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The Economics of the Public Sector

Social Insurance, Redistribution and Merit Goods

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EQUITY - Redistribution

Why is the allocation of resources resulting from the market operation inequitable?

Why is equity a problem of the government?

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There are two important aspects to consider:

i) Achieving a more equitable allocation of resources than the one produced by the market may or may not be desirable. It depends on the values of each person.

ii) If we think that the market outcome is efficient but not equitable and the government needs to intervene, then very often this implies that the new more equitable allocation of resources is also less efficient – equity is costly.

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Equity has Efficiency CostsMost government interventions in the market imply some kind of distortion in incentives. If incentives were conducive of efficiency to start with, then distorting them is likely to produce inefficiencies. It is important to acknowledge and quantify these distortions in order to understand the costs of redistribution programs, which can be very high. For example, progressive taxation distorts incentives to work at the top of the income distribution, while welfare programs distort these incentives at low income levels.

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Different Individuals have Different Views on Equity

Then, which one should we adopt? How equitable is equitable enough? How much inefficiency are we willing to trade-off for a given increase in equity?

Different individuals have different preferences. We need a mechanism to aggregate preferences of individuals into a social preference (social welfare function).

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There are two extremes we can think of: tyranny and direct democracy. However, there are many other ways to aggregate preferences, that do not even correspond to a particular political system.

Even if we can construct such a social welfare function, do we usually think of the government as exercising the will of society (maximizing the social welfare function)? We will see this in more detail when we study public choice.

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Social Insurance

There is a related topic which is related with redistribution but has different characteristics: Social Insurance.

All of us can experience several random events that put us at a disadvantage. Two of the most important ones are health problems and unemployment. Because these events occur randomly one would like to insure against them. However, insurance markets do not always function perfectly.

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Another important type of uncertainty concerns old age. Since the date of death is random it is not easy to make adequate provisions for retirement. Again, one would like to have access to adequate private insurance markets, but often they do not exist.

Social insurance systems are designed to be self-financing. In that respect they are different from other social programs.

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Why does the market fail to provide insurance?

1. Some aggregate risks are hard to insure

2. Because of Adverse Selection bad risks are priced out of the market.

3. Because of Moral Hazard insurance is only partial.

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Merit Goods

These are goods that the government believes individuals should consume more of (or less of) what they currently consume. The reason individuals do not consume adequate quantities of these goods is because, even though they are good for them, they do not know better and make bad decisions. This may be one reason (but not the only one) for compulsory schooling. In these cases we say that the government acts paternalistically.

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Some examples

1. Compulsory Schooling

2. Forced Savings and Retirement Benefits

3. Public Television

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Redistributive Programs

There exist several redistributive programs. The most obvious are welfare programs that provide cash, goods and services to poor households.

There exists substantial debate on two issues:

a. In-kind vs. Cash Transfers

b. Categorical vs. Broad Based Aid

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In-Kind Transfers are Inefficient

Suppose we have a household choosing how much to consume of food and childcare.

This household can receive cash or income transfers that change the budget constraint.

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Cash Transfer

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In-Kind Transfer – Unconstrained Household

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In Kind Transfer – Constrained Household

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Why then do governments make in-kind transfers?

1. Paternalism – Provide incentives for consumption of “desirable” goods

2. Target Particular Groups of the Population (such as Children)

In developing countries there are similar programs called conditional cash transfers.

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Categorical vs. Broad Based Aid(Targeted vs. Universal Programs)

The main issue is targeting. Targeting is often useful to decrease deadweight losses of programs, or increase their efficacy.However, targeting may be administratively costly, it is difficult to do because of lack of information, and it may induce perverse incentives (incentives to become a member of the targeted group). Furthermore, targeted programs may also be seen as less fair than universal programs.

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Incentive Problems

Most welfare programs can have perverse incentives on work, fertility and education decisions.

Ex. 1. Means Tested Welfare Programs – impose high marginal tax rates on poor individuals because they lose benefits when their income rises.

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Ex. 2. Aid to Single Mothers – decreases the cost of out of wedlock childbearing

Ex. 3. Subsidies to Work – increase incentives to work but decrease incentives to accumulate human capital in school (although it encourages accumulation of human capital on the job through work experience).

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Measurement I: Measurements of Inequality in the UK

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Measurement II: Inequality, Mobility and Intergenerational Mobility

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Measurement III: Short and Long Run Poverty

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Measurement IV: Data on Public Expenditures

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