1

Economics of Public Policy

– Labor Market Equilibrium

– Economics of Health Care

– Public Goods

2

Labor Market Equilibrium

Understand the relationship between wages and the marginal productivity of workers

Analyze how wages and employment are determined in competitive labor markets

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The Labor Market

• Marginal product of labor (MP)– The additional output a firm gets by employing one

additional unit of labor• Value of marginal product of labor (VMP)

– The dollar value of the additional output a firm gets by employing one additional unit of labor

• In a competitive market,

wage = VMP

4

Adiron Woodworking Company

• Makes cutting boards from free scrap wood– Price of a cutting board is $20

• Going wage is $350 per week

# of Workers Output

0 0

1 30

2 55

3 76

4 94

5 108

MP

30

25

21

18

14

VMP

$600

500

420

360

280

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Adiron Woodworking Company

• The company will hire workers until the value of the marginal product of the last worker is equal to the wage– Cost-Benefit Principle– Workers earn $350 per week

• Adiron will hire four workers– The fifth worker costs

more ($350) than the benefits he delivers ($280)

# of Workers VMP

1 $600

2 500

3 420

4 360

5 280

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Demand for Labor

Wag

e ($

/hou

r)W

age

($/h

our)

Firm 1

Firm 2

Work hours/day

100

12

50

12

D1 = VMP1

D2 = VMP2

150

6

6

100

Total Employment

Wag

e ($

/hou

r)

Market

150

12D = VMP1 +

VMP2

250

6

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Individual Labor Supply

• Individuals trade-off income and leisure– More work hours means more income AND less

leisure• Suppose the wage increases

– Substitution effect: work more• Leisure is more expensive

– Income effect: work less• Purchasing power increases for a given work

schedule– A higher wage may increase or decrease the quantity

of labor supplied by the individual

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Labor Supply of Programmers

• Labor supply for a single profession has a positive slope– Higher wages attract

workers from other careers

• An increase in wages from W1 to W2 increases quantity of labor supplied from L1 to L2

– Movement along the labor supply curve

Employment of programmers(work-hours/year)

L1

W1

L2

W2

S

Wag

e ($

/hou

r)

9

Equilibrium in the Labor Market of Programmers

• Demand for programmers increases from D1 to D2

– Initial impact is a shortage of programmers at W1

– In the short-run, wages are bid up to W3

• In the long run– Movement up the supply

curve and down the demand curve

– Quantity of labor supplied increases from L1 to L2

– Wages settle at W2

Employment of programmers(work-hours/year)

S

L1

W1

D1

L2

W2

W3

D2

10

Health Care Delivery

• Health care spending has grown faster than income– Up from 4% of national income in 1940 to

14% in 2005– Part of the increase is due to improved quality

of tests, procedures, drugs, etc.– Part is due to the third-party payment system

• Growth in use of insurance for payments– Employer-provided and government-provided

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Health Care Delivery

• Cost-benefit test assures efficient allocation of health care– Perform a service only if the benefit exceeds the cost

• Costs are easy to measure• Benefits are complicated

– Usual measure is willingness to pay marginal cost• Some patients are unable to pay for basic services

– Society assumes some responsibility via government-provided insurance

– Confused by third-party payment system

The Demand for Hospital Care

12

• Price of hospital room is$300 per day– If David pays, MC to

him is $300– David equates marginal

cost and marginal benefit and stays one day

– If insurance pays, MC to David is zero• He stays 3 days

Length of hospital stay (days)

D

3

300

Pric

e ($

/day

)

1

Full Insurance Coverage Creates Waste

• If David pays, stay is 1 day• If insurance pays, stay is 3 days

– Extra benefit of 2nd and 3rd day to David is $300

– Extra cost is 2 days times $300 per day = $600

– $300 surplus lost

Alternative Coverage Scheme

• Insurance company pays David $700– Insurance company

saves $200 compared to a 3-day stay

• David stays 1 day– Pays hospital $300– David keeps $400

• The $300 benefit he would get from staying 3 days PLUS $100 pure surplus

• Total surplus increases $300

Length of hospital stay (days)

D

3

300

Pric

e ($

/day

)

1

Policy Implications

• Research shows that when individuals pay for their health care, they consume less

• An more efficient system can be designed– Adopt a system of high deductible health

insurance– Use stipend payments for the poor

• An efficient policy will increase the size of the health care pie

Public Goods

• Government is the only organization with the power to compel actions– Taxes– Military service– Imprison people

• All other institutions – family, business, charitable organizations, etc. – rely on voluntary transactions

• Government decisions can be analyzed using economic principles

Public Goods

• Public good is a good that is both nonrival and nonexcludable– A nonrival good is one whose consumption by one

person does not diminish its availability to others• National defense ; Economics lectures

– A non-excludable good is one that is difficult or costly to exclude non-payers from consuming• Over-the-air broadcasts; Fireworks displays

• A pure public good is, to a high degree, both nonrival and nonexcludable.

Public Goods and Government

• A collective good is a good or service that, to at least some degree, is nonrival but excludable– Sometimes provided by government

• A good is a pure private good if – Non-payers can easily be excluded and – Each unit consumed by one person means one less

unit available for others• A pure commons good is a rival good that is

nonexcludable Fish in open water

Types of Goods

Paying for Public Goods

• Not everyone benefits equally from a public good or service.

• Example– Prentice and Wilson have adjacent properties

• Fighting zebra mussel infestation• New device to control mussels is $1,000 to serve

both properties• Wilson's income is higher and value device at $800• Prentice values device at $400

Paying for Public Goods

• Equal sharing of costs with a head tax• A head tax is a tax that collects the same amount

from every taxpayer• Result: no new device

– $500 is more than Prentice's reservation price• Prentice vetoes device

• A regressive tax has a tax rate that varies inversely with income• A proportional income tax requires all taxpayers to pay the same

proportion of their incomes in taxes• A progressive tax takes a larger share of higher incomes as tax