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15.4 Review and Practice


In this chapter we examined the role of the public sector in the market economy. Since 1929, both the size and scope of government activities in the market have expanded considerably in the United States.

People demand government participation in three areas of economic activity. First, people may want correction of market failure involving public goods, external costs and benefits, and inefficient allocation created by imperfect competition. In each case of market failure, the shift from an inefficient allocation to an efficient one has the potential to eliminate or reduce deadweight losses. Second, people may seek government intervention to counteract irrational behaviors. Third, people often want government to participate in the transfer of income. Programs to transfer income have grown dramatically in the United States within the past few decades. The bulk of transfer payment spending is not means-tested.

Government activity is financed primarily by taxes. Two principles of taxation are the ability-to-pay principle, which holds that tax payments should rise with income, and the benefits-received principle, which holds that tax payments should be based on the benefits each taxpayer receives. Taxes may be regressive, proportional, or progressive. The major types of taxes in the United States are income taxes, sales and excise taxes, and property taxes. Economists seek to determine who bears the burden of a tax by examining its incidence. Taxes may be borne by buyers or sellers, depending on the relative elasticities of demand and supply.

Two broad perspectives are used to examine choices in the public sector. One is the public interest approach, which uses cost-benefit analysis to find the efficient solution to resource allocation problems. It assumes that the goal of the public sector is to maximize net social benefits. Cost-benefit analysis requires the estimation of benefits and costs that are not revealed in the marketplace. The second approach to the analysis of the public sector is public choice theory, which assumes utility-maximizing and rent-seeking behavior on the part of participants in the public sector and those trying to influence it. We examined two insights stemming from public choice theory: the problem of rational abstention from voting and the role of special interests.

Concept Problems

  1. Identify each of the following government programs as efforts to correct market failure, to promote or discourage the consumption of goods subject to irrational decisions, or to transfer income.

    1. Head Start, a preschool program for low-income children
    2. Sports leagues for children sponsored by local governments
    3. A program to limit air pollution generated by power plants
    4. Species preservation efforts by the government
  2. Public Broadcasting System (PBS) stations regularly solicit contributions from viewers. Yet only about 11% of these viewers, who on average have much higher incomes than the rest of the population, ever contribute. Why?
  3. Do you expect to benefit from the research efforts sponsored by the American Cancer Society? Do you contribute? If you answered “Yes,” then “No,” does this make you a free rider?
  4. Suppose the population of the United States increases. What will happen to the demand for national defense? What will happen to the efficient quantity of defense?
  5. How could a program that redistributes income from rich to poor be considered a public good?
  6. Local governments typically supply tennis courts but not bowling alleys. Can you give a public choice explanation for this phenomenon? How about a public interest explanation?
  7. Find out the turnout at the most recent election for student body president at your school. Does the turnout indicate student apathy?
  8. Some welfare programs reduce benefits by $1 for every $1 that recipients earn; in effect, this is a tax of 100% on recipient earnings. Who pays the tax?
  9. Suppose the quality of elementary education is a public good. How might we infer the demand for elementary school quality from residential property values?
  10. V.I. Lenin, founder of the former Soviet Union, wrote that “the State is a machine for the oppression of one class by another.” Explain whether Lenin’s view typifies the public interest or the public choice school of public sector choice.
  11. Sugar prices in the United States are several times higher than the world price of sugar. This disparity results from a federal government program that keeps enough foreign-produced sugar out of the United States to hold U.S. sugar prices at a high level. The program raises the price of all sweetened foods produced in the United States; it boosts food costs for the average household by more than a hundred dollars per year. Who benefits from the program? Why do you suppose it exists?
  12. The table on federal income tax rates facing various income groups suggests that the marginal tax rate in the United States has fallen since the 1993–1996 period used in the study of marginal tax rates and labor supply discussed in the Case in Point essay. What would your prediction be as to how this reduction in the marginal tax rate would affect the quantity of labor supplied in the United States?
  13. Given that we cannot have a perfectly accurate count of the votes in any election, is there any point in having elections at all?

Numerical Problems

  1. In an effort to beautify their neighborhood, four households are considering leasing a small section of vacant land for a park. For a monthly leasing fee, the owner of the vacant land is willing to arrange for some of the maintenance and to make the park available only to the four households. The demand curves for the four households (A, B, C, and D) wanting parkland are as follows (all demand curves are linear):

    Acres of Parkland Demanded per Month
    Price per month A B C D
    $100 0 0 0 0
    $75 1 0 0 0
    $50 2 1⅓ 0 0
    $25 3 2⅔ 2 0
    $0 4 4 4 1

    Draw the demand curves for the four neighbors, and show the neighborhood demand curve for parkland.

  2. Suppose the owner of the vacant land will provide for and maintain a neighborhood park at a fee of $125 per acre; the neighbors may lease up to 5 acres of land per month. Add this information to the graph you drew in Problem 1, and show the efficient solution. Are the neighbors likely to achieve this solution? Explain the problems involved in achieving it.
  3. The perfectly competitive blank compact disc industry is in long-run equilibrium, selling blank discs for $5 apiece. Now the government imposes an excise tax of $2 per disc produced.

    1. Show what happens to the price and output of discs in the short run.
    2. Now show the impact in the long run.
    3. Who pays the tax? (Note: Show quantities as Q1, Q2, etc.)
  4. A monopoly firm has just taken over the blank compact-disc industry. There have been technological advances that have lowered production cost, but the monopoly firm charges a price greater than average total cost, even in the long run. As it turns out, the firm is still selling compact discs for $5. The government imposes an excise tax of $2 per disc produced.

    1. What happens to price?
    2. What happens to output?
    3. Compare your results to your answer in Problem 3 and explain.
  5. The following hypothetical data give annual spending on various goods and services for households at different income levels. Assume that an excise tax on any of these would, in the long run, be shifted fully to consumers.

    Income range Average income Food Clothing Entertainment
    $0–$25,000 $20,000 $5,000 $1,000 $500
    $25,000–$50,000 $40,000 $8,000 $2,000 $2,000
    $50,000–$75,000 $65,000 $9,750 $3,250 $5,200
    $75,000–$100,000 $80,000 $10,000 $4,000 $8,000
    > $100,000 $200,000 $16,000 $10,000 $30,000

    Determine whether a tax on any of the following goods would be progressive, proportional, or regressive.

    1. Food.
    2. Clothing.
    3. Entertainment.