Economics of the Public Sector - Theme 1: Introduction

Theme 1: Introduction to Public Economics

• Chapters:
  • Chapter 1: Introduction
  • Chapter 2: Political theory: Social justice and the state
  • Sub-chapters 3.1-3.2: Efficiency as a reason for state intervention
• Reference: Barr, N. (2020). The economics of the welfare state (6th ed.). Oxford University Press.

What is Public Economics?

• Public economics studies economic efficiency, distribution, and government economic policy.
• It analyzes the public sector and its interaction with the economy, addressing market failures like externalities and public goods.
• Topics include taxation and social security systems.

What is the Welfare State?

• Welfare Economics: The part of economics concerned with the effects of economic activity on the overall welfare of society.
• Welfare State: A state committed to ensuring that all its citizens have at least some minimum standard of living, including housing, education, and medical services.

Objectives of the Welfare State

• Three broad objectives:
  • Efficiency (allocative efficiency)
  • Equity
  • Administrative feasibility

Objective 1: Efficiency

• Macro-efficiency:
  • The efficient fraction of GDP should be devoted to welfare-state institutions (static efficiency).
  • The state should contribute to economic growth (dynamic efficiency).
• Micro-efficiency: Resources should be efficiently divided among different programs (cash benefits, medical treatment, education).
• Consumption Smoothing: Institutions should enable individuals to reallocate consumption over their lifetime.
• Risk Sharing: No one should face an unexpected and unacceptably large drop in their living standard.

Incentives

• Benefits should not have adverse effects on labor supply and saving.

Objective 2: Equity

• Relieving Poverty: No individual or household should fall below a minimum standard of living.
• Reducing Inequality:
  • Vertical equity: The system should redistribute towards individuals or families with lower incomes.
  • Horizontal equity: Differences in benefits should consider age, family size, etc.

Addressing Social Exclusion

• Social Cohesion: Benefits should depend on criteria unrelated to socio-economic status (e.g., child benefit, state pension).
• Dignity: Benefits should be delivered in ways that preserve individual dignity and without unnecessary stigma.

Objective 3: Administrative Feasibility

• Intelligibility: The system should be simple, easy to understand, and cheap to administer.
• Absence of Abuse: Benefits should be as little open to abuse as possible.

Challenges to Achieving Welfare State Objectives

• Globalization raises questions about the competitiveness of expensive welfare states in the global market.
• Demographic change, particularly aging populations, puts pressure on public finances.
• Changes in family structure challenge social policies designed for nuclear families.
• Changes in the job structure lead to increasing polarization between skilled workers and low-wage peripheral workforce.
• Rising expenditure on the welfare state is driven by higher demand for social protection, technological changes, and an aging population.

Public Sector Definition

• Public economics (economics of the public sector):
  • A field of economics that studies economic efficiency, distribution, and government economic policy.
  • It deals with the analysis of the public sector and its interaction with the economy, responses to market failure in the presence of externalities, public goods, taxation, social security systems, etc.
• Public sector:
  • Parts of the economy not controlled by individuals, voluntary organizations, or privately owned companies.
  • Includes government at all levels, government-owned firms, and quasi-autonomous non-governmental organizations.

Positive vs. Normative Economics

• The Public Sector operates through what is often known as “policy.”
• Normative questions:
  • What are the objectives of (economic) policy?
  • This question is normative and ideological.
  • Objectives can be defined in different ways and often require trade-offs; ideology puts different weights on different objectives.
• Positive questions:
  • By what methods are those objectives best achieved?
  • This question is positive and technical.
  • Once the objective of the policy is clear, it should be clear how to achieve it.
  • The market or the state is neither good nor bad and can be used in different instances.

Welfare State vs. Public Sector

• Welfare State: A state committed to ensuring that all its citizens have at least some minimum standard of living, including housing, education, and medical services.
• Public sector: Parts of the economy that are not controlled by individuals, voluntary organizations, or privately owned companies, including government at all levels: national and local; government-owned firms, and quasi-autonomous non-governmental organizations.
• The difference depends on interpretation; in this course, the terms are used almost interchangeably.

Political Theory and Views on State Involvement

Theories of Society

• Three broad types of theory:
  • Libertarian theories
  • Liberal theories
  • Collectivist theories

Libertarian Views

• Goal: Maximize individual freedom through support of private property and the market mechanism.

Natural-rights libertarians (e.g., Robert Nozick)

• Everyone has a right to their property if justly acquired (justice in holdings).
• State intervention is morally unacceptable unless it protects our person and property, including contract enforcement (‘nightwatchman’ state).
• Tax and redistribution are theft; only the individual has the right to choose how to spend their resources.

Empirical libertarians (e.g., F. Hayek and M. Friedman)

• The market cannot be unjust; it can have good or bad outcomes, but it will never be unjust; it is more of a force (like ‘Nature’).
• Striving for social justice is harmful.
• Insisting on freedom – political and economic; the more the government tries to redistribute, the greater the loss of individual freedom.
• The State should have a limited role: protection (from inside and outside), enforcing contracts, fostering competitive markets, very limited distribution (to alleviate destitution).

Libertarian Thinkers

• Robert Nozick (1938-2002)
  • Anarchy, State and Utopia (1974)
• F. A. Hayek (1899-1992)
  • The Road to Serfdom (1944)
  • The Constitution of Liberty (1960)
• Milton Friedman (1912-2006)
  • Capitalism and Freedom (1962)
    Free to Choose (with Rose Friedman, 1980)

Liberal Theories

• Three premises:
  • Capitalism is the most efficient system.
  • The costs of that efficiency are poverty and inequality.
  • Government can ameliorate those costs – a combination of capitalism and government action can jointly maximize efficiency and equity.
• The free market does not always lead to the best possible outcomes in the production and distribution of certain goods.

Utilitarianism

• The aim is to distribute goods (including goods and services, rights, freedoms, and political power) so as to maximize the total utility of the members of society.
• The utility of every individual contributes to the welfare of the whole society.

There are two aspects of maximization:

• Production and allocation of goods must be efficient.
• The distribution of the goods must be equitable (but not necessarily equal).

Rawlsianism

• The aim is social justice, derived from a process that everyone considers fair (veil of ignorance).
• Maximin rule – the state should maximize the position of the least well-off individual.
• Social justice is morally desirable, but it is also the only way for institutions to survive.

Principles of justice:

• The liberty principle: same basic liberties which cannot be taken away (speech, due process).
• The difference principle: inequality permitted only on the basis that it helps the worst off.
• If they are in conflict, the priority principle says that the liberty principle should be followed.

• Utilitarianism
  • According to utilitarians, a policy that would benefit anyone (rich or poor), without harming anyone else, increases Pareto efficiency and is desirable.
• Rawlsianism
  • According to Rawls, a policy must benefit the least well off in order to be desirable.
  • Hence, a Pareto improvement is not necessarily desirable as it is not necessarily just.

• John Rawls (1921-2002)
  • A Theory of Justice (1971)
• William Beveridge (1879-1963)
  • Beveridge Report (1942)
• John Maynard Keynes (1883-1946)
  • The General Theory of Employment, Interest and Money (1936)

Collectivist / Socialist Views

• Three central aims of socialists: equality (vertical equity), freedom, and fraternity (social cohesion).
• Collectivist writers/thinkers generally agree on the importance of equality.
• Equality of opportunity might be insufficient since substantial inequality of outcome might persist.

Criticism of the free market:

• Pursuit of personal advantage does not lead to the general good.
• The market is undemocratic.
• The market is unjust.

Democratic Socialism

• Both markets and the state should be able to coexist (mixed economy).
• State intervention helps deal with the negative effects of capitalism (‘taming’ capitalism).
• Democratic socialists, thus, do not reject capitalism completely but aim to achieve their goals by altering it.

Marxism

• The aim is not necessarily equality, but meeting needs.
• The market allows for the exploitation of labor and gives too much economic and political power to a small group of capitalists.
• The state needs to have the primary role in production and allocation.
• The central planning would guarantee freedom (i.e., economic security).
• On Democratic Socialism➔ Mixed economies allow for the survival of capitalism and, as such, are not acceptable.

• Karl Marx (1818-1883)
  • Capital (1867)
  • The Communist Manifesto (with Engels, 1848)
• Richard Henry Tawney (1880-1962)
  • Equality (1931)
• Richard Titmuss (1907-1973)
  • The Gift Relationship (1970)

Attitudes towards the Welfare State

• Natural-rights libertarians reject the welfare state as it is a threat to individual freedoms.
• Empirical libertarians accept only the residual welfare state with minimal redistribution (e.g., limit destitute).
• Liberals and most democratic socialists support the welfare state, although they differ on the extent of government intervention.
• Some democratic socialists see the welfare state as a step towards pure socialism.
• Marxists mainly reject the welfare state (it aids capitalism), although some accept that it improved the lives of workers.

Economic Efficiency and State Intervention

Aim of Public (Economic) Policy

• Question: Why are some goods provided by the state (e.g., education, healthcare) and some left to the market (e.g., food)?
• The reason can be found in the two broad aims of public policy:
  • economic efficiency
  • social justice
• These are the two justifications for state intervention.

Maximization Problem:

• Maximize: $W = W(U<em>A, U</em>B)$, subject to:
  1. Tastes – the utilities of individuals A and B are constrained by their consumptions of goods X and Y:
     • $U<em>A = U</em>A(X<em>A, Y</em>A)$,
     • $U<em>B = U</em>B(X<em>B, Y</em>B)$
  2. Technology – consumption is constrained by the production functions of X and Y that depend on the inputs:
     • $X = X(K<em>X, L</em>X)$,
     • $Y = Y(K<em>Y, L</em>Y)$
  3. Resources – the inputs used to produce X and Y are constrained by the total availability of capital and labor:
     • $K<em>X + K</em>Y = \bar{K}$,
     • $L<em>X + L</em>Y = \bar{L}$

Recap: Pareto Efficiency

• Pareto efficiency or Pareto optimality
  • A situation where no individual can be better off without making at least one individual worse off.
  • The concept is best explained with an example:
    • 2 goods in the economy: (1) apple and (2) orange.
    • Two consumers: Stefan and Francisco.
      • Stefan’s preferences: is indifferent between apples and oranges (oranges = apples)
      • Francisco’s preferences: prefers oranges to apples (oranges > apples)
• Preferences: Stephan (oranges = apples); Francisco (oranges > apples)
  • Is the following allocation Pareto efficient?
    • Stefan: an orange.
    • Francisco: an apple
  • If there is an opportunity for a Pareto improvement, then it is not Pareto efficient.
    • A trade can be made in which
      • Francisco gives Stefan the apple, and Stefan gives Francisco the orange.
      • Stefan is not worse off (as he is indifferent between the two, oranges = apples)
      • Francisco is better off (as he prefers oranges to apples, oranges > apples)
• Preferences: Stephan (oranges = apples); Francisco (oranges > apples)
  • Is the following allocation Pareto efficient?
    • Stefan: an orange and an apple.
    • Francisco: nothing.
  • Is a Pareto improvement possible?
    • No, Stefan will become worse off if he tries to give either the apple or the orange to Francisco.
  • Pareto efficiency does not necessarily reveal anything about whether an allocation is fair.

Conditions for Economic Efficiency

To achieve economic efficiency, three conditions must hold:

• Productive efficiency – the activity should be organized to obtain the maximum output from given inputs.
• Efficiency in product mix – the optimal combination of goods should be produced, given existing production technology and consumer tastes.
• Efficiency in consumption – a person’s consumption choices should maximize their utility, given the utility of others (the marginal rate of substitution must be equal for all individuals).

The Edgeworth box

• The Edgeworth box combines the indifference curves of two customers (A and B, or Stephan and Francisco).
• The total output of good X is equal to the length of the box, and the total output of good Y is equal to the width of the box.
• The number of goods that each individual gets is calculated from their origins $O^A$ and $O^B$.
• The contract curve $O^A O^B$ shows those combinations of X and Y at which the marginal rate of substitution between the two goods is the same for both individuals.
• If c is the initial allocation, Pareto improvements are possible.
• Move to d would increase the utility of B without affecting the utility of A.
• Move to e would increase the utility of A without affecting the utility of B.
• Any move from the point c to a point between d and e (including d and e) is a Pareto improvement.
• The question is, though, which points are socially optimal?

Efficiency and different theories of society: libertarianism

• Welfare is increased by any Pareto improvement.
• Natural-right libertarians accept any distribution on the contract curve.
• For empirical libertarians, any point on the contract curve between b and l is acceptable (if b and l show subsistence for individuals A and B).

Efficiency and different theories of society: utilitarians

• Welfare is increased by any Pareto improvement.
• The socially optimal point depends on whether utility is ordinally or cardinally measurable.

Efficiency and different theories of society: Rawls

• Welfare is increased by any move that makes the 'poorer' individual A better off.
• Any move to a point between d and e (including e but excluding d) is both a PI and RI.

Efficiency and different theories of society: socialism

• Welfare is increased by any move that increases individual A’s relative share of output (between f and k on the contract curve, assuming that the relative share is the same at f as in c).
• Any move to a point between f and e (including e but excluding f) is both a PI and SI.

Efficiency and different theories of society: conclusions

• An increase in efficiency has the same meaning in all theories of society.
• Welfare is increased under all theories of society by a movement from a point like c to a point between e and f (excluding f). This movement is SI and RI, and PI.
• For any of the theories of society, all first-best socially just distributions are also Pareto efficient.
• Efficiency in this case is a necessary condition for social justice.
• In a second-best economy, efficiency may be possible only at the expense of social justice.

A first-best economy - Characteristics

• Perfect competition
• No problems such as externalities, public goods, or increasing returns to scale.
• Perfect information on the part of buyers and sellers.
• Maximizing behavior in the context of well-behaved utility and production functions.
• Complete markets.
• No distortionary taxation.

Two Fundamental Theorems of welfare economics

• The First Fundamental Theorem shows that in a first-best economy, the operation of perfect competition will lead to a Pareto efficient allocation of resources to a point on the contract curve.
• The Second Fundamental Theorem shows that in a first-best economy, it is possible to reach any desired point on the contract curve by establishing a suitable set of initial endowments and then letting agents trade until a point on the contract curve is reached
• In a first-best economy, the state has no role except for redistribution.
• However, the first-best economy is only a benchmark against which to evaluate policy.

Deviations from first best

• Public goods and externalities (week 2)
• Imperfect competition, increasing returns to scale (week 3)
• Imperfect information (week 3)
• Non-rational behavior (week 3)
• Incomplete markets and incomplete contracts (week 3)
• Distortionary taxation (week 4)

Not including distortionary taxation, the deviations from first best are market failures.

• They are usually (but not always) corrected through state intervention.