Public Sector Economics: Collective Choice and Fiscal Federalism

Political Economy: Collective Decision-Making

Lindahl Pricing

Individual Marginal Benefit (MB) curves are summed vertically to determine the Social Marginal Benefit (SMB). Efficiency is achieved at the quantity (Q) where SMB = Social Marginal Cost (SMC). While theoretically efficient, it often fails due to preference issues:

• Revelation Problem: Individuals may misrepresent their true preferences.
• Knowledge Problem: Difficulty in knowing individual preferences.
• Aggregation Problem: Challenges in combining diverse preferences.

Voting Mechanisms

Voting works effectively with single-peaked preferences (where individuals have one most preferred choice).

Problems with Voting

• Non-Single-Peaked Preferences: Can lead to cyclical outcomes, known as the voting paradox. For example, if H > L, L > M, and M > H, there is no clear winner.
• Arrow’s Impossibility Theorem: No voting system can satisfy all fairness criteria simultaneously, leading to inconsistent results. Key criteria include:
  • Dominance: If A is preferred over B by all voters, A should be chosen.
  • Transitivity: If A > B and B > C, then A > C.
  • Independence of Irrelevant Alternatives (IIA): The ranking between A and B should not change with the addition or removal of a third alternative (D).
• Intensity of Preferences: Voting systems often ignore the strength of individual preferences.

  Example: If 51% of voters gain $10 each, and 49% lose $50 each, a project might pass by majority vote, but overall social surplus would decrease. Lobbying can sometimes better capture preference intensity.

Median Voter Theorem (MVT)

The MVT predicts moderate outcomes in elections but relies on strict assumptions:

• Single-peaked preferences among voters.
• Voting on a single issue.
• Only two candidates.
• Full voter turnout and complete information.

Public Choice Theory

This theory focuses on government inefficiency, often stemming from lobbying efforts and the self-interest of government officials.

Leviathan Theory

Proposes that government aims to maximize its size and power. This suggests a need for constraints, such as balanced-budget rules, to limit potential inefficiency.

Fiscal Federalism: State and Local Government

Federal vs. State and Local Funding

The allocation of funding responsibilities between federal, state, and local governments is based on several factors:

• Federal Funding Reasons:
  • Spillovers: Benefits that extend across state lines (e.g., national defense, interstate highways).
  • Redistribution: To prevent local welfare programs from driving out wealthy residents or attracting poorer ones, ensuring more equitable distribution.
  • Economies of Scale: For complex services that benefit from larger-scale provision.
• State/Local Funding Reasons:
  • Local Preferences: To tailor services (e.g., parks, policing) to specific community needs and preferences.
  • Tax-Benefit Linkage: Direct connection between local taxes paid and benefits received (e.g., road repairs funded by local property taxes).

Importance of Matching Scale

It is crucial to match the scale of benefits with the appropriate level of government for efficient service delivery.

Tiebout Model

The Tiebout Model suggests that individuals "vote with their feet" by moving to communities that offer their preferred mix of public goods and taxes (e.g., choosing Town A for higher taxes but better schools).

Conditions for the Tiebout Model:

• Free mobility of residents.
• Complete knowledge of costs and benefits of local public goods.
• A large number of towns to choose from.
• Public goods are localized (benefits do not spill over to other towns).

Problems with the Tiebout Model:

• Immobility: High moving costs or social ties can limit mobility.
• Spillovers: Benefits like clean air are not localized.
• Zoning: Regulations (e.g., large lot sizes, no apartments) can exclude lower-income residents.

Public Goods Provision

For non-rival public goods (where everyone can benefit simultaneously, like a park), the Social Marginal Benefit (SMB) is the vertical sum of individual marginal benefits. For example, if Jack values a public good at $5 and Ava at $3, the SMB is $8.

Zoning and Fiscal Exclusion

The phenomenon of "chasing the rich" occurs when poorer residents move to wealthy towns, potentially leading to free-riding on the tax base. A common solution is zoning, which uses regulations (e.g., minimum lot sizes, prohibition of apartments) to exclude certain populations.

Tradeoff: While zoning can protect a town's tax base, it often exacerbates equity issues by limiting access for lower-income individuals.

Federal Grants to State and Local Governments

Federal grants influence state and local spending in different ways:

• Matching Grants

  These grants offer a federal contribution for every dollar spent locally (e.g., $1 federal for $1 local). They effectively decrease the price of public goods, leading to increased spending due to both:

  • Income Effect: Local governments feel wealthier, increasing their capacity to spend.
  • Substitution Effect: Public goods become relatively cheaper, encouraging more spending on them.

  Implication: Matching grants rotate the budget constraint (like a subsidy) and are effective for addressing externalities.

• Block Grants

  These provide a fixed amount of money with few or no restrictions on how it can be spent. Towns can allocate these funds freely, resulting in a smaller increase in public goods spending but a greater increase in overall welfare.

  Implication: Block grants cause a parallel shift outward of the budget constraint and are good for redistribution.

• Conditional Block Grants

  These grants provide a fixed amount of money but mandate spending on specific areas (e.g., education). They only impact spending if the mandated amount is greater than what the local government would have spent otherwise.

  Implication: Conditional block grants create a kinked budget constraint, affecting spending only if the mandate exceeds the original spending level.