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Define welfare state

Welfare state: Concept of government in which the state or a well-established network of social institutions plays a key role in the protection and promotion of the economic and social well-being of citizens


We distinguish between two dimensions of welfare/well-being, what are they?

Efficiency is an objective goal: it can be judged on positive grounds - “make total pie as large as possible” (pie = e.g. GDP)
Equity is a subjective goal: involves normative judgments that go beyond economics - “give everyone his/her fair share of the pie” (more egalitarian outcome)


What is the distinction between welfare state and welfare society.

A welfare society involves norms, institutions and rules in society aiming at correcting the outcomes of an unregulated market economy and in particular aiming at more egalitarian outcome. Not just government intervention.

An example of a distinction is family friendly workplaces. If all workplaces are organized according to norms rooted deeply in the society, e.g. all are off at three p.m. so they can pick up their kids, then if this is rooted in norms there is no reason for the government to make regulations.
Although the public sector is an essential and large element of the welfare state, it is misleading to equate the two since the objectives of the welfare society go beyond the activities of the public sector in a narrow sense (therefore the term welfare society may be more appropriate than welfare state).


What is market efficiency and market failure?

Market mechanism: Competitive markets tend towards efficiency, i.e. maximize total surplus
- total surplus = sum of consumer and producer surplus
Market failure: Situation in which the market fails to produce the efficient level of output. Public policy can intervene to increase efficiency


Which situations might create market failure?

Imperfect competition resulting in market power (e.g. monopoly)
Externalities (e.g. pollution, education, research)
Public goods (e.g. infrastructure, defense)
Asymmetric information (e.g. insurance markets)


What is an externality?

A cost or benefit that affects a third party not directly involved in an economic transaction.


What is an external marginal cost and an external marginal benefit?

An external marginal cost is the cost imposed on a third party when an additional unit of a good is produced or consumed.
An external marginal benefit is the benefit conferred on a third party when an additional unit of a good is produced or consumed.


What is a social cost and a social benefit?

A social cost is the cost of an economic transaction to society, equal to the private cost plus the external cost.
A social benefit is the benefit of an economic transaction to society, equal to the private benefit plus the external benefit.


What is a private cost and a private benefit?

A private cost: cost borne by the producer
Private benefit: benefit received by the consumer


1. Contrast negative and positive externalities. Provide an example of each type of externality.

Negative externalities, like pollution, impose costs on third parties not directly involved in the economic transaction, when the social marginal cost is larger than the private marginal cost. Positive externalities confer benefits on third parties, when the social marginal benefit is larger than the private marginal benefit. Factors such as education and increased immunizations provide benefits to people beyond those directly involved.


2. Why does an unregulated market overproduce goods with negative externalities?

In an unregulated market, firms pay only the private cost of the good. For a good with a negative externality, this private cost does not equal the social cost of the good, since the external marginal cost of the good is positive. As a result, firms face lower costs than the social cost and overproduce the good.


Why does an unregulated market produce too little of goods with positive externalities?

When a good has a positive externality associated with it, the market will likely provide too little of the good because the external marginal benefit is ignored.


3. How can the external marginal benefit and external marginal cost curves be used to find the efficient level of an externality?

The efficient production level of an externality occurs at the intersection between the social marginal cost curve (equal to the private marginal costs plus external marginal costs) and the social demand curve (equal to the private marginal benefits plus external marginal benefits).


5. How do regulators use Pigouvian taxes to produce efficient outcomes?

A Pigouvian tax is a tax that equals the external marginal cost imposed by an externality. It is imposed on an activity that creates a negative externality. This tax rate shifts marginal costs up to the social marginal cost, resulting in efficient production on the market. The cost of the tax is split between the consumers and the producers. There is now no deadweight loss.


What is a Pigouvian subsidy?

A subsidy paid for an activity that creates a positive externality. The subsidy raises the effective price at which producers can sell their products, thus making it profit-maximizing for them to increase their outputs to the socially optimal level.


6. Describe how tradable pollution permits can be used to address pollution.

The holder of a government-issued tradable permit has two options: The firm may emit a certain level of pollution allowed by the permit, or the firm may trade its permit to another firm in the industry. By restricting the number of tradable permits issued, the government puts a cap on the amount of pollution that a given industry can produce. At the same time, since permits may be traded, the policy allows pollution across individual firms to vary and effectively creates a market for pollution.


What is a quota?

A regulation mandating that the production or consumption of a certain quantity of a good or externality be limited (negative externality) og required (positive externality).


7. Compare and contrast Pigouvian taxes and quantity based solutions to externalities. What are some of the advantages and disadvantages of each?

In a market in which the optimal level of the externality is known, a price-based mechanism such as a Pigouvian tax or a quantity-based mechanism such as a quota or tradable permits market will produce the same efficient result. But when the optimal level is unknown, a deadweight loss is produced. Depending on market characteristics, a Pigouvian tax or a quantity-based mechanism will prove more optimal. In particular, the deadweight loss from regulation is minimized in a market with a relatively flat marginal abatement cost curve when a quantity regulation is imposed. A Pigouvian tax is more optimal in a market with a relatively steep marginal abatement cost curve.


What is the deadweight loss?

The deadweight loss equals the area between the marginal benefit of pollution (or the marginal abatement costs) and the marginal cost of pollution for each of the units of pollution between the efficient level of pollution and the current level of pollution.


What is a rival vs a nonrival good?

Rival: one individual’s consumption affects another’s consumption
Nonrival: one individual’s consumption has no effect on another’s consumption


What is an excludable vs a nonexcludable good?

Excludable: Individuals can be kept from consuming
Nonexcludable: Individuals cannot be kept from consuming


What is a public good?

A good that is accessible to anyone who wants to consume it, and that remains just as valuable to a consumer even as other people consume it. Public goods are similar in some ways to positive externalities: They can provide external benefits to individuals other than those who purchase them.


9. What are the two defining properties of public goods (or pure public goods)?

Public goods are nonexcludable and nonrival. This means that anyone can access and use the good (nonexcludable), and that any one person's consumption of the good does not diminish another consumer's enjoyment of it (nonrival).


What is the total marginal benefit (in relation to public goods)?

The vertical sum of the marginal benefit curves of all of a public good’s consumers.


10. When is a public good being produced efficiently?

When produced efficiently, a public good's total marginal benefit-the vertically combined marginal benefit curves of all its individual consumers-equals its marginal cost


Why isn't this efficiency condition (for public goods) achieved in the private market?

For the same reasons we saw in markets with externalities, the free market is going to encounter a problem providing the right level of public goods. The market facilitates private exchanges until a good's private marginal cost equals individuals' private marginal benefits. However, that is not where the combined marginal benefits of multiple consumers equal the good's marginal cost. If individuals could buy the public good themselves at marginal cost, each would buy the quantity at which her own marginal benefit equals its marginal cost.
Therefore, although both individuals would be willing to pay for some quantity of the public good, neither would by herself pay for the efficient quantity because her individual marginal benefit is less than the joint marginal benefit. The inefficiency arises in a way that is similar to how inefficiency arises with a positive externality: Individuals paying privately for a public good don't consider everyone else's benefit from the good. This is one reason why private markets fail to produce the efficient quantity of public goods. Left to their own devices, private markets don't supply enough national defence, mosquito abatement, clean air, fireworks displays, and the like. In addition to not taking into account the total marginal benefit of the good and thus having less of it available than is socially optimal, the free-rider problem is another source of inefficiency in the markets for public goods. A free-rider is someone who enjoys a good or service without paying for it.


11. Why does the free-rider problem arise?

A free-rider is an individual who uses a good or service without paying for it. Since a public good is nonexcludable and nonrival, the free-rider problem arises.


How can we solve the free-rider problem?

A common solution to the free-rider problem in the fireworks case, the online retailer case, and in paying for public goods more generally is for an entity like the government or the manufacturer to compel people to pay their share through a tax or a retailer fee. This is why the most expensive and broad-scoped public goods such as national defence, "rule-of-law" goods (e.g., court systems, police services), and national transportation infrastructure items for which free-riding might be the most severe-are paid for through taxation.
Other solutions are also possible. Beneficiaries of a public good can form an organization that compels members to pay their share of the public good's costs. The tricky issue in such situations is convincing potential members to voluntarily form a group that will compel them to pay for something they'd rather not pay for at all.


What is the tragedy of the commons?

A common resource (a type of public good that is rival but nonexcludable) isn' t a pure public good, but it presents a similar kind of inefficiency called the tragedy of the commons. The concept of the "tragedy" comes from the dilemma that common resources create: Because everyone has free access, the resource is used more intensively than it would if it were privately owned. This leads to a decline in the value of the resource for everyone. A reservoir of water, public forests, public airwaves, and even public restrooms are all examples of common resources. The key element is that the common resource is nonexcludable: Anyone can use or take from it, and those who use it cannot be monitored easily. Because access to the resource is shared by all comers, common resources are also called common-pool or common-property resources.


12. What types of solutions can address the tragedy of the commons?

The tragedy of the commons is the phenomenon whereby anyone can use a common resource without restraint. As a result, that common resource is used more intensely than it would if it were privately held. As with other negative externalities, Pigouvian taxes or quantity-based mechanisms are one set of solutions to the tragedy of the commons. Another solution is to grant property rights to an individual, transforming the resource from one that is commonly held to one that is privately held.


Is there a trade-off between efficiency and equity?

Traditionally, the choice between state and market is perceived to be mainly a question of efficiency vs. equity. The market mechanism is taken to function efficiently, and to the extent that its outcomes are judged politically unacceptable, public intervention may be justified to ensure more equitable outcomes - although it comes at a cost in terms of lower efficiency
Traditional view: trade-off between efficiency and equity:
Loosely regulated market economies: high GDP and high inequality
Strictly regulated market economies (in particular, high income taxes that allow more equal distribution, but imply lower work incentives): low GDP and low inequality
However, cross-country comparisons show no correlation between size of public sector and efficiency (e.g. US vs. Denmark). No apparent trade-off.
However: in the presence of market failures, more redistribution can lead to more efficiency, e.g. education subsidies, health/disability insurance (ex-post redistribution, but ex-ante insurance) . The welfare state provides goods complementary to working (e.g. childcare, elderly care), which results in high labour supply
Foundation of Denmark’s economic success?
Caveat: optimal public intervention requires information often not available to policy-makers and there is a potential for abuse of political power for personal rent-seeking


What are the three different types of welfare models?

The liberal welfare model, the corporatist or continental European model and the universal or Scandinavian model


Describe the liberal welfare model

Residual role of the state i.e. the state plays a residual role by providing the ultimate floor in cases where the market or civil society does not suffice. State only interferes to ameliorate poverty and provide for basic needs, largely on means-tested basis
Market dominance
Concerns about work incentives plays a dominant role
e.g. U.S., Canada


Describe the corporatist or continental European model

Central role of family: activities of the state directed towards families rather than individuals
Importance of private insurance schemes, mostly tied to (labour market) status
Principle of subsidiarity (i.e. insurance is regulated by state, but provided by private insurers)
e.g. Germany, France


Describe the universal or Scandinavian model

Central role of the state
Universalism: access to benefits and services based on citizenship, not tied to labour market status or income. I.e. the rights are universal and defined at the individual level applying equally for all.
e.g. universal pension in Denmark (Folkepension)
Public sector solutions (education, health care, etc.) are intended to meet the needs and requirements of most people.
Extended social safety net for unemployment, sickness, etc.
E.g. Sweden, Denmark


What are the three main roles of the public sector?

Organising, providing and financing particular services or activities.
The public sector does not always have all three roles simultaneously. E.g. car insurance is only organised by the public sector (requires everyone who owns a car to have the right insurance, if not the police will cut your license plates), not financed or provided.
In a few instances, the only thing the public sector does is finance or at least partly finance some services. Two examples are dental care (subsidies to dental care) and taxes (e.g. alcohol taxes imposed by the public sector).
Many things have all three dimensions, e.g. healthcare such as hospitals.
The Danish welfare model has the public sector in a central position along all three dimensions


What is the gross-principle (DK) vs. the net-principle?

In DK all income transfers are made with the gross-principle, which means that any kind of support, study grants, unemployment benefits and so on are taxable income in DK. One of the reasons we have the gross principle in DK is that it allows people to compare the income they get from employment vs. unemployment benefits.


How can we look at the size of the public sector?

One way - total government spending. Approx. 50% of GDP in DK, high in international perspective.
Another way of measuring is looking at total production costs. Costs of goods and services produced by the public sector (excl. transfers).Also high in DK in international perspective
Employment in public sector approx. 1/3 of total employment


What are four types of transactions in the public sector?

Public consumption - supply of goods and service (2/3 of public consumption are wage payments in DK, 1/3 of total employment is in the public sector in DK)
Capital accumulation (public investment) - mainly infrastructure investments
Capital transfers - interest rate payments


Describe the public sector structure in DK

Three-tier system: the state (central government), regions and municipalities. In addition, there are social funds responsible for the administration of e.g. unemployment insurance.
The state is responsible for general government activities such as military, the legal system, administration etc.
The regions are responsible for health care, while the municipalities are responsible for the remaining majority of public activities.