Public Finance

Why 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: Clintons 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 economy
Facts 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 individuals 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 welldefined 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 individuals 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 firms output
Marginal Cost: the incremental cost to a firm of producing one more unit of a good
Profits: differences between a firms 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 societys 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 gvts equity-efficiency decision
Utilitarian SWF: societys 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 cant 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 => dont)
However, the groups differ in a way correlated to the treatment because the stupid ones
take classes while the clever ones dont. 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 doesnt (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 (wouldnt 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 cant 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 firms 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 individuals 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 firms production increases the well-being of others but
the firm is not compensated by those others
Positive Consumptino Externality: when an individuals 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 partys 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:
T&S change the private marginal cost or benefit
Corrective taxation to discourage use
without affecting the social marginal cost or benefit
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

 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 dont 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 Governments 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 doesnt 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 Externalities

Damage 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
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 substanceSO2)
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 earths 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 worlds 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 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 ones 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 Goods
Public 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 individuals consumption does not affect anothers 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 Socratess way of proceding)

Consumers demand different quantities of the good at the same price => SUM

Optimal Provision of Private Goods:

One persons consumption does not reduce anothers, 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 dont, 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 cant 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 dont 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 Analysis
Cost-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 cant 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 pricecontrolled 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: lifes 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 Economy
Direct Democracy: voters directly cast ballots in favour of or in opposition o particular public projects
Representative Democracy: voters elect representatives, who in turn make decisions on public
projects
Government 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 dont 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 doesnt Work

Cycling: when majority voting does not deliver a consistent aggregation of individual
preferences => violation of the principle of transitivity!

Arrows Impossibility Theorem:

In the above example it is clear that no voting system will produce a consistent outcome

Kenneth Arrows 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, dont explain everything => the legislators own ideology and core constituency
Washington argues the more daughters you have the legislator is more likely to vote in
favour of womens issues (e.g. reproductive rights) or womens 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 politicians
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, were 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): bureaucrats 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 governments 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

Federalism
Optimal 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 doesnt 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 dont 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 dont 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 doesnt 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)

Education
Introduction:
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 childrens 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, todays 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 workers 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
education
Higher 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