Market Failure and Public Finance
|
Per
Unit Excise Subsidies vs. Ad Valorem Subsidies (or Taxes) |
Are
Payroll and Sales Taxes Proportional or Regressive Taxes? |
Market Failure and Public Finance
Free Riders Who Don't Have a Heart
Gary Galles,
Students typically understand the concept of free riding rather easily, but are often unable to appreciate the many forms it takes. To expand their abilities to apply the analysis, I have found a simple example from the card game "Hearts" to be helpful.
In the game the object is to get as few points as possible, where each of the 13 hearts taken in a "trick" is worth one point, and the Queen of Spades is worth 13 points. The one exception, sometimes called "shooting the moon," occurs when a player gets all 26 points possible in a hand, in which case every other player gets 26 points, or else the player with 26 points subtracts them from his total.
When a player decides to try to "shoot the moon," stopping him has public good aspects in that all the other players gain, but it also has a cost (because you get the points), leading to the desire to free ride and let someone else bear the costs. This concept can be used to introduce the standard public goods/free rider problem in a memorable fashion and to illustrate other conclusions that also generalize. These conclusions include the fact that people are more willing to bear the costs when it is less expensive to do so, for example, when one heart will be taken rather than possibly the Queen of Spades, or when later in the hand, as more information is revealed, it is more certain that if they don't stop it, it won't get stopped. Additionally, the results are often inefficient because what could have been stopped was not; future retribution is a consideration since opponents can dump "taxes" on you later, etc.
If further explanation seems necessary, you can then do the same sort of thing with group class projects, which can also be used to begin introducing some theory of the firm.
Shedding Light on Public Goods
Russell Shannon,
For "private" goods such as hamburgers and TV sets, the exclusion principle works. If I eat a hamburger, you can't have it but must buy your own. This good is both rival and exclusive. While I might invite you to enjoy The Cosby Show with me, I can instead lock my door, pull down the blinds, and watch it alone. Although the good is somewhat nonrival, exclusion is still possible.
But some goods are not like that and must inevitably be consumed in common. For example, suppose the White family buys a piece of land in an undeveloped area and builds a home. Then the Brown family buys the lot next door and builds a home of their own. One evening after supper Walter White and Bruce Brown get together and decide to put up a light at the street on their property line. The light provides illumination and protection for both families, and so is nonrival and nonexclusive.
Then along comes the Green family. They buy some land across the street and put up their dream home. One afternoon Walter and Bruce saunter across the street, taking some freshly‑baked cookies to welcome Greg Green and his family to the neighborhood. "And by the way," Walter mentions, "I'm sure you've noticed the convenient and attractive light we've erected for our illumination and safety." Bruce quickly adds with a cheery smile on his face, "Since you cannot be excluded from enjoying the light's benefits, we think it would be grand if you'd chip in and help us pay the electricity bill. You might even replace the light bulb from time to time."
This scenario has two possible outcomes. (a) Greg Green may have a sense of community spirit and agree to the proposal. Then all three families will dwell together happily ever after. (b) However, Greg may not be the gregarious sort and refuse. He will choose to be a "free rider." Lacking the power of government to tax, Walter and Bruce will be unable to compel a contribution. They might even take back their cookies.
Such a light, like national defense and police protection, is a "public" good. Once provided for one, it is unavoidably available for all. Financing such a good through taxes may be the only way to achieve an optimal amount. Needless to say, however, there are still many difficult details to determine, such as the proper number of missiles and Marines. The market system is clearly not apt to provide an "efficient" solution, but it is not necessarily the case that the political system will either.
An Example of an Intermediate Benefit from a Public Good
Wade L. Thomas,
The classifications of the benefits and costs from public goods are many: real or pecuniary, inside vs. outside, direct or indirect, tangible vs. intangible, and final vs. intermediate. Examples of an intermediate benefit are hardest to come by. A popular public finance text uses weather forecasts as an intermediate benefit to aviation and family picnics. These benefits are good, but there still exists a haze around how certain publicly provided or produced goods or services manifest themselves, perhaps quite accidentally, as intermediate inputs in the production of some final output.
The U.S. Postal Service's development of the ZIP (Zone Improvement Plan) code to identify postal delivery areas is an example of something that was designed to improve mail delivery, which has a public good aspect to it. The emergence of privately operated parcel and mail delivery firms such as the United Parcel Service, Purolator, Federal Express, etc., creates rivals for the independent public enterprise of the U.S. Postal Service. Those rivals realize benefits from the Postal Service's time, effort, and cost associated with developing ZIP codes. Private carriers can procure a ZIP code directory at low cost and use it as a model for identifying delivery areas, thereby avoiding the cost of developing their own system. Clearly, ZIP codes present an intermediate benefit to private mail and parcel carriers, mainly by lowering the information cost associated with delivering the final service.
Beyond this example is that of telemarketing surveyors who often use ZIP codes to identify the geographic locations of survey respondents. The list can go on and on, but the point is made: a public enterprise developed the ZIP code as part of the system for providing mail delivery as a final output, but private enterprise can make use of codes i.e., enjoy an intermediate benefit, in producing and delivering other goods and services.
John Neal, Lake‑Sumter Community College
When I introduce the two characteristics of public goods that distinguish them from private goods‑‑nonexcludibility and joint consumption‑‑I use a helpful prop, one red delicious apple. The trivial case of a person selling apples offers the opportunity to show how easily a seller can exclude others unwilling to pay the costs of production from consuming his apples. I then start eating the apple and show how my eating of the apple obviously makes it no longer available for consumption by another individual. All the relevant costs and benefits have been taken into account by both parties to the exchange. No benefits nor costs have been imposed on third parties to the transaction. Then the transition to a discussion of national defense and its inherent differences is easily accomplished.
Jose Alberro,
After the midterm I come into class and in a very conspiratorial manner I offer to sell grades. My acting is semi-believable and the students love to play the game. But the grade I will sell is the same for the whole class; everybody will get the same grade. Furthermore I don't care who pays me as long as I get my "price." I then announce my supply schedule and wait. My experience is that all the problems inherent in public goods will soon appear: The social optimum cannot be obtained by market forces, there needs to be an "enforcer" of community decisions (the state); incorrect specification of property rights; free riders; inability to exclude anyone once the grade has been bought; "A" students are at the mercy of the rest of the class (they cannot supply their own private good and barter property rights).
Joint Costs and Cost Allocation
Mark S. Jelavich,
I use the following example to illustrate the problem of allocating costs where two or more outputs are produced from one production process. I developed this example from a British Rail cost allocation study. (See Stewart Joy, "Pricing and Investment in Railway Freight Services", Journal of Transport Economics and Policy, Sept. 1971.)
Say you have a single track railway line, with neither signals nor sidings, running between two cities. If the only commodity hauled between the two cities is coal, and there is at most only one train on the lie at any one time (eliminating the need for sidings), then all costs of that rail line can be attributed to coal haulage, including all of the fixed costs. No joint costs exist.
Now say that in addition to coal, the rail company begins to haul wheat between the two cities. If coal traffic does not grow, then any additional fixed cost items, such as signals and sidings, can be attributed to wheat traffic as the rail company expands the line's freight capacity. However, the original single track ‑ no signal ‑ no siding system represents a joint cost, since both wheat and coal use that system. Furthermore, if coal and wheat are hauled together, then the wages of the engineer, brakeman, and freight conductor are also joint costs, since two "outputs" (wheat and coal traffic) are being produced. Any "bridge traffic" (traffic traversing the line but neither originating nor terminating on the line) adds to the joint cost allocation dilemma.
Externalities and Public Institution Tuitions
Ralph T. Byrns
If you teach at a public institution, the difference between in state and out of state tuition is at least arguable as good example of a governmental estimate of the money value of an external benefit.
Market Failures and Efficient Allocations
Ralph T. Byrns
Economic efficiency is only a problem if resources are scarce. In this case the society has more goals than resources can accomplish. Resources are allocated efficiently if all ends achieved are more valuable to society than any end that is not achieved. To be efficient, a society must develop an institution or institutions that:
(a) Determine and then reveal the preferences of the individuals whose preferences are to count.
(b) Transfer information about preferences to owners of resources.
(c) Create incentives for resource owners to use their resources to accomplish the most urgently needed goals.
Discuss the circumstances under which the market accomplishes these tasks efficiently. Show how in cases of market failure, market signals fail to do at least one of the three tasks listed above. Discuss how lack of information about the relevant preferences hinders the government's ability to correct market failure.
Mark Zupan,
As an application of tax incidence and elasticity, I tell students that as far as who ends up bearing a tax goes, it doesn't matter whether a tax is placed on producers or consumers‑‑even though intuition may say that it does. As an example, I use an analogy based on the Exxon price-overcharge case of the early 1980s.
During the 1970s' oil price
controls, Exxon was told it could charge whatever it chose to for a certain
category of oil but that, since the Department of Energy wasn't sure whether
that oil should be price-controlled, Exxon's revenue above the price-controlled
level had to be escrowed in a bank in
The DOE now had to decide who would get the $2 billion; with the split between refiners and consumers ideally being determined by which group had borne the Exxon "overcharge tax" in the mid 1970s. Suppose that the gasoline market could be depicted as in Figure 32‑1 and that Exxon's overcharge effectively raised the MC of gasoline by 5 cents per gallon. That would raise the supply of gasoline in height by 5 cents per gallon at each output level‑to S'.
Figure 32‑1
Now ask your students by how much
the price faced by buyers rises? (to P0), and how much of
the price sellers get after Exxon takes its 5 cents? (Ps =
P0 ‑ 5 cents) Ask them if buyers get stuck with the
entire tax . . . Sellers? (No, in both cases). And they will start getting the
picture that, even though the tax was placed on suppliers (refiners); suppliers
bore only P*‑P cents of the tax while demanders bore (P0 ‑
P* cents.) As a general rule tell them that who bears a tax depends on who has
the least elastic/response curve. Specifically, the proportion of any per unit
tax borne by demanders equals: Es/ (Es +
Ed).
In the Exxon case, the refiners' lawyers argued in court that the demand for gasoline was perfectly elastic and that demanders bore none of the tax; refiners got stuck with all the Exxon tax (i.e. P* ‑ P0 = 5 cents and P0 ‑ P* = 0). What these lawyers were arguing was that the elasticity of demand (Ed) equaled infinity. If Es is finite, then [roughly], Es/ (Es + Ed) = Es/ (Es + infinity) = 0, and the proportion of the tax borne by demanders was negligible. This is illustrated by Figure 31‑2.
Figure 32‑2
Lawyers representing consumers, however, argued that gasoline was perfectly inelastic in demand and that buyers bore all the tax and were entitled to the entire $2 billion (i.e., P* ‑ P0 = 0 cents, and P0 ‑ P* = 5 cents). What these lawyers were arguing was that Ed = 0 ‑‑‑ that Es/(Es + Ed) = Es/(Es + 0) = 1, so that the proportion of the tax borne by buyers as effectively 100 percent. This argument is illustrated in Figure 32‑3.
Figure 32‑3
Incidentally, the best estimates on Es and Ed indicate that refiners (or, more precisely, their stockholders or owners), bore 40% of the tax while consumers of refined petroleum products bore 60%.
Principles of Taxation and Class Absences
Roger H. Goldberg,
To highlight basic principles of taxation in a personal manner, a tax system is developed for the class which uses student absences as the tax base. Each student is allowed one absence as a "personal exemption". A second absence is permitted "tax‑free" as a "zero‑bracket deduction". Succeeding absences are then taxed as a percentage of grading points which students may earn in the course. "Flat‑rate" taxation may be easily contrasted to a "progressive rate" which provides for increasing point losses with each subsequent student absence. The illogic of regressive taxation from the instructor's viewpoint; i.e., reducing the rate of tax (point loss) due to incremental absences, completes the discussion. Ideally, a student raises a question concerning itemized deductions. I respond that a valid note from the health clinic may be taken as a "medical deduction" for absence without penalty, but that "tax reform" has eliminated the charitable deduction!
Per Unit Excise Subsidies vs. Ad Valorem Subsidies (or Taxes)
David E. R. Gay,
A local grocery store marks down the price of its steaks toward the end of the expiration date on the package. Usually, a sticker is attached which says either $1 off or, occasionally, $.50 off. Using a specific example of a package which had been priced at $3.45 vs. one marked $4.25, which would consumers select? Initially, about 1/3 or more of the class will pick the higher priced steak, although each steak only has a reduction of $1 which yields a 29% price cut for the lower priced steak vs. 24% for the larger steak. The grocery store provides a per unit subsidy which yields a different percentage reduction in price. Then I can revise the example to illustrate what happens if the case involved taxes instead of subsidies.
Are Payroll and Sales Taxes Proportional or Regressive Taxes?
Eric Steger,
I explain that there is a difference of opinion regarding whether payroll and sales taxes are proportional or regressive taxes. On one hand, these taxes are proportional because the tax rate remains the same regardless of the size of income. I explain, though, that the sales tax is not based upon income but upon the amount of the purchase. Therefore, the sales tax is proportional. Payroll taxes are proportional also because the tax rate is the same regardless of the size of income.
I explain that the dispute arises because of the regressive impact (hurts low and middle income people more than upper income people) of these taxes. I indicate that for some purposes, there needs to be a differentiation between a regressive tax system and taxes with a regressive impact.
Notes: