) reports that more than 800 private

security guards patrol neighborhoods within

the city boundaries of Los Angeles (a number

equal to about one-tenth of the size of the

LAPD). In an economic sense, one can think of

the public police as providing a general social

benefit, with the additional private service

satisfying additional marginal private benefits

(demand).

The growth of private security services and

expenditures—both for traditional services

such as alarm systems and for newer private

security guards and patrols—also creates a

number of challenges for public police agen-

cies. False alarms are one major problem. Gov-

erning Magazine (1998) reports that there are

about 7 million private electronic security sys-

tems in the United States that average about

two alarms each per year. But 98 percent of

those alarms are false, creating substantial

direct costs for public police who respond to

the alarm and diverting the time and atten-

tion of the public police away from actual

criminal activity. Competition for workers is

another issue. The growth of private security

guards and patrols has made it more difficult

for public police agencies to attract and retain

police officers, driving up public safety costs.

In a few instances, private security guards

or firms are actually replacing public police, at

least for some services. Some public police

agencies are hiring private guards or security 6For more discussion of these types of security expenditures and the economic relationship to public police sere

see Clotfelter (1977).

Marginal Benefits

Students Faculty/Staff Visitors Total Cost $75,000 $37,500 $12,500 $30,000 60,000 35,000 5,000 70,000 45,000 30,000 0 120,000 25,000 25,000 0 180,000

5,000 20,000 0 250,000

PART I ■ INTRODUCTION

CHAPTER TWO ■ MICROECONOMIC ANALYSIS: MARKET EFFICIENCY AND MARKET FAILURE

49

Application 2.1—Public and Private Provision of Public Safety present, private choices by consumers and firms in private markets generally will not provide an economically efficient result. Government may be able to inter- vene and create incentives through the use of taxes, subsidies, or regulations so that private choices of consumers and firms will be efficient in the presence of externalities.

If production of some commodities exhibits increasing returns to scale, it is impossible to have a single price equal to marginal cost (which is required for efficiency) and have the producer earn a profit. Government may resolve this difficulty either by becoming the producer or by regulating monopoly production.

Many, although not all, state—local government activities can be explained by the problems of public goods, externalities, and increasing returns to scale. Redis- tribution of society's resources also can be a legitimate and explicit objective of government policy.

firms, without true police power, to provide

such functions as patrolling parks, transport-

ing prisoners, directing traffic, enforcing park-

ing rules, or providing a security presence in

government buildings. In essence, public

police agencies that do this are changing the

way public safety services are produced simi-

lar to the way in which other services (such as

medicine) divide tasks among specialized

groups of workers (physicians, physicians'

assistants, nurses). Such changes often reflect

pressures to produce public services at lower

cost, as discussed in Chapter 7.

In a few other cases, private security forces

may completely replace public police. Sussex,

NJ. replaced its local police force in 1993 with

private security guards under contract to the

city. Although driven partly by cost consider-

ations, such complete privatization moves

also create new issues for government to

resolve—how to specify the contracted-for

service, monitor the performance of the pri-

vate supplier, and enforce details of the con-

tract if the contractor fails to comply.

The increasing private provision of public

safety services challenges the conventional

economic efficiency arguments used to

support government provision. If police

services really are nonrival and nonexclud-

a ble, then why do businesses or individ-

uals voluntarily offer to pay for such services?

Interestingly, in a historical sense, private secu-

rity provision and private security forces once

were the norm. In the United States, it was only

in the late 1800s and early part of this century

that serious civil liberty concerns were raised

about private security forces, fueling an

increase in public police services. Clifford

Shearing (1992) notes that private police

began to be perceived as protecting the pri-

vate interests of the firms that employed

them—particularly as a result of the role of

private security forces in violent conflicts with

emerging labor unions—rather than some

general public interest. Since the 1960s,

however, such concerns seem to have become

less important, at the same time that cost con-

siderations and demand for security have

become more important. As a result, private

security services have grown in impor-

tance again.

Some important aspects of microeconomics are reviewed in this chapter. An ecort omy is Pareto efficient if it is not possible to make at least one person better o without making someone else worse off. Market efficiency requires that margin social benefits equal marginal social costs.

Public goods are nonrival, meaning that one additional person can consume good without reducing any other consumer's benefit. After a nonrival good is p duced, the marginal social cost of another consumer is zero, so efficiency req a zero price.

An externality exists if one economic agent's action (consumption or prod tion) affects another agent's welfare outside of the market. When externalities

DISCUSSION QUESTIONS

1. In parts of the country where snow is a regular occurrence, local govern- ment almost always provides snow removal from public streets, but seldom provides snow removal from public sidewalks. Sidewalk clearing is either left to individual choice or regulated by the government, perhaps by requir- ing that property owners clear the walks along their property. Yet the theoretical aspects of these two services are the same. What factors might explain why local governments typically do not plow sidewalks or, from the other point of view, why localities do not simply require property owners to clear snow from streets along their property? What does this imply about the standard externality/public goods argument justifying government intervention?

2. "For an efficient amount of a public good to be provided, the marginal cost of producing another unit of that good must equal the marginal benefit to each individual who consumes the good." Is this statement true or false, and why?

Suppose your university is considering building new parking lots on campus. The following table shows the marginal benefit to students, faculty/ taff, and visitors for one to five new lots. The table also gives the total cost f acquiring/constructing those lots.

No. of Lots

1 2 3 4

given a set of local governments in a metropolitan area, should one service,

say police protection, be transferred from city to county government?

Alternatively, knowing the types and characteristics of the services that

will be provided may help determine the best federal structure to provide

those services. In that case, the issue is how many governments there

should be, or, equivalently, how big those governments should be. At one

end of the spectrum, some services may require only one government,

which would cover the entire nation. In contrast, some services may be

provided better by many small governments.

The issue then is the optimal design of subnational governments or the

optimal allocation of fiscal responsibilities among existing subnational

governments. In the following four chapters, we will use economic analy-

sis to explore how individual choice about the activities of government

affects the best structure for government.

CHAPTER 3

PUBLIC CHOICE WITHOUT MOBILITY: VOTING

. . . The measurement of the preferences for [public] goods . . . cannot be subjected to individual consumer

choice. The closest substitute for consumer choice is voting. 1

—HOWARD R. BOWEN

HEADLINES

. VOTERS HAVE APPROVED MONEY FOR PROGRAMS THAT HELP KIDS IN TROUBLE.

WITH ALL PRECINCTS REPORTING . . . , THE JUVENILE JUSTICE MILLAGE PASSED 27,159 TO

024.

THE NEW MILLAGE IS EXPECTED TO RAISE ABOUT $1.5 MILLION A YEAR FOR EACH OF THE

T FIVE YEARS," SAID THE COUNTY'S CIRCUIT AND PROBATE COURT ADMINISTRATOR.

HE OWNERS OF A HOUSE VALUED AT $100,000 WITH A TAXABLE VALUE OF $50,000

L PAY AN EXTRA $20 A YEAR IN PROPERTY TAXES.

OF THE MONEY ... WILL BE USED TO DEVELOP COUNTY PROGRAMS THAT HELP JUVE-

ELINOUENTS WITH PROBLEMS SUCH AS ALCOHOL ADDICTION, WHICH HE SAID ARE LESS

SIVE THAN PLACING KIDS IN STATE PROGRAMS. 2 "

f Voting in the Allocation of Economic Resources." The Quarterly Journal of Economies. 58 : 33.

"Eaton County Passes Juvenile Millage." Lansing State Journal. November 3, 2004.

53