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Chapter 13 Public goods and tax policy Copyright 2007 Mc. Graw-Hill Australia Pty Ltd Chapter 13 Public goods and tax policy Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 1

Introduction • Observations – In 2005 the Australian government had recorded a cash surplus Introduction • Observations – In 2005 the Australian government had recorded a cash surplus of $13. 6 billion. – Most of the surplus was used to finance a generous income tax cut. – Some political and economic commentators argued that this surplus should have been used partly to effectively reduce the size of the government, which they believed to be too big. – Others demanded a radical tax reform of the taxation system. – Some also argued that the surplus should be used to improve public hospitals, literacy standards in the education system and the investment crisis in public infrastructure. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 2

Introduction (cont. ) • Questions – – How big, exactly, should government be? What Introduction (cont. ) • Questions – – How big, exactly, should government be? What goods and services should government provide? How should government raise revenue? How should the responsibility for providing these goods be apportioned among different levels of government? – Do the incentives that government faces lead to efficient decisions? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 3

Four different types of goods • Public goods versus private goods – Rivalry: the Four different types of goods • Public goods versus private goods – Rivalry: the extent to which consumption of a good or service by one person diminishes its availability for others. – Excludability: the extent to which non-payers can be excluded from consuming a good or service. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 4

Four different types of goods (cont. ) • Private goods: goods and services that Four different types of goods (cont. ) • Private goods: goods and services that are both excludable and rivalrous in consumption. • Common goods: goods and services (or resources) that are rivalrous in consumption and are nonexcludable. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 5

Four different types of goods (cont. ) • Collective goods: goods and services that Four different types of goods (cont. ) • Collective goods: goods and services that are excludable and non-rivalrous in consumption. • Public goods: goods and services that are both nonrivalrous and non-excludable. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 6

Classification of goods and services based on the properties of rivalry and excludability Rivalry Classification of goods and services based on the properties of rivalry and excludability Rivalry Non-rivalrous Non-excludable Excludability Excludable Rivalrous Public good (national defence, street signs) Common good (fish in the ocean, atmosphere) Collective good (pay TV, uncrowded toll road) Private good (cheeseburger, massage) Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7

Four different types of goods • Rethinking public goods – Technological change, privatisation and Four different types of goods • Rethinking public goods – Technological change, privatisation and globalisation allow markets to expand. – Some goods become public or private as a result of deliberate policy choice or collective human action. § Government allows some type of knowledge to be made exclusive with patents. § Government leaves open-source software in the public domain. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 8

Government provision of public goods • Free-rider problem – The incentive that arises to Government provision of public goods • Free-rider problem – The incentive that arises to not contribute to the provision of a good or service in situations in which individuals are able to enjoy the benefits of a good or service without contributing to its cost. • Paying for public goods – Not everyone benefits equally from the provision of a given public good or service. – Therefore, the most equitable way to pay for the public good or service is to tax people in proportion to their willingness to pay. • Example – Will Prentice and Wilson buy a water filter? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 9

Government provision of public goods (cont. ) • Example – Scenario § Prentice and Government provision of public goods (cont. ) • Example – Scenario § Prentice and Wilson own adjacent shacks along an isolated stretch of coast. § Both use septic tanks to treat household wastes and have experienced water shortages. § They can buy and share a new septic tank filtration device for $1000. § Wilson earns twice as much as Prentice. § Wilson is willing to pay $800 and Prentice $400. § The benefit, $1200 > than the cost, $1000. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 10

Government provision of public goods (cont. ) • Example – The outcome § Sharing Government provision of public goods (cont. ) • Example – The outcome § Sharing is efficient § Barriers to sharing the cost • Cost of negotiation • Free-rider problem • Reluctance to share information • Example – Will government buy the water filter if there is an ‘equal tax’ rule? • Example – Assume § There is a ‘non-discrimination’ tax rule. § A majority of the citizens must approve the provision of a public good. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 11

Government provision of public goods (cont. ) • Example – The outcome § A Government provision of public goods (cont. ) • Example – The outcome § A head tax will collect $500 each from Prentice and Wilson. § Prentice has a $400 reservation price, and will vote against it. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 12

Government provision of public goods (cont. ) • A head tax is a regressive Government provision of public goods (cont. ) • A head tax is a regressive tax. – Head tax § A tax that collects the same amount from every taxpayer. – Regressive tax § A tax under which the proportion of income paid in taxes declines as income rises. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 13

Government provision of public goods (cont. ) • A head tax rule will rule Government provision of public goods (cont. ) • A head tax rule will rule out the provision of many worthwhile public goods. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 14

Government provision of public goods (cont. ) • Example – Will the government buy Government provision of public goods (cont. ) • Example – Will the government buy the filter if there is a proportional tax on income? • Proportional income tax – A tax under which all taxpayers pay the same proportion of their incomes in taxes. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 15

Government provision of public goods (cont. ) • Example – With a proportional tax Government provision of public goods (cont. ) • Example – With a proportional tax § § Wilson pays $667 and Prentice pays $333. Both amounts are below their reservation prices. They would approve the filtration system. Economic surplus would increase • Wilson: $800 - $667 = $133 • Prentice: $400 - $333 = $67 • Total increase = $200 Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 16

Government provision of public goods (cont. ) • Thinking as an economist – How Government provision of public goods (cont. ) • Thinking as an economist – How does free riding affect the private provision of public goods? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 17

Government provision of public goods (cont. ) • Thinking as an economist – Why Government provision of public goods (cont. ) • Thinking as an economist – Why don’t most married couples contribute equally to joint purchases? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 18

Government provision of public goods (cont. ) • Thinking as an economist – Scenario Government provision of public goods (cont. ) • Thinking as an economist – Scenario § Beth earns $100 000 a year. § Bill earns $40 000 a year. – Observation § What would happen if they choose to contribute equally on all purchases? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 19

Government provision of public goods (cont. ) • Thinking as an economist – Observation Government provision of public goods (cont. ) • Thinking as an economist – Observation § Different individuals are free to consume whatever quantity and quality of most private goods they choose to buy, but in consuming public goods, jointly consumed goods must be provided in the same quantity and quality for all persons. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 20

Government provision of public goods (cont. ) • Thinking as an economist – Income Government provision of public goods (cont. ) • Thinking as an economist – Income elasticity of demand for public goods and services is greater than 1. – A head tax would reduce the economic surplus. – A progressive tax increases economic surplus. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 21

Government provision of public goods (cont. ) • Progressive tax – A tax under Government provision of public goods (cont. ) • Progressive tax – A tax under which the proportion of income paid in taxes rises as income rises. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 22

Government provision of public goods (cont. ) • Local, state, federal or global? – Government provision of public goods (cont. ) • Local, state, federal or global? – Local government will be more responsive to communities who elect them. – Local choices will reflect the unique preferences of the residents. – Some public goods, such as streetlights and fireworks, are best provided by local government. – Some government functions are not best performed at the local or even state level. – Provision of defence at the national level is appropriate due to economies of scale. – Externalities that transcend local boundaries provide an additional rationale for national and international agreement. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 23

The optimal quantity of a public good • The demand curve for a public The optimal quantity of a public good • The demand curve for a public good – To calculate the socially optimal quantity of any good, we must first construct the market demand curve for that good. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 24

Constructing the demand curve for a public good Price ($/unit) A public good demand Constructing the demand curve for a public good Price ($/unit) A public good demand curve is the vertical summation of the individual demand curves. 24 P 2 D 2 8 + 24 Price ($/unit) P 1 36 Q D 1 18 24 36 Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Q 25

Constructing the demand curve for a public good (cont. ) = Price ($/unit) A Constructing the demand curve for a public good (cont. ) = Price ($/unit) A public good demand curve is the vertical summation of the individual demand curves. 42 D = D 1 + D 2 P 8 36 Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Q 26

The optimal quantity of a public good • Example – What is the optimal The optimal quantity of a public good • Example – What is the optimal quantity of urban parkland? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 27

The optimal quantity of urban parkland Marginal cost $1000 s/hectare 200 140 80 Demand The optimal quantity of urban parkland Marginal cost $1000 s/hectare 200 140 80 Demand A 0 A* Hectares of parkland Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 28

Private provision of public goods • Advantages of using government to provide public goods Private provision of public goods • Advantages of using government to provide public goods – Cost of adding a tax is relatively low. – Minimises the difficulty in determining who will bear what share of the tax burden. – May be the only feasible provider. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 29

Private provision of public goods (cont. ) • Disadvantages of using government to provide Private provision of public goods (cont. ) • Disadvantages of using government to provide public goods – One size fits all approach will not satisfy everyone’s demand for public goods. – Many people may oppose mandatory taxation. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 30

Private provision of public goods (cont. ) • Some methods to use taxes to Private provision of public goods (cont. ) • Some methods to use taxes to fund public goods – Funding by donation § In January 2005, Australians gave more than $11 billion to private charities, many of which provide public goods to their communities. – Development of new means to exclude non-payers § New electronic technology makes it possible to exclude nonpayers from many goods. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 31

Private provision of public goods (cont. ) • Some methods to use taxes to Private provision of public goods (cont. ) • Some methods to use taxes to fund public goods – Private contracting § Some private organisations function much like ordinary local governments in providing security services, communal space and fire protection etc. – Sale of by-products § Many public goods are financed by the sale of rights or services that are generated as by-products of the public goods. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 32

Private provision of public goods (cont. ) • Thinking as an economist – Why Private provision of public goods (cont. ) • Thinking as an economist – Why do commercial television networks favour The OC over Inspector Rex? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 33

Private provision of public goods (cont. ) • Thinking as an economist – Assume Private provision of public goods (cont. ) • Thinking as an economist – Assume § § § The OC has 20% market share. Inspector Rex has 18% market share. The OC viewers are willing to pay $10 million. Inspector Rex would willing to pay $30 million. Detergent advertising pays for the show and chooses the largest audience. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 34

Private provision of public goods (cont. ) • Thinking as an economist – Outcome Private provision of public goods (cont. ) • Thinking as an economist – Outcome § The indirect financing of public goods may reduce the economic surplus. § Public control of programming may be inefficient. § The pay-per-view alternative limits the audience and reduces efficiency because the MC of another viewer is zero. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 35

Private provision of public goods (cont. ) • Observations – The mix in the Private provision of public goods (cont. ) • Observations – The mix in the public and private provision of public goods and services will vary by society and groups within society. – Technology for delivery and paying for public goods and services and people’s preferences will influence the mix of public and private financing of public goods. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 36

Private provision of public goods (cont. ) • Example – By how much is Private provision of public goods (cont. ) • Example – By how much is economic surplus reduced as a result of a pay-per-view charge? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 37

The loss in surplus from a pay-to-view fee • Pay-per-view • Fee = $10 The loss in surplus from a pay-to-view fee • Pay-per-view • Fee = $10 • 1 million viewers • Broadcast TV • No fee • MC of additional viewers = 0 • 2 million viewers • Loss in economic surplus • $5 million Cost ($/episode) 20 10 Lost surplus from $10 viewing fee 1 000 Viewing households Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 2 000 38

Private provision of public goods (cont. ) • Observations – Charging a positive price Private provision of public goods (cont. ) • Observations – Charging a positive price for a good whose MC = 0 will reduce the economic surplus. – The more elastic the demand, the greater the loss in economic surplus. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 39

Sources of inefficiency in the political process • Thinking as an economist – Why Sources of inefficiency in the political process • Thinking as an economist – Why does bill-splitting at your work Christmas lunch make the total restaurant bill higher? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 40

Sources of inefficiency in the political process (cont. ) • Thinking as an economist Sources of inefficiency in the political process (cont. ) • Thinking as an economist – Scenario § 10 people going to dinner agree to split the bill evenly. § You are choosing between ice-cream (price = $6; reservation price = $3) and cheesecake (price = $10; reservation price = $4). § Price to you is $. 60 for the ice-cream or $1. 00 for the cheesecake. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 41

Sources of inefficiency in the political process (cont. ) • Thinking as an economist Sources of inefficiency in the political process (cont. ) • Thinking as an economist – Economic surplus § Ice-cream = $3. 00 - $0. 60 = $2. 40 § Cheesecake = $4. 00 - $1. 00 = $3. 00 – All diners will order desert and have an economic loss of $6. 00. – If they had paid individually, no one would have had dessert. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 42

Sources of inefficiency in the political process (cont. ) • Pork barrel legislation – Sources of inefficiency in the political process (cont. ) • Pork barrel legislation – Pork barrelling § Enacting legislation and regulations whose total costs are more than the total benefit it creates, but that is favoured by a legislator because his or her constituents benefit from the expenditure by more than their share of the resulting extra taxes. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 43

Sources of inefficiency in the political process (cont. ) • Rent seeking – The Sources of inefficiency in the political process (cont. ) • Rent seeking – The socially unproductive efforts of people or firms to win a prize. – Inefficiency occurs when § The gains from a government program are concentrated in the hands of a few beneficiaries. § The costs are spread among many. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 44

Sources of inefficiency in the political process (cont. ) • Thinking as an economist Sources of inefficiency in the political process (cont. ) • Thinking as an economist – Why would anyone pay $50 for a $20 note? – The rules § Initial bid of $0. 50. § Succeeding bids must exceed the previous bid by at least $0. 50. § When bidding stops, the 1 st and 2 nd highest bidders must pay their respective bids. § The highest bidder receives the $20 note. § The second highest bidder gets nothing. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 45

Sources of inefficiency in the political process (cont. ) • Rent seeking – Example Sources of inefficiency in the political process (cont. ) • Rent seeking – Example § How much will mobile phone companies bid for an exclusive licence? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 46

Sources of inefficiency in the political process (cont. ) • Starve the government – Sources of inefficiency in the political process (cont. ) • Starve the government – What do you think? § Is it efficient to reduce government waste by reducing tax collections? Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 47

What should we tax? • The objectives of the tax system are to – What should we tax? • The objectives of the tax system are to – Raise sufficient revenue to finance public goods and services. – Minimise the side effects of the taxes. • Crowding out – The extent to which government borrowing leads to higher interest rates, causing private firms to cancel planned investment projects. Copyright 2007 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 48