Transcript INSTITUTIONAL ECONOMICS AND ECONOMICS OF THE PUBLIC SECTOR

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Institutional Economics/
Economics of the Public Sector
Legal and Regulational Infrastructure
of the Economy
Government can—and does—contribute to the
economic efficiency of markets by

providing infrastructure that permits markets to
function
 there is a strong relation between infrastructure
quality and output per worker
3
 physical infrastructure—bridges, airports,
waterways, and buildings
 institutional infrastructure—laws, courts,
and regulations, stepping in when markets are
not working properly
4

The backbone of a market economy’s institutional
infrastructure is the legal system

Important part of the institutional infrastructure that
supports market economy is regulation
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◦ While criminal law has important moral and ethical
dimensions, its central economic function is to limit
exchanges to voluntary ones
◦ By making most involuntary exchanges illegal,
criminal law helps to channel energies into exchanges
and productive activities that benefit all parties
involved
◦ In this way, criminal law contributes to economic
efficiency
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
Property law gives people precisely defined, enforceable
rights over things they own

When property rights are poorly defined
◦ Much time and energy are wasted in disputes about
ownership
◦ People spend time trying to capture resources from
others (time that could have been spent producing
valuable goods and services)
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
A contract is a mutual promise
◦ Often one party does something first and the other
party promises to do something later
◦ Contract lax enable us to make exchanges that take
place over time and in which one person must act
first
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
Contract law plays a special role in a market
economy
◦ Without it, only transactions involving
simultaneous exchange could take place
◦ In this way, contracts help society enjoy the full
benefits of specialization and exchange
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
In countries in which contract law is less well
defined or less strictly enforced, both traders
and investors would worry that they would not
be able to collect their revenue

Because of contract law, people are more willing
to take a chance with a new business
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
Deals with interactions among strangers or
people not linked by contracts

Specifically, a tort is a wrongful act — such as
manufacturing an unsafe product — that causes
harm to someone, and for which the injured
person can seek remedy in court
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Tort law defines types of harm for which
someone can seek legal remedy and what sorts
of compensation the injured person can expect
When people and business are held responsible
for injuries they cause, they act more carefully

Also
protects against fraud in which a seller of
something—a product, a business, shares of
stock—lies to the buyer in order to make the sale
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
Designed to prevent business from making
agreements or engaging in other behavior that
limits competition and harms consumers
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Operates in three areas
 Agreements among competitors —prohibits
“contracts, combinations, or conspiracies” among
competing firms that would harm consumers by
raising prices
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Operates in three areas
 Monopolization - it is illegal to monopolize or
attempt to monopolize a market
 Mergers. In a merger, two firms combine to form
one new firm. The result is to increase the danger
of higher prices from oligopoly or monopoly
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
Important part of the institutional infrastructure
that supports a market economy

In addition to protecting public safety and health
regulation is also used to help markets function
more efficiently

Regulation differs from use of legal procedures
in a fundamental way

Under regulation,a government agency has
power to direct business to take specific actions

While legal procedures typically result in fines or
other penalties if businesses do something
wrong, regulators reach deep into the operations
of business to tell them what to do
 Ownership of the regulated firm remains
private.
 Pricing and production decisions controlled
by a government regulatory agency.
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
An efficient regulatory infrastructure must
consider and balance benefits - safer products,
reduced crime - against the costs of achieving
legal and regulatory goals

A legal and regulatory system that ensured the
complete elimination of crime, unsafe products,
and other unwelcome activities would be less
efficient than a system that tolerated some
amount of these activities
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
Prior to the 1880s most regulation of business took
place at the state and local level

Justification for Government Regulation - the use of
private property can be regulated to serve the public
interest

Level of government regulation remained low until
the Great Depression in the 1930s

The Depression (stock market “crash” and
collapse of the banking industry) represented to
many:
- “the failure of the free enterprise
system”
- the problems with concentration of
economic resources

By the 1960s government regulation of prices
and entry was commonplace in the
- transportation (railroads, trucking, airlines),
- communications (telephone services, radio,
television),
- “natural monopoly” utility (electricity, natural
gas) industries

Increased significantly starting late 1960s and
continuing in the 1970s with the emergence of
environmental and consumer movements

Scale & scope of regulatory activity expanded

Governments imposed new controls on
environmental pollution, the safety of the workplace
& consumer products
 Cycles
of regulation:
◦ periods of heavy regulation
◦ followed by periods of deregulation
 Economic
and political influences
The last decades of the 20th century saw a wave
of attempts to remove, reduce, or simplify restrictions
on business and individuals with the intent of
encouraging the efficient operation of markets.


The stated rationale for deregulation. i.e. greater
reliance on market forces, was often that fewer and
simpler regulations will lead to a raised level of
competitiveness, therefore higher productivity, more
efficiency and lower prices overall.

Emanated from
-- the perceived failure of government regulation
-- the value placed on the efficacy of free markets

Removal of many price and entry restrictions in
regulated industries (Telecommunications,
Electrical Utilities, Banking/Financial Services
etc.)
 For example, deregulation of the air industry in
Europe in 1992 gave carriers from one EU country
the right to operate scheduled services between
other EU states.
addition, there have been regulatory
innovations, usually suggested by economists,
such as emissions trading

In
 While
economic regulation declined, social
regulations (e.g., environmental, product and
workplace safety,, equal employment opportunity,
increased min. wage) remained
 Interest
groups and general public support
remained high for social regulation

What is the rationale for economic regulation ?

Whose interests are represented in regulation?
Sometimes regulatory commissions protect the
interests of companies, e.g. monopolies they
are supposed to regulate.
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 Monopolies and natural monopolies, anticompetitive behaviour and predatory pricing
 Externalities
 Information inadequacies and asymmetry
While economists and policy-makers agree in theory on
what causes a market failure, dealing with real-world
market failures remains one of the most controversial
aspects of government policy
 Unequal bargaining power
 Moral hazard
 Continuity and availability of service
 Scarcity and rationing
 Distributional justice and social policy
Industry/areas of specific regulations cover
mainly:
 Air Transportation
 Electricity
 Gas
 Telecommunications
 Environment
 Financial and capital markets

Consumer protection

Health care

Employer-Employee relationships

Energy use
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Parliament

Government institutions (ministries)

Independent regulatory bodies (central
banks, specialized agencies)

European Commission
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Courts

Self-regulatory (private) bodies

If regulation is implemented through
independent commissions and agencies,
regulatory statutes and practices can be
appealed to the courts to test their
constitutionality and to ensure that agencies
satisfy due process in their decision making
◦ Intervention
in the market is often required (in
situations of market failure)
- to ensure that the pursuit of profit does not
conflict with social welfare
- to ensure socially desirable outcomes when
competition cannot be relied upon to achieve
them.

(Natural) monopoly is the classic case.

Regulation replaces the invisible hand of
competition with
- direct intervention (bans, requirements,
e.g. price regulation, rate of return regulation)
- or indirect intervention (taxes, subsidies)

The central issue of regulatory economics is
the design of administrative and/or
economic mechanisms that regulators can
apply to induce firms to achieve optimal
outcomes.
◦ What is the desired outcome of regulation
(behavior of regulated subjects)?
◦ Can we design a regulatory mechanism that
induces the regulated firm to act in a way that
results in the optimal outcome?
◦ Can we balance the benefits of regulation with its
costs (compliance costs) and risks, e.g. regulator’s
capture?
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A market with just one seller, or a few oligopolists
who cooperate and behave as a monopoly, is a
serious market failure justifying government
intervention
A firm has monopoly power when it can influence
the price that it charges for its product
Monopolies (imperfectly competitive markets) are
generally inefficient: price is too high, and output
is too low, to maximize net benefits in market
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
Government responds to the problem
of monopoly in one of three ways
◦ Making monopolized industries more
competitive.
◦ Regulating the behaviour of
monopolies.
◦ Turning some private monopolies
into public enterprises.
 Legislation
designed to encourage
competition and discourage/ban the use of
monopoly practices can curb the
inefficiencies resulting from market power
in general and monopoly in particular
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To promote economic efficiency, anti-trust policy
attempts to ensure entry and fair competition in
industries with barriers to entry and anticompetitive practices
Anti-trust policies (as with all govt regulations)
change over time and are strongly influenced by
economics and politics
Broad language of anti-trust acts leaves
considerable room for interpretation for
courts/judges
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(1)
-
Horizontal Restraint of Trade
a division of market, which reduces
competition and creates monopoly
a single company dominates a market
and/or industry
(2) Vertical Restraint of Trade
examples:
-
resale price control (manufacturer tries to
control the retail price)
a single firm controls supply chain
(3) Predatory Pricing
-
-
firms price below marginal cost until other
firms get driven out of business and then
they price and profit as a monopolist
most relevant in industries with high barriers
to entry (e.g., airlines)
- what is the relevant market?
- market share of competitors?
- prices, are they fair?
- barriers to entry (capital costs,
distribution chains, software platforms)?
- is there international competition?
- cost structure of industry (is it subject to
increasing returns to scale?)
- incentives to innovate ?
- the effect of tech change on relevant
market?
Breaking up a monopoly would not make
sense when the market would perform even
worse with more competition
Monopolies that arise from patents and
copyrights, provide an incentive for artistic
creations and scientific discovery

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Monopoly power that arises from network
externalities offers benefits that would be
hard to achieve under more competitive
conditions

When a monopoly arises as a natural
monopoly, using anti-trust law to break it up
or even to prevent its formation is a poor
remedy


A natural monopoly exists when, due to
economies of scale, one firm can produce
for the entire market at a lower cost per
unit than can two or more firms
◦ If government steps aside, such a market will
naturally evolve toward monopoly
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
If breaking up a natural monopoly is not
advisable, what can government do to bring
us closer to economic efficiency?
◦ One option is public ownership and operation
 Public takeover of private business is rare, except when certain
conditions are present
◦ That leaves one other option
 Regulation
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
Under regulation, a government agency
digs deep into the operations of a business
and takes some of the firm’s decisions
under its own control
◦ In the case of a natural monopoly, regulators are
interested in achieving economic efficiency, which
they do by telling the firm what price it can
charge
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
At first glance, you might think that natural
monopoly regulators have an easy job
There is the matter of information:
regulators often depend on information obtained
from monopolies
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Regulators determine a price that gives
owners a “fair rate of return” for funds they’ve
put into the monopoly
This price should give monopoly what
economists call normal profit. i.e. profit just
high enough to cover all of the owners’
opportunity costs, including the foregone
interest of their own funds
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
Price regulation is not a perfect solution
 Provides little or no incentive for the natural
monopoly to economize on capital
 Tendency of regulated natural monopolies to
overinvest in capital
 When a firm is not striving to maximize profit (in
this case, because the government is guaranteeing a
specific rate of return), it does not economize on
costs. Regulated firms thus have little incentive to
hold down costs.
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 Regulatory
boards are often made up of individuals
from the industry being regulated.
 Industries
that could very well compete desire to be
declared natural monopolies.
 If
the competition laws are to raise social
welfare, the government must determine
which mergers are desirable and which
are not.
The two views of competition are
judgment by performance and judgment
by structure
: 61

Judgment by performance – we should judge
the competitiveness of markets by the
performance (behavior) of firms in the
market.
A firm’s size within an industry is
insufficient evidence for the court to rule
against it in an antitrust suit. Issue is
behavior not size.
Evidence must show that the firm
actually used its size to violate antitrust
laws.
: 63

Judgment by structure – we should judge the
competitiveness of markets by the structure
of the industry.
A firm’s size within an industry is
considered sufficient evidence for the
court to rule against it in an antitrust suit.
Does not differentiate between good and
bad monopolies.
: 65

A trust or cartel is a combination of
firms in which the firms have not
actually merged, but act as a single
entity.

A trust sets common prices and governs the
output of individual member firms.

A trust can, and often does act like a
monopolist.

In 1911, the U.S. Supreme Court determined
that both Standard Oil and American Tobacco
were structural monopolies in that each
controlled over 90 percent of their markets.

In spite of this, they were not judged to have
violated the antitrust legislation because of
their structure, but because of their “unfair
business practices.”

This judgment on performance, not structure,
is often called the abuse theory since a firm
is legally considered a monopoly only if it
commits monopolistic abuses.

Judging by structure seems inherently unfair
since the alleged wrongdoer is doing what it
is supposed to be doing—producing the best
product at the lowest possible price.

Supporters of this position recognize this
problem, but they nevertheless favor the
structure criterion because of its
practicality.

Judgment by performance requires that each
action of a firm must be analyzed on a caseby-case basis.

This is enormously expensive and timeconsuming.

Courts must find a way to limit the cases they
look at.
 Some
argue that structure is a predictor of future
performance.

A monopolist may be charging low prices now.

Once the competition melts away, the offending
firm jacks up its prices.


The structural approach is not without faults.
Choosing the relevant market when
evaluating competitiveness is difficult to do.

In the du Pont case (1956), the relevant
market for cellophane was the flexiblewrap industry not the cellophane market
of which du Pont owned 100 percent.

Therefore, du Pont was not considered a
monopolist.

Both structure and performance criteria
have ambiguities, and in the real world
there are no definitive criteria for judging
whether a firm has violated the antitrust
statutes.


In recent years, antitrust law has worked
mainly through its deterrent effect
Many potential mergers are never even
proposed because firms know the merger
would not be allowed.

Technology was changing so fast that
by the time litigation reached the
courts, the issues were no longer
relevant.

The modern era of antitrust policy has
been marked by important cases in
the computer and telecommunications
market.

Microsoft is the dominant player in the
software industry, controlling over 50 percent
of the world market for software and between
80 and 90 percent of the operating systems
market worldwide.

Since all software must be compatible with an
operating system, Microsoft has an enormous
competitive advantage for its other divisions.

The U.S. Justice department charged
Microsoft with an antitrust violation:

Possessing monopoly power in the market for
personal computing operating systems.

Tying other Microsoft products to its Windows
operating system.

The U.S. Justice department charged
Microsoft with an antitrust violation:

Entering into agreements that kept computer
manufacturers that install Windows, from offering
software that competes with Windows software.

Monopolists need barriers to entry.

The computer software industry has two
sources of monopoly power – network
externalities and economies of scale.

Network externalities exist because
as the number of applications
supported by a single platform
increase, the value of the platform
also increases.

Economies of scale exist because of the cost
of developing a new platform and new
software is significant while the cost of
producing it is minimal.

With its stable 90 percent market
share, it certainly is a monopoly.

By directing the development of in-house
software to favor Windows, Microsoft
strengthened the barrier to entry created by
network externalities.

Microsoft also penalized computer
manufacturers that installed Windows
if they installed competing software.

Microsoft packaged Internet Explorer as
part of Windows at no additional cost to the
buyer which froze out Netscape Navigator.

In late 1999, a federal judge ruled that
Microsoft violated the Sherman Act by
attempting to maintain its monopoly power
by anti-competitive means.

In order to achieve economies of scope and
economies of scale, firms have been
simultaneously breaking up and merging.

The law allows firms to break up any way
they like.

Mergers, on the other hand, must fall
within the law's antitrust guidelines.

Acquisitions and takeovers both result
in the combining of firms.

The term merger is a general term
meaning the act of combining two
firms.

There are three types of mergers:
horizontal, vertical, and conglomerate.


A horizontal merger is the merging of two
companies in the same industry.
Most antitrust policy has centered on
horizontal mergers.

A vertical merger is a firm merging with the
supplier of one of its inputs.

If the merged firms are able to limit access of
other buyers or sellers to the market, the
merger would be in violation of the antitrust
law

A conglomerate merger is the merging of
two companies in unrelated industries.

There are five reasons why unrelated firms
would wish to merge.
To achieve economies of scope.
 To get a good buy.
 To diversify.
 To ward off a takeover bid.
 To strengthen their political-economic
influence.



Globalization leads to mergers because firms
can gain instant foreign distribution,
knowledge of local markets, and lower the
costs by redirecting production to low-cost
areas.
Deregulation has caused mergers to occur
among banks, electricity, and
telecommunications companies.

Technological change has created takeover
targets.

If a firm wants a new technology it
could buy the firm that owns it.


Regulators sometimes will not let mergers to
go through without a deacquisition program.
Deacquisitions occur when a firm sells parts
of another company it has bought or parts of
itself.


Antitrust policymakers now view that the
relevant market is the international market.
Some countries oppose antitrust laws
because of economies of scale, lack of a
strong ideology supporting competition, and
strong cultural ties between government and
business.
 Competition
laws have costs and benefits.
 Sometimes companies merge not to reduce
competition but to lower costs through joint
production.
The benefits of greater efficiencies through
mergers are called synergies.

Almost all economists agree that antitrust
enforcement has not reduced the size of
firms below the minimally efficient level, the
level at which a firm can take full advantage
of economies of scale.

Performance advocates generally believe
enforcement was not needed while structural
advocates generally believe that it was.

They are also mixed on their judgment about
whether any type of antitrust action is
feasible in a rapidly changing technological
arena.

Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.

Price discrimination is not possible when
a good is sold in a competitive market
since there are many firms all selling at
the market price. In order to price
discriminate, the firm must have some
market power.

Perfect Price Discrimination refers to the
situation when the monopolist knows
exactly the willingness to pay of each
customer and can charge each customer
a different price.

Three important effects of price discrimination:
◦ It can increase the monopolist’s profits.
◦ Need to separate customers according to
their ability to pay.
 No arbitrage, the process of buying a
good in one market at a low price and
selling it in another market at a higher
price.
◦ It can reduce deadweight loss.
In financial markets, participants trade
securities (shares, bonds, etc), money, foreign
exchange, insurance, commodities etc.

The main types of financial markets cover:
 Money Market
 Capital Market (Primary and Secondary)
 Insurance Market
 Derivatives Market
 Forex Market

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
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Financial institutions (intermediates) –
banks, investment funds, brokers, …
Flow of money
Financial risks
Information
Scope of participants
Debts
The toughest regulation form - licences



Supervisors of national financial markets –
central banks
Supervisors of national capital and securities
markets – Securities and Exchange Commissions
(SEC)
EU bodies: EU Commission, European central
bank (ECB), European Securities Committee
(ESC), Committee of European Securities
Regulators (CESR)
 Central banks - regulate banks on the
basis of Basel II Directive
 Securities and exchange commissions use the Markets in Financial Instruments
Directive (MiFID) framework

Issued by the Basel Committee on Banking
Supervision
The purpose is to create an international
standard that banking regulators can use
when creating regulations about how much
capital banks need to put aside to guard
against financial and operational risks banks
face
Main aims:


The greater risk to which the bank is
exposed, the greater the amount of capital
the bank needs to hold
Ensure that capital allocation is more risk
sensitive


The Markets in Financial Instruments Directive
(MiFID) goal:
 to complete the process of creating a single EU
market for investment services
 to respond to changes and innovations which
have occurred in securities markets
 to protect investors by making markets deeper,
more competitive and more robust against fraud
and abuse
MiFID is the cornerstone of the European
Commission's Financial Services Action Plan


Firms covered by MiFID are authorised and
regulated in their "home state" (the country in
which they have their registered office whereas
formerly, a service was regulated by the member
state in which the service took place).
Once a firm has been authorised, it can use the
MiFID passport to provide services to customers in
other EU member states.

MiFID has requirements relating to the
information that needs to be captured when
accepting client orders, ensuring that a firm
is acting in a client's best interests and as to
how orders from different clients may be
aggregated.



MiFID requires firms to categorise clients as
"eligible counterparties", professional clients or
retail clients (these have increasing levels of
protection).
Clear procedures must be in place to categorise
clients and assess their suitability for each type of
investment product.
That said, the appropriateness of any investment
advice or suggested financial transaction must be
verified before being given.

MiFID requires firms to publish the price,
volume and time of all trades in listed shares,
even if executed outside of a regulated
market, unless certain requirements are met
to allow for deferred publication.


MiFID requires that firms take all reasonable
steps to obtain the best possible result in the
execution of an order for a client.
The best possible result is not limited to
execution price but also includes cost, speed,
likelihood of execution and likelihood of
settlement and any other factors deemed
relevant.

Social regulation concerns with the conditions
under which goods and services are
produced, the quality of those goods, and the
side effects of production on society.

Social regulation affects large aspects of all
aspects of business: working conditions, the
quality of the products, and the production
process firms are allowed to use.

Social regulation has increased substantially
in the last three decades regardless of the
deregulation initiatives

Some economists argue that this is bad.
The regulatory costs outweigh the social benefits
derived from the regulation.
 Regulations are poorly written and ambiguous.
 Regulatory burdens become unbearable for small
firms.


Others argue that this is good.
The benefits outweigh the costs.
 Better regulation is needed.


Government ownership is when government
takes over the entire operations of a firm.

European governments had a history of
taking over large industries and running them
themselves.

Sadly, they found out that government
ownership precluded keeping costs down and
introducing new technology.

Workers in government-owned firms were
guaranteed jobs, and used political threats to
hold their wages high.

The economic integration of Europe has been
accompanied by privatization of many of the
formerly government-owned industries.
Theory of Public Choice
The economic theory of public choice is concerned with
the provision of public goods

The theory explores situations where firms' profitseeking does not lead to (efficient) provision of the so
called public goods

In economics, the term public good refers to goods
that are non-excludable (as well as non-rival).

This
means it is not possible to exclude individuals
from the good's consumption.
.
Non-excludability may cause problems for the
production of such goods

Consumers can take advantage of public goods without
contributing sufficiently to their creation. This is called
the free rider problem

.
Non-excludability leads to market failure: since
no private organisation can get all the benefits of a
public good it has produced, there will be
insufficient incentives to produce it voluntarily.

Public goods - goods the free market may not
produce at all

security, defense and law enforcement (including the
system of property rights enforcement),


environmental goods,
information goods, such as software development,
authorship, and invention etc.

Public Spirit
If enough people do not think like free-riders, the
private and voluntary provision of public goods may be
successful

Public spirit may be encouraged by tradition and social
norms involving concepts such as nationalism and
patriotism

Coasian solution
Potential beneficiaries of a public good band together and
pool their resources based on their willingness to pay to
create the public good.

Provision: the transaction costs between potential
beneficiaries of a public good are sufficiently low, and it is
therefore easy for beneficiaries to find each other and pool
their money based on the public good's value to them.

Legal exclusion
 Another
solution, which has evolved for information
goods, is to create intellectual property laws, such as
copyright or patents, covering the public goods.
The downside of these laws is that they imply private
monopoly: the patent rights given to pharmaceutical
companies encourage them to lobby for the extension of
patent rights in a form of „rent seeking“.

Government provision
If private provision of public goods will not work, then
the obvious solution is making their provision/financing
involuntary.

General solution to the problem is for governments to
impose taxation to fund the production of public goods.

The difficulty is to determine how much funding should
be allocated to different public goods, and how the costs
should be split.

Subsidies
 A government
may subsidize production of a public
good in the private sector. Unlike government provision,
subsidies may result in some form of competitive market.
 An
alliance between political insiders and the
businesses receiving subsidies can be limited with secret
bidding for the subsidies or application of the subsidies
following clear general principles.

Goods that the government feels that people will
underconsume and which therefore outght to be
subsidised or provided free

Consumption of public/merit goods is thought to
generate positive externality effects
Regardless of the method of providing public/merit
goods, the efficient level of such provision should be
subjected to economic (cost-benefit) analysis.

Public choice theory describes how political decisionmaking may result in policy that conflicts with the
overall desires of the general public.

In other words, the theory aims to apply economic
analysis to the political decision-making process in
order to reveal possible systematic trends towards
inefficient government policies.

example, many „special interest projects“
(promoted by „special interest groups“) are not in the
interest of the general public, however, it makes sense
for politicians to support these projects since they can
benefit from them.
For
Public choice theory attempts to look at
governments from the perspective of the bureaucrats
and politicians who compose them

It
makes the assumption that they act in a selfinterested way for the purpose of maximizing their
own economic benefits (e.g. their personal wealth).
One of the basic claims of public choice theory is
that good government policies are an
underprovided public good, because of the
rational ignorance of the voters.

Each voter is faced with a tiny probability
that his vote will change the result of the elections,
while gathering information necessary for a wellinformed voting decision requires substantial effort.

Therefore,
the rational decision for each voter is to be
generally ignorant of politics and perhaps even abstain
from voting.
On the other hand, there are many interest groups
with strong incentives for lobbying the government
to implement specific inefficient policies that would
benefit them at the expense of the general public.

One that generates substantial personal benefits
for a small number of subjects while imposing
diffused, small individual cost on a large number of
other persons

The
total costs dispersed on a large number of people
are usualy higher than the total benefits
15
9
The costs of such policy dispersed over all citizens
are often unnoticeable to each individual.

On the other hand, the benefits are shared by
a small special-interest group with a strong incentive
to perpetuate the policy by further lobbying.

Therefore, there is also an incentive for the
interest groups to try and influence policy in order
to ensure that the policy gets enacted which
favours them („rent-seeking“).
16
1
For example, lobbying by the agricultural industry
might result in subsidis for the production of agricultural
goods, either directly or by protectionist measures.


In public choice theory, such scenarios of
inefficient government policies are
referred to as government failure
Actions by individuals and interest groups
designed to (permanently) restructure institutional
environment in a manner that will either directly or
indirectly redistribute more income to themselves.
16
4
The typical example of rent-seeking is the
monopolist example.
Firms seek government privilegies (such as
barriers to entry) to secure a monopoly and
therefore monopoly rents.
16
5
Politicians are likely to offer policies where the
costs are widely diffused, but where the benefits
are more significant for a particular interest
group
Politicians have a strong incentive to favor special
interest even if action is inefficient.
16
6
Therefore there may be bias in political decisions
towards public intervention
It may also explain why (certain) governments like
to finance expenditure by borrowing as opposed to
by levying taxes
16
7
Widespread use of the taxing, spending, and
regulatory powers of government that favor
some at the expense of others will encourage
rent seeking.
16
8
Rent seeking moves resources away from
productive activities.
The output of economies with substantial amounts
of rent seeking will fall below their potential.
16
9
Actions of individuals, groups, or firms to
influence the formation of laws, regulations,
decrees, and other government policies to their
own advantage
17
0
Examples:
An influential industrial group could buy off
legislators to erect barriers of entry in a
particular sector
 Ministry of public health can promote
primarily inrests of doctors, ministry of
transport interests of road construction
companies etc.
17
1
Public choice theory has debated the extent to which
elected officials can control their bureaucratic agents.

Bureaucrats often have more information than elected
officials about what they are doing.

 Bureaucrats
have a motivation to support policies
and project promoted by interests groups because
these policies provide them with more power and
budgets

The interests of bureaucrats are often
complementary with those of interest groups they
serve.
17
3
Therefore, bureaucrats might have both ability and
motivation to implement policies or regulations that
go against the public interest.


Issues that yield clearly defined current
benefits at the expense of future costs that
are difficult to identify.
 Political process is biased toward the adoption
of such proposals even when they are
inefficient.
17
5
In the public sector, the absence of the profit motive
reduces the incentive of producers to keep costs low.
Neither is there a bankruptcy process capable of
weeding out inefficient producers.
Public-sector managers are seldom in a position to
gain personally from measures that reduce costs.
17
6
 Public
sector is therefore biased toward higher
costs/lower efficiency
17
7




The power of special interests
Rent seeking/redistribution of costs
The shortsightedness effect
Lack of incentives to
promote operational efficiency
17
8
Public Choice Theory and the
democratic process
Majority Voting:
Fails to take into account the strength
of the preferences of individual voters and may yield economically inefficient
outcomes.
Benefit; Tax
An Inefficient “NO” Vote
700
The NO vote wins but
is inefficient since...
300
250
200
(YES)
Adams
(NO)
(NO)
Benson
Conrad
Benefit; Tax
An Inefficient “NO” Vote
700
The NO vote wins but
is inefficient since...
MSB 1,150 > MSC 900
300
250
200
(YES)
Adams
(NO)
(NO)
Benson
Conrad
Benefit; Tax
An Inefficient “YES” Vote
The Yes vote wins but
is inefficient since....
350
350
(NO)
(YES)
(YES)
Adams
Benson
Conrad
300
100
Benefit; Tax
An Inefficient “YES” Vote
The Yes vote wins but
is inefficient since....
MSB 800 < MSC 900
350
350
(NO)
(YES)
(YES)
Adams
Benson
Conrad
300
100








Private provision of public goods (example)
Reasons of government failure (example)
Economic role of the bureaucracy
Economic theory of public choice – main
principles
Special interest groups (example)
Rent-seeking behaviour (example)
Economics of corruption
Rational ignorance of voters/Economics of the
voting process




Raise revenue for central & local government
Macro-economic demand-management
Achieve more equality in income & wealth
Correct externalities and other forms of market failure

People should pay taxes according to their ability to pay in
accordance with the benefits derived from government
expenditure

Taxes should be clear and certain

Taxes should be convenient

Costs of collection relative to the tax yield should be minimal
Tax Theory: Distribution of the Tax
Burden
Benefits-Received Principle
Ability-to-Pay Principle
o Progressive Tax
o Proportional Tax
o Regressive Tax
18
8
Tax Theory: tax rates
o Tax rate is the legally imposed rate. An income tax can has
multiple statutory rates for different income levels or it can
be a flat rate
o A progressive tax is a tax by which the tax rate increases
as the taxable base amount increases. "Progressive“ referres
to the way the rate develops as income increases
18
9
Tax Theory: tax rates
o A flat (or proportional) tax is a tax system with a
constant tax rate.
o Usually the flat tax applies to corporate profits being
taxed at one rate.
19
0
Tax Theory: tax rates
o A regressive tax is a tax imposed in such a manner that
the tax rate decreases as the amount subject to taxation
increases
o A regressive tax imposes a greater burden (relative to
resources) on the poor than on the rich — there is an
inverse relationship between the tax rate and the
taxpayer's ability to pay as measured by assets,
consumption, or income.
19
1
Identify whether progressive, regressive,
or proportional
 Personal Income Tax
Progressive
 VAT or Sales Tax
Regressive
 Corporate Income Tax
Proportional
 Payroll Taxes
Proportional/Regressive
 Property Taxes
Regressive
19
2
Tax Theory: marginal and effective
tax rates
A marginal tax rate is the tax rate that applies to the last euro
of the tax base (taxable income or spending) – it corresponds to
the change in one's tax obligation as income rises
The effective tax rate is the amount of tax an individual or
firm pays when all other government tax offsets or payments are
applied, divided by the tax base (total income or spending).
19
3
 keep
overall tax burden as low as possible
 reduce marginal tax rates on income and
business profits to sharpen incentives to work
maintain a broad tax base
shift balance of taxation from taxes on income to
taxes on spending
ensure taxes are applied equally and fairly
use taxes to make markets work better (making
decision makers aware of external costs)
raise revenue in ways that do least economic harm

The objects to which taxation is applied
 income
 wealth
 spending

The tax base is affected by
 the number of tax-paying units
 the rates of tax
 tax allowances and tax reliefs
 the extent of tax evasion & avoidance

Tax base can contract or expand

Tax base can contract or expand
◦ Strong link with the economic cycle - in a recession the
tax base shrinks
◦ Extension of the range of objects to which taxation is
applied
◦ Changes in the economically active population
◦ “Fiscal drag” effects due to inflation
◦ Increased employment in low-paid jobs
◦ Scope of evasion & avoidance of tax paying units

Tax avoidance is the legal utilization of the tax system
to one's own advantage. It is based on reduction of the
amount of tax that is payable by means that are within
the law

Tax evasion, on the other hand, refers to the efforts by
individuals, firms and other entities to evade taxes by
illegal means.

Both tax avoidance and evasion are unfavorable to a
state's tax system.

Law establishes from whom a tax is collected

However, who ultimately pays the tax (the tax
"burden") is determined by the marketplace: taxes can
be shifted on other persons

Economic theory suggests that the economic effect
of tax does not necessarily fall at the point where it
is legally levied.

For instance, a tax on employment paid by
employers will impact on the employee, at least in
the long run.
Properties of taxes: Direct Taxation
◦ Taxes on income and wealth
◦ Burden (liability) of tax cannot be shifted
 Income Tax
 Corporation Tax
 Tax on interest from savings
 Capital Gains Tax
 Inheritance Tax

Usually taxes on spending

Burden of the tax might be shifted from producer to consumer
depending on
◦ price elasticity of demand
◦ price elasticity of supply

Examples
 Vat
 Excise duties
Probable Shifting of Taxes
Corporate Income Tax
Stockholders – Consumers –Suppliers Employees
Sales and Excise Taxes
Consumers
Property Taxes
Renter
20
3
Tax Efficiency
Administrative costs
Efficiency in collecting revenue
Possibility of tax evasion
Changes of economic motivations
20
4
Deadweight costs of taxation
Taxes reduce economic efficiency, by introducing a
deadweight loss
It does not matter whether a tax on a good is levied
on buyers or sellers of the good
The price paid by buyers rises, and the price
received by sellers falls.
20
5


Because of this, the quantity sold falls below
the level that would be sold without a tax
The size of the market for that good shrinks.

Changes in Welfare
◦ A deadweight loss is the fall in total
surplus that results from a market
distortion, such as a tax.

The change in total welfare includes:
◦ The change in consumer surplus,
◦ The change in producer surplus, and
◦ The change in tax revenue.
◦ The losses to buyers and sellers exceed
the revenue raised by the government.
◦ This fall in total surplus is called the
deadweight loss.

What determines whether the deadweight
loss from a tax is large or small?
◦ The magnitude of the deadweight loss
depends on how much the quantity
supplied and quantity demanded respond
to changes in the price.
◦ That, in turn, depends on the price
elasticities of supply and demand.

The greater the elasticities of demand and
supply:
◦ the larger will be the decline in
equilibrium quantity and,
◦ the greater the deadweight loss of a tax.

The Deadweight Loss Debate
◦ Some economists argue that labor taxes are
highly distorting and believe that labor supply is
more elastic.
◦ Some examples of workers who may respond
more to incentives:
 Workers who can adjust the number of hours
they work
 Families with second earners
 Elderly who can choose when to retire
 Workers in the underground economy (i.e.,
those engaging in illegal activity)

With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.



For the small tax, tax revenue is small.
As the size of the tax rises, tax revenue
grows.
But as the size of the tax continues to rise,
tax revenue falls because the higher tax
reduces the size of the market.


As the size of a tax increases, its deadweight
loss quickly gets larger.
By contrast, tax revenue first rises with the
size of a tax, but then, as the tax gets larger,
the market shrinks so much that tax revenue
starts to fall.


The Laffer curve depicts the relationship
between tax rates and tax revenue.
Supply-side economics refers to the views of
Laffer who proposed that a tax cut would
induce more people to work and thereby have
the potential to increase tax revenues.
Deadweight costs of taxation
 The only way to completely avoid deadweight costs
is to find taxes which do not change economic
incentives
 Examples cover a lump sum tax such as a poll tax
which is paid by all adults regardless of their choices,
or a windfall profits tax which is entirely unanticipated
and so cannot affect
21
6
Additional Deadweight costs of
taxation: Tax Transparency
 The more complicated tax policy is, the more
opportunities for legal tax avoidance and illegal tax
avasion
These not only result in lost revenue, but involve
additional deadweight costs: for instance, payments
made for tax advice are essentially deadweight costs
because they add no wealth to the economy.
21
7
Additional Deadweight costs of
taxation: Perverse incentives
 Complicated tax codes offer perverse economic
incentives.
 For instance, a sale from one company to another
might be liable for tax, but if the same goods were
shipped from one branch of a corporation to another, no
tax would be payable.
To address these issues, economists often suggest
simple and transparent tax structures which avoid
providing loopholes.
21
8






Introduction of flat tax rate in some countries
Introduction of new lower rates of tax
Lower corporation tax rates
Switch towards indirect taxes (e.g. VAT and excise
duties)
Reforms to tax on personal savings and share
investments
Wider use of environmental taxes






Energy production/consumption (eg.motor fuels)
Agricultural fertilisers & pesticides
Disposable household goods
Waste disposal
 household
 industrial
Water usage
Out of town car parking space

Tax Freedom Day is the first day of the year in
which a nation as a whole has earned enough
income to fund its annual tax burden

Capital expenditure
◦ highways; airports; schools; hospitals; defence equipment

Current expenditure
◦ E.g. salaries of public servants, teachers & health care
workers; drugs used in the national health service

Transfer payments
◦ welfare benefits to benefit claimants

Debt interest
◦ payable to holders of government debt
Social Security
Health Care Services
Education
Debt Interest
Defence
Law & Order
Other functions
32%
17%
12%
7%
7%
5%
21%
•
•
•
Cyclical trends in national output and employment
Demand for state provided public and merit goods
Social & demographic change
• long term changes in the age structure of the
population
• social changes (ie changes to the structure of
family life)
• income inequality and the scale of poverty
•
•
•
•
Political decisions and priorities
Costs of publicly-provided goods & services
Interest Rates and Inflation Rate
Privatization Programme (affects the size of the
public sector)

The Public private initiative (PPI) is a new way for
the government to provide services for the public.

The government decides what service it wants to
provide, then the private sector finds the best way to
design, build, finance and operate that service in
partnership with the public sector.

Taxation of some benefits (inc. unemployment
benefit)

Reduction in eligibility (e.g. job-seekers
allowance)

Breaking of link between state pensions and
average earnings

Encouragement of private pensions and health
care

Increase of the pension age

Tougher criteria for claiming incapacity benefit

Freezing of child benefit (reducing its value in real
terms)

Gradual reduction in the real value of student
grants - replaced by a student loan component

The Budget Deficit is the annual difference between
Total Government Spending and Total Tax Revenues

It is the amount the government must borrow to
finance overall spending

Budget deficit dends to be quite volatile from year to
year

There is a strong link between the budget deficit and
the economic cycle

Combined annual borrowing of
 Central Government
 Local Governments
 Public Corporations
◦ Measured by
 nominal PSBR
 PSBR as percentage of GDP
 Borrowing
requires the issue of debt
(so-called government securities, e.g.Treasury bills,
Long-dated government bonds
 Debt
is sold to the financial sector, the non-financial
private sector and foreign institutions & individuals

Requires financing in the short-term
◦ higher interest rates to attract buyers of debt
◦ may “crowd out” funds available for private sector
investment

“Today’s borrowing is tomorrow’s taxation”
◦ Higher taxation to reduce the deficit
◦ Alternative is strict control of govt spending

High PSBR adds to future interest costs
◦ might have been spent elsewhere by the govt

When a government borrows only to finance
investment and not to fund day to day spending, it is
following the Golden Rule.

Public spending on current goods and services and
social security benefits should be met by taxes, but
investment for the future can be met by borrowing.


Budget deficits impose an unjustifiable
burden on future generations by raising their
taxes and lowering their incomes.
When the debts and accumulated interest
come due, future taxpayers will face a
difficult choice: They can pay higher taxes,
enjoy less government spending or both.


By shifting the cost of current
government benefits to future
generations, there is a bias toward too
large a public sector.
Deficits reduce national saving,
thereby retarding capital formation,
causing lower productivity, and
limiting real growth.


The deficit is only one small part of
fiscal policy. The problem with the
deficit is often exaggerated.
Intergenerational transfers may be
justified and some government
purchases produce benefits well into the
future (i.e. reducing budget deficit by
cutting spending on education).



A balanced budget requirement would limit
the policy options available to deal with
emergencies and future economic crises.
The government debt can continue to rise.
Population growth and technological
progress increases the nation’s ability to
pay the interest on the debt.
The budget deficit can be sustained
annually, at 5 percent of the total
government debt, or $28 billion.

How a budget deficit makes future
generations worse off.

How reducing the budget deficit might
make future generations worse off.
“A nation’s productive capability is determined
largely by how much it saves and invests for the
future.”


A nation’s saving rate is a key
determinate of its long-run economic
prosperity.
When the saving rate is higher, more
resources are available for investment
in new plant and equipment.


“Our society discourages saving in too many
ways, such as by taxing the income from
capital heavily and by reducing benefits for
those who have accumulated wealth and
capital.”
The consequences of high interest income
tax policies are: reduced saving, reduced
interest accumulation, lower labour
productivity, and reduced economic growth.


An alternative to current tax policies,
advocated by many economists is a
consumption tax like the VAT.
A person pays taxes only on the basis of
what they consume (spend) not on what they
produce. Income that is saved is exempt
from taxation until the saving is later
withdrawn and spent on consumption goods.


Most of the proposed changes in the tax
policies to stimulate saving would benefit
primarily the wealthy at the expense of
lower income groups.
High-income households save a higher
fraction of their income than low-income
households. Any tax change that favors
people who save will also tend to favor
people with high income.


Reforms would be either regressive or
would further the inequality of income in
our society.
Raising public saving by eliminating the
government’s budget deficit would provide
a more direct and equitable way to
increase national saving.

A large and growing part of government is
devoted to transferring income.
24
5

There are three major reasons why large-scale
redistribution will reduce the size of the economic
pie:
◦ When taxes take a larger share of one’s income, the
individual reward derived from hard work and
productive service is reduced.
24
6
◦ As public policy redistributes a larger share of
income, more resources will flow into wasteful rent
seeking activities.
◦ Higher taxes to finance income redistribution and an
expansion in rent-seeking will induce taxpayers to
focus less on income-producing activities, and more
on actions to protect their income.
24
7
Role and impact of taxation (example)
Taxation and Tax evasion
The role of government subsidies
 Developments in tax policy
 Unemployment compensation benefits and fight
against unemployment
 Costs and benefits of the public health care
