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Book Notes: “Principles of Microeconomics" - Part 4: Economics of the Public Sector (Mankiw)

This post is 4th in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).

Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)

Part 4: The Economics of the Public Sector

Chapter 10: Externalities

  • Markets do many things well but they do not do everything well.
  • Government actions can sometimes improve market outcomes.
  • One category of market failure are externalities.
  • Externality: The uncompensated impact of one person’s actions on the well-being of a bystander.

    • Negative externality: An adverse impact on a bystander.
    • Positive externality: A positive impact on a bystander.
  • Society’s interest in market outcomes go beyond just the buyer and seller. Society must consider the positive and negative effects of market transactions on society as a whole as well.
  • Buyers and sellers neglect the external effects of their actions.
  • Market equilibrium does not maximize the well-being of society at large. Market equilibrium only maximizes the outcome narrowly for the buyer and seller.
  • Examples of externalities:

    • Pollution from automobiles (negative externality). Consumers generally ignore this externality when purchasing a vehicle. The government addresses this problem by setting emissions standards and taxing the consumption of gasoline.
    • Restored historic buildings (positive externality). Neighbors, tourists and urban dwellers get to enjoy the beauty and sense of history of these buildings. Building owners do not get the full benefit of restoration (and often prefer to tear buildings down). Local governments regulate the destruction of historic buildings and can provide tax breaks (incentives) for landlords who maintain these buildings.
    • Barking dogs (negative externality). Dog owners do not bear the full cost of the noise that disturb and upsets their neighbors. Local governments can implement local noise ordinances to minimize this phenomenon.
    • Research on new technologies (positive externality). Universities and individuals will not pour energy into novel research without sufficient incentives. The government addresses this problem, in part, through the patent system which affords exclusive use of new innovations for a period of time.

10-1 Externalities and Market Inefficiency

  • Externalities can impact economic well-being.
  • Negative externality example: An aluminum factory:

    • Background:

      • Aluminum factories emit pollution (a negative externality).
      • For each unit of aluminum produced, a certain amount of smoke enters the atmosphere.
      • The smoke poses a health risk for innocent bystanders who breath the air.
    • How does a negative externality affect the efficiency of the market outcome?

      • The cost to society producing aluminum is larger than the cost to the aluminum producers.
      • The social cost includes the private costs of the aluminum producers plus the costs of the bystanders impacted by the pollution.
      • The social-cost curve is above the supply curve (because it adds the external costs of aluminum production).
    • Chart illustrating social cost curve and impact on market outcomes:

(Image from
  • The socially optimal equilibrium (intersection of social-cost curve and demand curve) is different from the actual equilibrium (where externalities are not considered).
  • One solution: policymakers can tax aluminum producers for each ton of aluminum sold.

    • The tax shifts the supply curve upward by the size of the tax.
    • Tax should reflect the external cost of pollutants released into the atmosphere (in order to match the social-cost curve).
    • New market equilibrium would result in socially optimal quantity of aluminum.
    • Internalizing the externality: Altering incentives so that people account for the external effects of their actions.
  • Positive externality example: Education

    • Background:

      • Some activities yield benefits to 3rd parties.

      • Education results in numerous positive externalities:

        • More informed voters which leads to better government.
        • More educated populations yields lower crime rates.
        • More educated population results in improved technology adoption and higher worker productivity and wages.
      • A person should prefer neighbors who are well educated.

    • How does a positive externality affect the efficiency of the market outcome?

      • A standard demand curve does not reflect the value to society for a good.
      • Social value is greater than private value so the social-value curve lies above the demand curve.
      • The optimal quantity is found where the social-value curve and the supply curve intersect.
      • The socially optimal quantity is greater than the quantity that the private market would achieve on its own (normal market equilibrium).
  • Chart illustrating social value (social demand) curve and impact on market outcomes:
(Image from
  • Government can correct market failure by internalizing the externality:

    • Positive externalities require subsidies.
    • This will move the market equilibrium closer to the social optimum.
  • Summary of the impacts of positive and negative externalities:

    • Negative externalities result in production of larger quantities than desired by society.
    • Positive externalities result in production of smaller quantities than desired by society.
    • Government guide policies to “internalize the externalities” to adjust incentives to either increase production (subsidies) or reduce production (taxes) to achieve the socially optimal quantity.
  • Technology spillover is a type of positive externality where one firm’s research and production of a technology benefits other firms. Patent protections are one way to provide incentives for innovation while still making long-term benefits available to competing firms.

10-2 Public Policies toward Externalities

  • Governments can manage externalities in two ways:

    1. Comand-and-control policies which regulate behavior directly.

      • Regulations that require or forbid certain behaviors.
      • Example: Making it a crime to dump hazardous chemicals into the water supply.
    2. Market-based policies which provide incentives so that firms can determine the best way to solve a problem.

      • Corrective tax: A tax designed to induce private decisions makers to take into account the social costs that arise from a negative externality.
      • Tradable Permits (aka “Cap and Trade”): Example: Voluntary transfer of the right to pollute from one firm to another. The government, in effect, creates a scarce resource (“pollution permits”). The result is creation of a market governed by supply and demand. Permits end up in the hands of firms that value them most highly.
  • Economists prefer market-based policies to command-and-control policies. For instance, corrective taxes raise revenue for the government but they also create incentives for market participants.
  • Case study: Why is gasoline taxed so heavily?

  • Gasoline is one of the most taxed goods in many countries.

  • Gas tax is a corrective tax that addresses the externalities of driving:

    • Congestion: Gas taxes manage congestion by creating an incentive to take public transportation, carpool, eliminate unnecessary tips and walk. Result is reduced traffic.
    • Accidents: Larger vehicles make the driver safer but are less safe for everyone else. The gas tax creates an incentive to purchase smaller, more fuel efficient vehicles. Result is safer roads.
    • Pollution: Gas tax discourages driving and the resultant pollution it causes. Result is a cleaner environment.
  • A 2007 study suggested that the optimal corrective tax in the U.S. would be $2.78/gallon in 2015 dollars. Actual gas tax was only $0.50/gallon in actual dollars.

  • Tax revenue from a gasoline tax could be used to lower income taxes (which distort incentives and result in deadweight losses).

  • Gasoline tax could also result in fewer government regulations.

  • Unfortunately a higher gasoline tax is not politically popular.

  • Objections to the economic analysis of pollution:

    • Environmentalists are opposed to putting a price on pollution.
    • Economists respond with the axiom that trade-offs are part of decision-making and that a value must be assigned in order to make an intelligent comparison.
    • Economists view a clean environment as another good.

10-3 Private Solutions to Externalities

  • In some cases, government intervention is not needed to address externalities.
  • Types of private solutions:

    • Moral codes and social sanctions.
    • Charitable organizations (example: the Sierra Club).
    • The self-interest of the relevant parties.
  • Coase theorem: The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own.
  • The Coase theorem only works when the relevant parties come to an agreement and are able to enforce the agreement.
  • Transaction costs: The costs that parties incur during the process of agreeing to and following through on a bargain.
  • Efficient bargaining becomes increasingly difficult when the number of interested parties is large. This is because coordinating more people is costly.

10-4 Conclusion

  • “The invisible hand is powerful but not omnipotent.”
  • Market equilibrium optimizes the sum of producer and consumer surplus.
  • The costs born by 3rd parties, as byproducts of market transactions, need to be considered as well (externalities).
  • The invisible hand is not always effective when it comes to allocating resources efficiently to address externalities.

Chapter 11: Public Goods and Common Resources

  • There are many goods that have no market price.
  • These goods include things like nature (e.g. rivers, mountains, beaches, lakes, etc.) or government amenities and events (playgrounds, parks, parades).
  • These goods face a different set of economic problems since the normal market forces that provide efficient allocation are absent.

11-1 The Different Kinds of Goods

  • Economic goods can be grouped according to the following characteristics:

    • Is the good excludable? Excludability: The property of a good whereby a person can be prevented from using it.
    • Is the good rival in consumption? Rivalry in consumption: The property of a good whereby one person’s use diminishes other people’s use.
  • Using the above characteristics, it is possible to group goods into four categories:

    • Private goods: Goods that are both excludable and rival in consumption. Example: An ice cream cone. It is excludable because you can prevent someone from eating one. It is rival in consumption because if someone eat an ice-cream cone, another person cannot eat the same cone.
    • Public goods: Goods that are neither excludable nor rival in consumption. Example: A tornado siren in a small town. It is not excludable because it is impossible to prevent any single person from hearing it when the siren sounds. It is not rival in consumption because when one person benefits from the warning it does not reduce the benefit to others.
    • Common resources: Goods that are rival in consumption but not excludable. Example: fish in the ocean. It is rival in consumption because when one person catches a fish there are fewer fish for the next person to catch. It is not excludable because it is difficult to stop fishermen from catching fish from a large ocean.
    • Club goods: Goods that are excludable but not rival in consumption. Example: fire protection in a small town. It is excludable because the fire department can decide not to save a building from a fire. It is not rival in consumption because once paid for the additional cost of protecting one more house is small.
  • Matrix of economic goods with examples:
(Image from
  • The boundaries between goods is not always clear.
  • The characteristics of being excludable and rival in consumption can be a matter of degree.

    • Example: fish in an ocean may not be excludable because of practical challenges of managing ocean stocks. However, government restrictions and a large coast guard can make fish partially excludable.
  • Public goods and common resources are closely related to externalities: both these goods and externalities are the result of something of value having no associated price.

    • Example: If an individual builds and operates a tornado siren in a town, the neighbors will benefit from the siren without paying for it (positive externality).
    • Example: If an individual uses a common resource such as fish in the ocean, others are worse off because there are fewer fish to catch (negative externality).
  • “Private decisions about consumption and production can lead to an inefficient allocation of resources, and government intervention can potentially raise economic well-being.”

11-2 Public Goods

  • The Free-Rider Problem

    • Example: A fireworks display. This good is not excludable (you cannot prevent someone from seeing fireworks) and it is not rival in consumption (because on person’s enjoyment does not reduce another’s enjoyment).
    • Free rider: A person who receives the benefit of a good but avoids paying for it.
    • The free-rider problem prevents the private market from supplying public goods.
    • Government is one solution to this problem. If the total benefit exceeds costs, a government can finance a public good with tax revenue.
  • Important public goods:

    • National defense.
    • Basic research.
    • Fighting poverty.
  • Some goods switch between public goods and private goods (depending on circumstances).

    • Example: A fireworks display performed in a town can be a public good. A fireworks display at a private amusement park (e.g. Disneyland) is a private good.
    • Example: A lighthouse operated by the government is a public good. A privately owned lighthouse that charges adjacent ports for operation is a private good.
  • Cost-benefit analysis: A study that compares the costs and benefits to society of providing a public good.

11-3 Common Resources

  • Common resources are not excludable (like public goods). Unlike public goods, common resources are rival in consumption: one person’s use degrades the resource for others.
  • Tragedy of the Commons: A parable that illustrates why common resources are used more than is desirable from the standpoint of society as a whole.

    • Social and private incentives differ.
    • Government can solve the problem through regulation or taxes to reduce consumption.
    • Government can also solve the problem by turning the common resource into a private good.
  • Some important common resources:

    • Clean air and water.
    • Congested roads.
    • Fish, whales and other wildlife.
  • Case Study: Why the cow is not extinct:

    • Cows live on ranches that are privately owned and are private goods. Ranchers have strong economic incentives to maintain cattle populations because of market demand for beef.
    • Contrast with elephants which are commercially valuable (ivory) but are a common resource. Poachers have strong incentives to kill the elephants.
    • Some countries have experimented with treating elephants as private goods. Landowners with elephants on their land may allow individuals to hunt some of their elephants but the landowners also have a strong incentive to maintain their stock of elephants because of this profit motive.

11-4 Conclusion: The Importance of Property Rights

  • There are some goods that the market does not adequately address or provide for (clean air, for example).
  • Governments are relied on to provide necessary common goods.
  • Markets cannot allocate resources efficiently without property rights.
  • Goods that do not have well established “owners” lack similar incentives for firms and individual actors.
  • Policies that are well planned and necessary can make the allocation of resources more efficient and raise economic well-being.

Chapter 12: The Design of the Tax System

12-1 An Overview of U.S. Taxation

  • Size and role of U.S. government has grown over the past century:

    • 1902: Government taxes as percent of GDP was 7%.
    • 2015: Government taxes as percent of GDP was 30%.
  • Federal government collects 2/3 of total tax revenue. States and local taxes account for the remaining 1/3 of tax revenue.

  • 2014 total federal tax receipts were over $3 trillion. Roughly $10,235/per person.

  • Tax liability: How much is owed.

  • Taxes collected by the federal government:

    1. Personal income taxes: The largest source of revenue for the U.S. Federal government. Income tax is levied on a variety of sources: wages, interest, dividends, profits, etc.
    2. Payroll taxes: A tax on the wages that a firm pays its workers.
    • This includes social insurance taxes which is revenue earmarked for Social Security and Medicare.
    1. Corporate income taxes: A tax on a corporation (a legal business entity). The government taxes the profits of the corporation: the amount a corporation recess less the costs of producing the goods or services.

      • Corporate profits are taxed twice: Once by corporate income tax (when profits are earned). Second when the corporation uses the profits to pay dividends to its shareholders.
      • To compensate for this double taxation, policymakers tax dividend income at lower rates than other types of income.
    2. Other taxes:

      • Excise taxes: Taxes on specific goods like gasoline, cigarettes and alcohol.
      • Estate taxes: A tax on the transfer of the estate of a deceased person.
      • Customs duties: Tarrifs imposed on the import of goods.
  • Taxes collected by the state and local government:

    • Sales taxes: Taxes on the purchase of goods and services.
    • Property taxes: Taxes levied on the value of land and structures.
    • Individual and corporate income taxes
    • Miscellaneous fees and licenses (e.g. hunting permits, bridge and road tolls, fares for public transit, etc.)
    • States and local governments also receive funds from the federal government.

12-2 Taxes and Efficiency

  • The goal for a tax system is to raise revenue for the government.
  • Policymakers must choose from a variety of tax options (listed in previous sections) and design a tax policy that balances efficiency and equity.
  • Tax system costs:

    • Direct tax payments (the obvious cost).
    • Deadweight losses resulting from market distortions.
    • Administrative costs associated with executing and maintaining tax laws.
  • An efficient tax system aims to:

    • Minimize deadweight loss.
    • Minimize administrative burdens.
  • Taxes incur deadweight loss (see Chapter 8 for details on deadweight loss and how it is calculated).
  • Case study: Should income or consumption be taxed?

    • Premise: Taxes cause people to change their behavior.

    • The result is that a tax results in deadweight losses and makes the allocation of resources less efficient.

    • Consider the impact of government revenue primarily derived from a personal income tax.

      • Income tax discourages people from working as hard.
      • Income tax also discourages people from saving.
    • Example of impact on saving:

      • 25-year old making choice to save $1000.
      • If he puts his money into a savings account that earns 8% annually he will have $21,720 when he retires at age 65.
      • If the government taxes his interest income annually at a 25% rate, his effective interest rates only 6%. After 40 years with a growth rate of 6%, the $1000 grows to only $10,290.
      • Because interest income is taxed, saving is much less attractive.
    • Some economists recommend changing the basis of taxation:

      • Tax the amount the people spend (consumption disincentive).
      • Stop taxing the amount that people earn (savings disincentive).
    • European countries rely more on consumption taxes than the United States.

    • Value-added tax (VAT): Government collects the tax in stages as the good is being produced (as value is added along the production chain).

  • Marginal vs. Average tax rates:

    • Average tax rate: Total taxes paid divided by total income.

    • Marginal tax rate: The amount by which taxes increase from an additional dollar of income.

      • Rational people think at the margin.
      • The marginal tax rate determines the deadweight loss of an income tax.
  • Lump-sum tax: A tax that is the same amount for every person.

    • This is the most efficient tax possible.
    • A person’s decisions do not alter the amount owed, the tax does not distort incentives and there is no deadweight loss.
    • The administrative burden is minimal.
    • The reason lump-sum taxes are not employed is that they are not equitable.

12-3 Taxes and Equity

  • Benefits principle: The idea that people should pay taxes based on the benefits they receive from government services. Example: Gasoline taxes are justified via this principle when gas taxes are used to build and maintain roads. The consumers of gasoline benefit from tax revenue that maintains the roads they use.
  • Ability-to-pay principle: The idea that taxes should be levied on a person according to how well that person can shoulder the burden.

    • Vertical equity: The idea that taxpayers with a greater ability to pay taxes should pay larger amounts.
    • Horizontal equity: The idea that taxpayers with similar abilities to pay taxes should pay the same amount.
    • Proportional tax: A tax for which high-income and low-income taxpayers pay the same fraction of income.
    • Regressive tax: A tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers.
    • Progressive tax: A tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.
  • Tax incidence: The study of who bears the burden of taxes.
  • Flypaper theory: A pejorative term used by economists to describe the assumption that the burden of a tax sticks wherever it first lands (like a flypaper). This assumption ignores some key economic ideas:

    • It ignores the elasticity of goods.
    • It ignores the ability of producers to shift the cost of the tax onto consumers.
    • Example: A tax levied on a luxury good like fur coats. The tax targets the wealthy but may fail in this objective. Wealthy consumers will seek out substitute luxury goods. Meanwhile the merchants and workers who produce the good are the ultimate victims of the tax.
  • Case study: Who pays the corporate income tax?

    • Corporate income tax is an example of the importance of tax incidence when analyzing tax policy.

    • Politicians and voters are always eager to impose taxes on corporations (have them foot the federal tax bill rather than private individuals).

    • Key question: Who bears the true burden for corporate taxes?

      • “People pay all taxes.”
      • Corporations function more like tax collectors than tax payers when taxes are levied on them.
      • Corporations can pass the cost of taxes on through to their customers (the end of the value chain).
    • Example: The government taxes income from car companies.

      • Short-run impact is on the car companies who receive less profit.

      • Long-run: Car companies respond to the tax.

        • Producing cars is less profitable so car companies reduce capital investment in production (e.g. no new factories).
        • Car companies invest their wealth in other ways. For example: factories in other industries or countries.
        • Fewer car factories results in reduced supply and, in turn, lower demand for autoworkers.
      • The tax on corporations making cars causes the price of cars to rise and the wages of autoworkers to fall.

    • Corporate taxes are popular because they appear to be paid by rich corporations (the flypaper theory).

    • To analyze tax incidence you must look at the second order effects and long-term repercussions.

12-4 Conclusion: The Trade-Off between Equity and Efficiency

  • Equity and efficiency are the two important goals for a tax system.
  • These two goals are in opposition to each other.
  • Disagreements and debates over policy result from differences in which goal should be prioritized.
  • Economics should not be the sole voice in the debate over tax policy, but it is a useful framework for evaluating the costs and the benefits of such policies.

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