ECO 321 PUBLIC FINANCE LECTURE NOTES, Instructor RENDE Week 1: Chapter 1: Economic Role of the Government History: Imagine a time without political government, with no sovereignty, laws, courts, established property rights, or contract. Human beings could live in such a condition, but life would not go well. As Thomas Hobbes famously put it in the text that stands at the beginning of classical Western social contract tradition: “In such condition, there is no place for Industry; because the fruit thereof is uncertain: and consequently no Culture of the Earth no Navigation, nor use of the commodities that may be imported by Sea;…. And which is worst of all, continuall feare, and danger of violent death; and the life of man, solitary, poore, nasty and brutish, and short” (Nussbaum, Frontiers of Justice, 2006, pp. 9-10) So in exchange for security, individuals enter a contract with the government to promote common well-being, including economic prosperity. But why does government engage in some economic activities and not others? Does the government do too much, too less? These are the questions economics of public sector is concerned. Throughout history, there has been different rationales suggested on the role of government and here are several: ~ Mercantilism: Government should actively promote trade and industry, with French origin and has roots in colonialism. ~ In response, A Smith wrote Wealth of the Nations: individuals pursuing their best interest also promote public interest. In response to mercantilist view, which promoted the idea that the government should be active in the economy (colonials), yet some people benefited from this others did not. Smith asked the question "can society ensure that those trusted to govern actually have the best interest of the public?" The intuition behind Smith's idea is simple; if there is a need for a commodity or a service which individuals value but not provided, then they will be willing to pay something for it. Entrepreneurs, always looking for such opportunities, will produce that commodity or service if the value to the consumers exceed its production cost. If there is any cheaper way of producing, the entrepreneur who discovers it will undercut the competition. In this view, there is no need for government to be actively involved in the economy. ~ This view was developed into full bloom by the doctrine of laissez faire, government should let private sector alone and competition (unchecked by the government) serves the public interest best.

~ The inequalities that arose in the 19th century also promoted other schools of thought on the role of the government: Marx, Owens and others. Marx, for instance, placed the inequity he observed in the society to private ownership of capital, and envisioned a role for the State for full ownership of goods used for production. But what kind of economic activities the government engages in? 1. Production of goods and services 2. Regulation and subsidization of private production 3. Purchase of goods and services 4. Redistribution of income by transfers (ie payments made not in return of goods and services) How about government failures? Under what conditions the policy implemented by the government does not promote public interest? Several conditions should be satisfied: 1. Limited information-Public authorities do not have full information on the policy and its beneficiaries. Example: disability insurance being abused by people while the government has only limited information on who is disabled or not. 2. Limited control over private market responses - People may react differently than what the program predicts. Example: Privatizing health care to private hospitals and increases in health bills as a result. 3. Limited control over bureaucracy - Designing the legislation is different than designing the implementation. Example: Environmental policies in Turkey. 4. Limitations imposed by the political process: Different groups with vested interest may impede or ease the implementation of public policies. Example: Gun control in the US. Achieving the balance between private and public sector: If markets fail in providing the goods and services needed by the public, should public sector step in? Some believe yes, some believe no. Two dominant views on limiting the role of government: 1. Deregulation: Reducing the role of the government in regulating the economy (examples: banking sector) 2. Privatization: Shifting the economic activities of the government to private sector (example: public utilities) What makes a government a government from public economics perspective?

The government is made of people who are elected (therefore accountable to the citizens within a electoral process) and has the power to impose "compulsion": giving up land for public roads, the right to force to pay taxes, and the government restricts individuals giving power others for similar compulsions: a citizen is not allowed to sell him/herself for slavery. Thinking like a public sector economics:

1. What is to be produced? Consider the choices between private goods (produced and consumed privately) and public goods (produced and consumed publicly).

2. How is it to be produced - produce publicly or privately, whether to use capital- or labor-intensive technologies? Consider raki, until recently, raki was produced by the government and now several privately owned companies produce raki using different technologies. 3. For whom is it to be produced? Some groups benefit from production of public good, while others do not. Consider the plans for the third Bogazici bridge. 4. How are the decisions to be made? In public sector, the decisions are expected to be made collectively, in private sector the decision relies on the firms. Collective decision is very complicated, as individuals differ in their view of what is best for the public. Public parks or public garage for cars? Nuclear power plants or environmental concerns? So it is important to consider the formation and implications of "social choices", which we will in later chapters. In addressing all these questions, an economist should be able to 1. Know what activities the public sector engages in and how these activities are organized. 2. Understanding and anticipating the full consequences of these governmental activities.

Private Goods

Public Goods

A

B

C

D

3. Evaluating alternative policies: we need to know not only the consequence of the current project, but also the consequences of alternative projects. 4. Interpreting the political process: How to explain the actions and policies selected? Economic Models: Controlled vs. uncontrolled experiments: While natural sciences have the ability to run controlled experiments, the economists usually have to rely on what we call as "uncontrolled experiments", different policies being implemented in different settings. For this reason, often economists rely on "models", simulating the real conditions by using simplified assumptions. Positive vs. Normative economics: What "is" vs. what "should be" When models are used to predict the change that may happen as a result of a policy change, the economists are said to use "positive economics". Example: "A 5% increase in cigarette-tax will reduce its consumption by 10%%." This is one example of "what is". When they try to understand consequences of different public policies, they engage in "normative economics". Example: "If the policy aim is to reduce the number of deaths caused by smoking, then increasing the tax on cigarettes should reduce such deaths." Moral of the story: Positive economics identifies gains and losses, while normative economics identifies the systematic procedures through which we can compare gains and losses. Week 2: Market Efficiency Recap of the last week’s lecture: A Smith and “Wealth of Nations”: The basic question of Smith’s work is this – can society ensure that those who are provided with the power of governing actually pursue public interest? Sometimes, those who govern pursue their private interests at the expense of public interest. The public interest, Smith claimed, is best served when each individual does what is in his or her own best interest. The intuition is simple enough: If there is a commodity (NB: commodity is something which is owned and can be exchanged in the market) or service that individuals value and are willing to pay for, then entrepreneurs searching for profits will utilize such opportunities. As long as what

people are willing to pay exceed the cost of producing that particular commodity or service, then an entrepreneur will produce it. Notice how, according to Smith’s view, no government body needs to decide whether a commodity should or should not be produced. It will be produced only if it passes the market test - willingness of consumers to pay exceeds the cost of producing. Nor does any oversight body is needed, any particular firm not producing at the lowest cost will be driven out of the market by its competitor, another firm willing to produce at a lower cost and willing to sell, thus, at a lower price. ~Welfare Economics and Pareto efficiency: Welfare economics is the branch of economics which deals with normative issues: the state of affairs as they should be in the economy. This entails most often evaluating alternatives, with their costs and benefits. But then the problem is: what is the rule to evaluate alternative scenarios? Most economists use a criterion, called Pareto efficiency, to evaluate the alternatives, which is the area of normative economics. Simply put, Pareto Efficiency holds when the current resource allocation is such that no one can be made better off without someone being made worse off. Here is an example: Consider the plans for building the third bridge on Bosphorus: drivers willing to use it may pay more, but some people will be worse off, as it means more roads, congested traffic in the neighborhood. How about imposing higher tolls on the bridges during rush hours? The additional proceeds could be used for additional booths, and everyone will be better off. But some people may also want to wait, rather than paying higher tolls. While it is difficult to sustain Pareto efficiency, the aim is to search for "Pareto improvements" by applying a package of policy changes: compensate those who loss by carefully identify the gains from the policy change. For the third bridge, the policy may choose to build the bridge and compensate the neighborhood by lower property taxes. The caveat with the Pareto principle is its individualist nature. It is concerned with each individual's welfare, not with the "relative" wellbeing of different individuals. It is not concerned with inequality. Thus, giving more to rich, while leaving the poor unaffected, would be still a Pareto improvement. Secondly, it is each individual's perception of his or her own welfare counts. Consider why this may not be a helpful guideline to proceed? Answer: “false consciousness”. The Fundamental Theorems of Welfare Economics:

Two of the most important results of welfare economics describe the relationship between competitive markets and Pareto efficiency. These results are called the fundamental theorems of welfare economics. The first fundamental theorem tells us if the economy is competitive, it is Pareto efficient (NB: Remember the conditions for competitive conditions: ideal setting with millions of producers and consumers, each so small that none has the power for price setting and all the agents in the economy have perfect information, concerning the goods and prices charged in the market and in which there are no externalities) The second theorem tells us the only intervention the government has to make into the economy is to redistribute initial wealth. Under the conditions of competitive market processes, every Pareto efficient resource allocation can be obtained with an initial distribution of wealth. That is to say, if the current conditions of resource allocation are not what we would like to have, all the government needs to do is to change distribution of initial wealth. There is no reason to abandon competitive market processes. Believe or not, this is a very powerful statement: In a decentralized system, all outcomes individuals attain are “Pareto efficient”, i.e., as long as the decisions of what to consume and what to produce are done by competitive market forces, then the economy is a stage where not one person can be made better off by making somebody else worse off. Only if by intervening to initial wealth (be that wealth education, health, or simply providing income at the start of life), the government can improve the outcome that individuals attain. Consider the paragraph above from the point of a retired person whose retirement funds are gone bankrupt because the company did not make any wise investment decisions. What do you think the fundamental theorem of welfare would suggest? Analyzing Economic Efficiency: In order to obtain Pareto efficiency in an economy, the theory requires three (3) conditions be met. The first is “exchange efficiency”, which is mainly how the goods and the services in the economy are distributed. Secondly, there should be “production efficiency”, i.e., the available resources in the economy should be utilized to their fully capacity, such that increasing production of one good cannot be possible without reductions in the production of another good. And lastly, there should be “product mix efficiency”, what is produced must correspond to the desires of consumers.

1. Exchange efficiency: Given a particular set of available goods, any distribution of goods among consumers cannot be achieved without making someone else worse off. That is,

there is no scope for trade as long as people’s trade-offs exactly matches what they have in hand. All competitive markets satisfy exchange efficiency.

2. Production efficiency: All resources available should be used to their full capacity, in other words, the economy cannot produce more of a particular good without reducing production of another good first. This condition entails that available inputs are being used in the best mix possible, given their prices and the technology. Example: if using 6 machinery and 3 employees will produce the good at the lowest cost possible, then the firm should not use 2 machinery, 6 employees.

3. Product mix efficiency: This is easy. What consumers want should be in line with what firms produce and vice versa.

What is the use of these two theorems? The main concern of public economics is to identify areas in which these two fundamental theorems fail and develop the programs and policies in which government can play a role in correcting market failures. Then the premise of public economics is not to question the reliability of these two theorems, but to identify the areas when they do not work at all. ~ What is the prescription then -- when does the government act? When the markets fail.

1. Failure of competition: when there is a single firm producing the good for the market, the conditions necessary for competitive process does not exist: prices are not equal to marginal revenue. An example would be "Tekel", Devlet Demir Yollari.

2. Provision of public goods: there are some goods that either the markets will not supply, or if they do, the supply will be in limited quantity. For example: National Defense.

3. Externalities: when a consumer's or a firm's actions affect another consumer or another firm, economists think these as "externalities". Two types of externalities:

a. negative externalities: when the action of one party imposes a cost on to another party (such as your neighbor's having a party which keeps you awake). Then there are

b. positive externalities: when a party's action confers benefit onto others (if you are living with other people, such as your family or your dorm mates, then you being a neat person benefits them as well). Any examples when government can step in to enforce positive externalities?

When there are externalities, the resource allocation by the market will not be efficient. Because people imposing negative externalities do not bear the full cost of their actions, they will continue to engage in these activities (your neighbors will continue to party for instance). Conversely, if individuals do not fully benefit from their activities, they will have little incentive to engage in activities with positive externalities. Example: Excessive fishing and fishing bans. Another example: smoking ban in public places.

4. Incomplete markets: Even though there are people willing to pay for the product, and even though the cost of production is below the value the consumers are willing to pay,

if the market does not exist, then we call this as 'incomplete markets'. Examples: Rare diseases, diseases which are not lucrative, diseases which are more prevalent among poor people. 5. Information failures: The private sector has no incentive to inform the consumers (food safety programs). 6. Unemployment, Inflation and Disequilibrium: One of the main indicators of private markets not working is high levels of unemployment, in which majority of people seeking work cannot find a job even though they are actively seeking. In this case, the government can step in to correct the problems in the labor market.

Week 3: Chapter 5 Efficiency and Equity The previous notes argued that one of the main consequence and also objective of government activity is to change the distribution of income. Evaluation of such activities depends on comparing the benefits and costs of any program designed to alter income distribution. But this is not always an easy task, because there are trade-offs between efficiency (how big is the pie) and equity (how equally pie is divided). Here is an example for efficiency and equity trade-off: Suppose the policy decides to support the poor by taxing the rich. Economic theory suggests that taxing the rich would reduce incentives to work harder, perhaps take risks for innovative ideas. While taxing the rich may benefit poor --by dividing the pie equally--, in the long run, it will reduce the incentive to work and make the pie smaller. Almost all public programs and tax policies face similar trade-offs and the questions that should be answered are (i) to reduce inequality, how much efficiency we should give up (ii) what is the importance attached to being “efficient” and “equal”. This lecture is about the ways in which these two questions should be answered. Analyzing Social Choices—but first several concepts:

1. Utility Possibilities schedule: the trade-offs between transferring utility from one individual to the other.

2. Social Indifference curves: how society makes trade-offs between utility levels of different individuals.

Starting from these two concepts, the idea for analyzing social choices becomes very similar to the analysis of individual choices.

Utility of Person A

Utility of Person B

Utility Possibilities Schedule

Social Indifference Curve Utility of Person A

Utility of Person B

Utility Possibilities Schedule

Social Indifference Curve

Utility Possibilities schedule has the bowed-out shape because of diminishing marginal utility; the shape says when Person A has very little income, we can increase her utility a great deal with a small decrease in Person B’s utility, but when Person A is much better off, we can increase her utility only a little extra with even a large decrease in Person B’s utility. Social Indifference curve provides an index showing the utility the members of a society, in other words, the level of social welfare corresponding to a particular set of levels of utility attained by members of society. Evaluating the Trade-Offs Using utility possibilities curve and social welfare function, Pareto Principle says that we should prefer the allocations in which at least some individuals are better off and no one is worse off – if some people improve their welfare and no other person’s utility decreases, then that particular program should be undertaken. It is easy to see Pareto principle working through social indifference curves but difficult to satisfy in real life. What are the difficulties? A. At Point B, second group is better off than their position at point A, but first group is worse off. The social indifference curves provide a stronger criterion: The social indifference curve with point B is higher (therefore provides more social welfare) than the social indifference curve with point A. This shows point B is preferred to point A. The shape that the social indifference curve takes give us some idea how the society may conceptualize the trade-off between efficiency and equity. Social welfare function with straight social indifference curves tell us one unit of utility gain of one group has the equal weight of one unit of utility loss of the other group (here is an example: a program that gives from the poor to the rich is equivalent in social welfare to another program which gives from the rich to the poor). In reality of course, people are concerned whether as a result of the public policy the

Utility of First Group

Utility of Second Group

Social Indifference Curves

A

B

poor is getting worse or better, so it is plausible to consider the social welfare function with social indifference curves as shown in the above figure (bowed-in shape). This shape tells us, the changes in utility of rich and poor groups are not equal. The last shape to be considered is L-shaped social indifference curve, here the idea is simple: a society can increase its social welfare only to the extent of an increase in its worst-situated person’s utility. What are the problems? A. Interpersonal Comparisons are difficult, and it is not clear who should be the judge in these cases. So, most often, the economists limit themselves by pointing out the winners and losers of a particular program. B. considering how different peoples preferences and choices are, it is difficult to claim that “society has a preference over this or that”. In dictatorship, this problem is moot, as whatever the dictator claims, the society is thought to prefer it as well. In democratic societies, there will always be contenders and dissatisfied individuals. Social Choice in Practice: In practice, the first attempt is to measure the net benefits (benefits minus costs) received by different groups. Second step is to ascertain whether the project is Pareto improvement or not.

1. If the project is Pareto improvement, than it has to be undertaken 2. If the project is not Pareto improvement, then some gain, some lose. The decision

criterion is to look at two summary statistics: efficiency – summing up the gains and losses of each individual and equity – some measure of overall inequality in the society.

a. If a project has net gains (increase in efficiency) and reduces measured inequality, then it has to be undertaken.

b. If a project has net losses (reducing efficiency) and increases measured inequality, it should not be undertaken

c. If there are net gains, but also increases in inequality – the question becomes: how much extra inequality is society willing to accept for an increase in efficiency?

Measuring Benefits: One way of understanding the level of benefits a program may entail is to look at “willingness to pay”. We simply ask how much an individual would be willing to pay to be in one situation rather than another. NB: Willingness to pay is not the same as “has to pay”. From this point, a demand curve can be plotted using the information on the willingness to pay. This special demand curve, called as “compensated demand curve”, shows only how much the person is willing to buy that particular commodity, if the price of the commodity changes. The area between the actual price and the compensated demand curve shows “consumer surplus”, i.e., the benefits the person is getting from that particular project. Measuring Inefficiency:

Measuring inefficiency is similar to measuring benefits: how much the person is willing to pay to eliminate that particular program or policy – one example is cigarette taxes. If the person is willing to pay X amounts of YTL instead of paying cigarette tax each time she buys cigarettes, and imposing X amounts of YTL once to all purchasing cigarettes and eliminating taxes on cigarettes discards the inefficiency associated with taxes. How to understand the distributional impact of a policy?

A. Poverty index: the percentage of people who earn or spend below a certain threshold. B. Poverty gap: the distance from the poor to the threshold. It simply asks – how much

income is needed to bring the poor above the poverty threshold. Three Approaches to Social Choices: compensation principle, trade-offs across measures, weighted net benefits. Compensation principle: aggregate willingness to pay exceed the cost, the project should be undertaken. But this principle does not pay too much attention to distributional concerns. Trade-offs across measures: The public decision-making bodies should evaluate the trade-off between increases in efficiency and increases in inequality or vice versa. Weighted net benefits: If aggregate net benefits (sum of benefits minus costs) is positive, and if the poor are net beneficiaries and the rich are net losers, and the principles tells that the project should undertaken. Often, the matters are not as simple as that. For instance, what if the policy does not help poor, make the rich loser, but benefits the middle-income? One can assign weights to different groups affected by the project, and while the weights will be subject to considerable debate, still it gives a framework within which the project can be formulated. Week 4 Chapter 6: Public Goods and Publicly Provided Private Goods There are many goods and services a government provides to its citizens. Consider education and national defense. What is the difference? One of the ways to evaluate the provisions of the state is to consider the specific traits (features, characteristics) of the goods and services provided. One way is to consider “rival vs non-rival” features. Rival consumption means the consumption of a particular good by somebody affects the level of consumption of the same good by others. Here is a very simple example: When somebody eats the only banana left means people living with this person can’t eat the same banana. Consumption of that banana reduced the banana consumption of others

in the households. Now a more complicated example: Consuming too much water for various purposes (washing cars, excessive watering) means other people will not have enough water for their needs. Non-rival consumption, as expected, is the opposite; consumption of that good leaves the others’ consumption unaffected. Breathing is a good example of “non-rival consumption”. Watching TV is another good example, you can watch TV 24 hours a day, and your “TV consumption” has no effect on other people’s TV watching time. Another trait to consider for characteristics of goods and services is to understand whether the consumption of that good is ‘exclusive’ or “non-exclusive”. The idea with exclusion & non-exclusion is simple: Can you exclude/prevent/ allow not another person from consuming a particular good or service? Building fences around parks is an example; it keeps some people from getting in. Not providing services on the basis of people’s defined characteristics (as they did to Blacks during apartheid in South Africa) is another example. So food for thought: weather forecasts. How would you describe them? Always remember: classification along “exclusion” and “rival” dimensions depends on the state of the technology and market (as exemplified by apartheid example, sometimes it depends on politics as well). Public Goods and Market Failures When is there a need for the provision of public goods? Usually the need appears when there is a market failure. Consider the following: charging for a non-rival good is inefficient, it results with under consumption. However, without a charge for a non-rival good, there is no incentive to supply it. So, we have a market failure: underconsumption + undersupply (inefficient use of resources). Paying for Public Goods If exclusion is possible, even if the good is non-rival, then charging user-fees may be an option. Consider the tolls (fees paid) at the bridges in Istanbul.

Bridge capacity

Price

Demand Curve

P

Q* underconsumption

A monopoly owner building the bridge will charge a toll to maximize revenue, when government provides the bridge, other concerns enter the calculation: the toll could just cover the costs, equity versus efficiency, and alternative ways of financing. Free Rider Problem Free rider problem occurs when some of the beneficiaries of the program fail to pay for the costs. It is most prevalent in “non-exclusion” cases, for instance, people who should have but did not pay for taxes, still educate their children in schools built by tax revenues. What is the solution? Theoretically, free rider problem can be solved only with price discrimination. But perfect price discrimination is impossible to apply in reality, so price scales may help. Pure and Impure Goods Pure Public Goods: Marginal cost of providing it to an additional person is 0, and it is impossible to exclude people from receiving the good or the service. Graphically the relationship between Marginal cost of use and ease of exclusion can be depicted as follows: Public sector providing private goods: Sometimes public sector (government) provides goods and services that are excludable and rival. For instance consider water for use services. It is rival because how much one individual consumes affects the level of water consumption of others. Furthermore, use water services are excludable, some people may not receive water supply at all. Again if there is no charge for the service, there may be overconsumption. Three methods of rationing private goods provided by the public sector:

Ease of exclusion

MC of additional use

Ambulance services

Pure private goods: health

Congested highways

National Defense

1. User charges. In this case the beneficiaries pay for the service. The advantage is only

those who benefit bear the cost, the disadvantage is charging for the service may lead to underconsumption. And administrative costs may add to costs.

2. Uniform Provision: Universal provision of the service or the good to all people. Its advantage is uniform provision saves administrative costs, but the disadvantage is it leads to some underconsume and some overconsume the good or the service.

3. Wait-lines: In this case, only the people who truly need wait for the service provision. The advantage is the goods and the services are allocated in a way that does not necessarily benefit the wealthiest. The disadvantage is time is wasted.

Efficiency Conditions for Public Goods What is the most efficient amount to provide a public good? One way to measure is to ask people what they are willing to give up and what they are willing to pay. The first helps to construct a supply curve, summarizing the amount of goods that should be given up to get one more unit of public good and the second one summarizes the marginal willingness to pay – tax price. The theory predicts that the equilibrium quantity will be the efficient amount to provide. One last note: In public goods, we can’t separate out efficiency considerations (how the resources are being used) from distributional concerns (who gets what). Any change in the distribution of income, say a change in income tax structure, will be accompanied by corresponding changes in the efficient levels of public goods production. Week 5: Chapter 7 Public Choice The topic of this chapter is the ways in which expenditures on public goods (the definition of public goods: non-rival and non-excludable) are determined through a political process. The difference between private and public good allocation mechanism should be obvious: private good allocations are done by the price mechanism, whereas public good allocations are subject to different producers. In the private good market, an increase in the price of the good signals the consumers to substitute that particular good with another one, and to produces that to increase supply. The price system simply conveys information about

resource allocation to producers and consumers. Decisions about the resource allocation in the public sector are made in a quite different manner. Individuals vote for people representing the voters, these elected representatives in turn vote for a budget specifying the priority areas which may or may not coincide with the voters’ preferences in the first place. The problem is simple: how to ensure that preferences will be revealed correctly? While individuals may express their preferences in the market just by purchasing preferences, there is no comparable way that individuals can express their preferences for goods and services provided by the public sector. One reason is that tastes differ across individuals, preferences over the provision of public goods and policies vary widely. The other reason is the possibility of free riding. Individual preferences for public goods: Other sources of difference between individuals regarding the provision of public goods are incomes and taxes. Well-off individuals with their higher incomes normally prefer to spend more both on private and public goods. In case of private goods, well-off and poor typically pay the same price. But when the financing is done by taxation, well-off individuals pay a higher share of the cost of the provision of the public good. Tax price is the additional amount an individual must pay when government expenditures increase by one dollar (or unit of local currency). A higher tax price by itself means well-off people will prefer a lower level of expenditures on public good. Note how with higher income, the demand for public goods is higher, but also with tax price, the desired demand is lower for well-off people; the net effect of high income on demand for public good is thus ambiguous. Consider first a situation where there are N people and each must pay the same amount “uniform taxation”. In this case the tax price is simply 1/N and the tax payment to the government is G/N. With “proportional taxation” everyone pays the same share of income

as tax. If Ŷ is the average income, NŶ is total income, t x NŶ is the total government revenue. Since this must equal government expenditures G = t x NŶ, thus the tax rate is t = G/ NŶ. A progressive tax system is one in which tax payments increase more than proportionately with income, a regressive tax system is one in which they increase less that proportionately. Individuals with different incomes face different budget constraints, which in turn affects the preferred levels of public goods expenditures. With proportional taxation, poorer individuals face lower prices and their preferred level of expenditures is higher. But poorer individuals also have lower incomes and with lower incomes, they demand less public as well as private goods. With uniform taxation, there is only an income effect, so high-income individuals will prefer higher levels of public expenditure. With progressive income taxation,

lower-income individuals will face a lower tax price than with proportional taxation, so their preferred level of expenditures will be even higher than with proportional taxation.

The Problem of Aggregating Preferences In the private markets, the firm does not have to balance the claims and interests of one group against the other. In the public sector, on the other hand, decisions are made collectively, when a politician votes to increase expenditure on some public good, it is not as if he has to pay for the good himself. The politician’s vote is supposed to represent the interests of his constituents, but their opinion is likely to differ. Since different people want different things, how, out of these divergent views, can a social decision be made? With a dictator, it is easy, the dictator’s preferences prevail. For democracy, we have voting, the simplest one being “majority voting”. Majority Voting and the Voting Paradox Majority voting is when the option with most of the votes is selected. Sometimes, however, majority voting does not yield a single winner. Assume “>” represent the preference; A > B means A is preferred to B. With three options and three voters, simple majority voting may lead to an outcome where they may not be a single majority voting equilibrium. Suppose three individuals 1,2,3 voting on three different plans A,B,C. Their preferences are as follows: V1 : A>B>C V2 : C>A>B V3 : B>C>A If you count how A and C are preferred, you will se C>A twice, therefore C wins against A. if you count the times which A>B, you will see twice, therefore in between A and B, A wins. Since C >A>B, you may decide C is the winner. But a comparison of C and B shows that B>C; therefore C can’t be the winner. This is referred to as voting paradox. Often to avoid such results, the voting process is designed sequentially. For instance, voters first compare A to B, the winner of this is put against C and so forth. In that case, who controls the agenda becomes very important. Note also how if individuals realize there is going to be a particular sequence of voting, they may not reveal their true preferences and vote strategically. This analysis leads to two questions: First are there voting rules that will ensure a determinate outcome for any vote? Second, are there any conditions under which simple majority voting will yield a single outcome? Arrow’s Impossibility Theorem

An ideal political mechanism should have four characteristics: A. Transitivity

Using the preferences of the three voters above, transitivity is if A>B>C, then it can’t be C>A.

B. Non dictatorial choice One person’s preference between A and B can not determine the outcome, unless all other people are indifferent between A and B. C. Independence of irrelevant alternatives If the preference is between A and B, and the outcome is A>B, then including C to the available choices should not result with B>A. D. Unrestricted domain The rules above should work for every possible pattern of individual preferences. What Arrow’s impossibility theorem shows is the impossibility of designing an “all purpose” policy, constitution if there are comparisons to be made among and conflicts exist between individuals.

None of the available voting systems satisfy these at the same time; for instance rank-order voting does not satisfy C, simple majority voting fails in A. Single-Peaked Preferences and Existence of a Majority Voting Equilibrium While single majority voting does not satisfy all of the conditions above, under certain conditions it does yield a determinate outcome. If the relationship between utility and quantity of public goods exhibit a single-peak then we can expect a determinate outcome. If, however, the relation exhibits more than a single-peak, then the outcome is once again indeterminate. Consider the following example: if the level of expenditure on public education is below a certain minimum level, a rich individual may prefer sending her children to private schools. If he does this, any increase in expenditures on public goods simple increases his taxes; she gets no direct benefits. Thus her utility decreases with increases in government expenditures up to a level at which she decides to send her children to public school. For this individual, high level of expenditure is preferred to no expenditure but no expenditure is preferred to intermediate level of expenditure. There may be no voting equilibrium in this case. Equally important, for most distributional issues, there will not be majority voting equilibrium.

Tax Scheme A B C

Poor 20% 18% 17%

Middle 20% 18% 21%

Rich 20% 23% 22%

Suppose three groups, Poor, Middle and Rich are deciding between three tax schemes, A (strictly proportional), B(heavy on rich) and C (best for poor, worst for middle class). In this case, poor and middle class can propose plan B, but the rich may propose poor to vote for C. In return if C will be voted by poor and rich classes, the middle class may propose A only. Since it is in the interest of the rich A may win. Politics and Economics Why Do Individuals Vote? Since one person’s vote can not change the outcome, why do individuals vote? One explanation is civic duty, the second explanation is individuals derive utility from voting. The arguments above assumed that individuals are well informed about the choices, but this is not always the case. There may be people who depend on the choices others make for them, thus free ride if a politician representing their interest is elected. Sometimes special interest groups can attempt to lower the costs of voting and information, particularly for those who are likely to vote for them. Chapter 9 Externalities and the Environment Externalities happen whenever an individual or a firm undertakes an action that has an effect on another individual or firm for which the party affected from that action does not pay or is not paid. This causes inefficient allocations in the market. For instance, consider a firm polluting the environment, especially when the cost of cleaning is high. There will be large social benefits, but the firm has no incentive to reduce its level of pollution. In this lecture, our attention will be on the actions that affect the others negatively, i.e., negative externalities. Not in all cases however, the actions result with negative effects, sometimes people benefit from the action of others. These are called positive externalities. Why would externalities cause inefficient market allocation? If the parties responsible for the negative externality do not pay for it, then the cost of removing the externalities will not appear under production plans, i.e., there will be an overproduction of the goods producing negative externalities. Similarly for the positive externalities there will be undersupply. Another important class of externalities arises from what is referred to as “common resource problems”. The central problem in common resource problems is that access to the resource is not limited. Consider overfishing, or over grazing of animals. With each additional boat, or cattle, the available fish or graze for the others is reduced.

The distinction between public goods and externalities is a bit fuzzy. It is difficult to make a distinction between public goods and externalities as in some cases both are non-excludable and non-rival in consumption (pollution, lighthouse). However, public goods are intentionally

produced to provide benefit to a community, whereas externalities are the unintended consequence of an activity that an individual or firm undertakes for its own benefit.

Private (Sector) Solutions to Externalities

1. Internalizing Externalities: These are the cases when the externality is taken into consideration by the unit which is most affected by the externality. If keeping an apartment clean is beneficial for everyone, then the homeowners can collect fees from all of the units. The problem here is the free-rider problem, some people may benefit without contributing at all. Internalizing an externality depends mostly on whether the participants know each other to the extent that there is an enforcement mechanism for the ones who may shirk.

2. The Coase Theorem: Externalities can also be dealt with assigning “property rights” for what was once “common resource property”. The idea is simple – the right to control the asset increases the probability of the efficient use of that asset. Consider the forests. Coase Theorem predicts that forests owned by private individuals are protected better against externalities, such as overuse of forest products. Note however, the assignment of property rights need not to be a single individual. Sometimes group of individuals can claim the right to use the common resource within an agreement and restrict overuse of the common resource. Community forest management in rural Nepal and India and fisherman in Alanya, Turkey are the well-known examples. Coase theorem simply implies that in the presence of externalities, the parties will agree to some set of rules in order to internalize the externality.

Coase Theorem: as long as bargaining costs are small and the owners of resources can identify and prevent the source of damages, an efficient solution to the problem of externalities will be achieved by assigning property rights. The efficient solution will be achieved regardless of which party is assigned the property rights.

3. Using the Legal System: Even when property rights are not well-defined, the legal

system can protect against externalities. One well known example is the damage to the nature. The book talks about the Exxon Valdez spill in Alaska, dated 1989, with pictures following:

In Exxon Valdez case, the spill area had no legal owner, but on the basis of “existence values” of the species, the loss of fisherman and the tourist industry, the Court ordered Exxon to pay for the damage. One may argue that such payments for cleanups are inefficient solutions, especially if the cost of cleanup is higher than the incentive to avoid spills. Failures of Private Solutions While property rights, internalizing the externalities or using the legal system may be solutions for goods and services that may resemble a private good, in many cases externality problem involves a public good, for which it may be very costly to exclude anyone from enjoying the benefits or incurring the costs. Imperfect information may prevent to reach to an agreement, free-rider problem may prevent the options of internalizing the externality, or there may be transaction costs in using the legal system. Public Sector Solutions of Externalities These solutions fall into two broad categories; market-based solutions and direct regulations. Market-based solutions are about modifying the incentives, regulations are about mandatory rules that all involved parties are required to follow.

Market Based Solutions provided by the Public Sector

1. Fines and Taxes This is the simplest form of changing the incentives: anyone who commits the deed pays for it. The fines are applied in such a way that the cost of the firm is equalized with the cost to the society, called as “Pigouvian taxes”. If these costs can be computed correctly, the fine imposed is expected to rectify for the externality. In response the firms may change the level of production or the production technology so not to pay the fine. While administrating and monitoring fines have always been difficult, one may argue that at least fines imposed increases revenues of the government.

2. Subsidizing Pollution Abatement In this case, the firms who adopt green/ecological technology are supported by the government. The problem in this case is how responsive the firms may be to the subsidy. By subsidizing the firms with environmentally friendly production technologies, the firms creating the externalities may opt to continue to impose externalities. It must b obvious by now, in such cases, subsidies to “good practices” are preferred to “fines to bad practices”.

3. Marketable Permits This is possibly the most popular market-based solution offered by the governments (see EU environmental policies). In this case, the government allows all firms to “pollute” only up to a point. Any firm below its limit has the ability to trade its permit with any firm above its limit. In this case, firms with good practices (i.e., imposing negligible externalities) gain extra revenue by selling the marketable permits. Compared to imposing fines, marketable permits have the advantage of leaving the level of pollution to firms, but require at the beginning of assigning permits to the firms, the government should know the true level of externality created by the firm. There are two problems with the permits approach, especially for environmental externalities. One is the punishment of “good practices” – the firms adopting green technology will have a harder time to reduce their pollution level, thus trade the permits in the market. Second problem is more subtle, but relevant: permits work only when the locations of the firms are close enough to have an effect on the overall level of pollution. Non-Market Based Solutions for externalities by the Public Sector

1. Regulation: Most economists believe that market-based solutions provide the most promise for curbing environmental externalities, but governments traditionally has relied upon direct regulation. The plus sides of regulation include that firms are prohibited from emitting more than a given level of pollution, then regulations may be set for the maximum level of pollution. With fines, what the government needs to know is the cost of reducing the pollution. For this reason, regulation provide little or no inventive for firms to reduce pollution below the standard that has been set, regardless how low the cost of reducing pollution may be.

In case of environmental regulations, there should be a distinction between “performance-based regulation” and “input regulations”. Performance-based regulations are imposed only on the final outcome, whereas input based regulations are on the inputs used in the production process. Whenever it is feasible, the focus is on performance, wither for regulations or market-based mechanisms brought by the government. However, input based regulations are easier to monitor.

2. Innovation: One of the main reasons for regulations is that they address directly the direct address of concern – the level of pollution, and in doing so, they may induce innovation for new ways of producing with less pollution. How to induce innovation and the scope of innovation are open to debate: some believe that the industry should be forced to innovate (mostly non-economists), and others believe that the market mechanism will bring its own incentives to innovate (mostly economists). In practice, innovation may depend on many other factors – rather than spending money on innovation, the firm may opt to argue its case in the courts. In other cases, the firms may rely on other factors such as political backlash, should they be shut down, not on innovation.

3. Information Disclosure: This is simply the case of “finger-pointing”. The government, rather than relying on other mechanisms, just announces the potentially harmful substances in the production process. Public pressure on the firm may be a credible threat if the consumers are sufficiently informed and engaged. There is of course the risk of “misinformation”, in that what the public may choose to believe may not be what the real pollutant is.

Compensation and Distribution The discussion so far has focused on “efficiency” of alternative ways of controlling pollution (externalities). But much of the debate revolves actually around the distribution – who bears the cost of pollution. The systems of regulation have different distributive consequences. In some such as fines, the firms directly bear the cost, in “subsidy” programs, it is the tax payers. Thus, firms clearly prefer the subsidy programs. Why would governments still insist on subsidizing the environmentally friendly production processes? One reason is compensation to the “losers” of the externality are never paid, partly because the information is not available, but mostly because the ones who benefit form the externality are more organized. Implications for Income Distribution

1. Who Benefits?

Poor neighbourhoods benefit more from pollution abatement than high-income neighbourhoods as poor neighbourgoods tend to be more polluted (Cropper and Oates, 1992). Therefore, lowering the level of air pollution may lead to a more equal distribution of real income, ceteris paribus.

Benefits of environmental programs that enhance the quality of recreational areas tend to benefit high-income families who are the main users.

2. Who Bears the Cost

Pollution abatement measures are costly to implement. As we saw, they increase the cost of production which may lead to production reduction, and therefore have a negative impact on input markets, e.g. layoffs.

Increased output prices (e.g. cars because of safety and pollution regulations). While this is desirable from efficiency point of view, buyers are worse off. If the majority of consumers of a good are wealthy, that will tend to make income distribution more equal.