The Public Sector and Public Choice I. WHAT A PRICE SYSTEM CAN AND CANNOT DO: The benefits of a price system are high levels of efficiency, the existence of consumer sovereignty, promotion of personal freedom, and prevention of coercion of buyers and sellers by the existence of competition. A price system can also produce market failure.II. CORRECTING FOR EXTERNALITIES: An externality is a situation in which a benefit or cost associated with an economic activity spills over to third parties, i.e., parties who are not direct participants in the market transaction.A. External Costs in Graphical FormB. External Benefits in Graphical FormC. How Government Corrects Negative Externalities:1. Special Taxes: Taxes on output would reduce output, but would not provide an incentive to reduce pollution per unit of output. Taxes on the amount of pollutants emitted would provide an incentive to reduce pollution per unit of output.2. Regulation: The government could specify a maximum allowable rate of pollution.D. How Government Corrects for Positive Externalities1. Government Financing and Production: When positive externalities are large (e.g. public goods), government may finance and produce the good or service.2. Subsidies: A subsidy is a negative tax: a payment to the consumer or producer of the good or service for consuming or producing a good or service.3. Regulation: Government can require that certain actions be undertaken, e.g. inoculations of school children, mandatory educationIII. THE OTHER ECONOMIC FUNCTIONS OF GOVERNMENT: The functions of government that affect the way in which exchange and resource allocation are carried out in the economy.A. Providing a Legal System: All relationships among consumers and businesses are governed by legal rules. Much of the legal system is involved with defining and protecting property rights.B. The Importance of Property Rights1. Private Property Rightsa. Property rights: the right to use, control, and obtain benefits from a good or service.b. Several functions of private property rights(1) The provide the right to exclusive use(2) The provide legal protection against invaders(3) They provide the right to transfer to another2. Private Property Rights Incentivesa. Private owners can gain by employing their resources in ways that are beneficial to others. b. The private owner has a strong incentive to care for and properly manage what he owns.c. The private owner has an incentive to conserve for the future if the property’s value is expected to rise.d. The private owner is accountable for damage to others through misuse of the property: links responsibility with the right of control.C. Promoting Competition: Promoting competition is a way of increasing the efficiency of the economy. Antitrust regulation is used to reduce the power of monopolies and to discourage certain actions that restrain trade. *** D. Providing Public Goods: Public goods are goods to which the principle of rival consumption does not apply and are jointly consumed by many individuals simultaneously. This is in contrast to private goods that can beconsumed by only one person at a time. 1. Characteristics of Public Goodsa. Public Goods can be used by more and more people at no additional cost (zero marginal cost) without depriving others ofany services of the goods.b. It is difficult to design a collection system for a public good on the basis of how much individuals use it.2. Free Riders: The free rider problem is a situation associated with public goods when individuals presume others will pay for publicgoods so they can escape paying for their portion without causing a reduction in production.IV. THE MOST IMPORTANT FEDERAL TAXESA. Federal Personal Income Tax: This tax accounts for 49 percent of federal revenues. B. Treatment of Capital Gains: Currently capital gains, the positive differencebetween selling and buying price of an asset, are taxed several different tax rates.C. Corporate Income Tax: taxes paid on corporate profits1. Double Taxation: Taxed once as corporate profits which are paid by the corporations. Profits distributed as dividends to individuals are taxed again as personal income. If the corporationretains profits and invests them, the value of the business increases and its stock price rises. Upon selling the stock, the shareholder pays tax on the gain.2. Who Really Pays the Corporate Income Tax?: Corporations do not really exist apart from owners, employees, and customers. The question arises of tax incidence, i.e. who pays the corporate income tax. Some economists say that corporations charge higherprices to pay the tax, while others argue that shareholders and employees get lower incomes.D. Social Security and Unemployment Taxes: These are taxes on payrolls. The Social Security tax is a tax on earnings up to a taxable base. Currentlythe employer and employee each pay 7.65 percent of the first $80,000 of earnings. A Medicare tax is imposed on wage earnings at a rate of 2.9 percent.V. COLLECTIVE DECISION-MAKING: THEORY OF PUBLIC CHOICE: Collective decision-making is how voters, politicians, and other interested parties act to influence non-market decisions. The theory of public choice is the study of collective decision making (James Buchanan, 1986 Nobel Prize Winner).A. Similarities in Market and Public Sector Decision Making: There is an assumption of self-interest being the motivating force in both sectors.1. Scarcity: Because resources are fixed, there is a scarcity constraint for both sectors. If government gets more goods then there are fewer goods for the private sector. Every government action has an opportunity cost.2. Competition in Both Sectors: In the public sector the competitionis between bureaucrats, elected representatives and appointed officials for available funds. Economists assume that they will compete and act in their own interest, not society’s. 3. People in government face a different incentive structure (use it or lose it, maximize their budgets)B. Differences Between Market (Private) and Collective (Government) Decision Making1. Government Goods at Zero Price: Government gives the goods for “free.”2. Use of Force: Government is the only entity that can use force in the regulation of economic affairs.3. Voting Versus Spending: In the market sector a dollar voting system exists and is not equivalent to the voting system in the public sector.The Economics of Collective Decision MakingI. Overview of Collective Decision MakingA.