Public Finance: Introduction

transcript

Public Finance:Introduction

Fundamentals of Finance – Lecture 8

Outline of the Lecture

• Individuals and Government

• Efficiency, Markets, and Governments

• Externalities and Government Policies

• Public Goods

Individuals and Government

Public finance - introduction

Government

• Governments are organizations formed to exercise authority over the actions of persons who live together in a society and to provide and finance essential services.

• Political Institutions are rules and generally accepted procedures that evolve for determining what government does and how government outlays are financed.– Majority rule– Representative government

The Allocation between Private and Government Resources

• Private – Food– Housing– Cars – Clothing

• Government – National Defense – Public Schools– Police

A Production-Possibility Frontier

M X2 X1

Private Goods and Services per Year

Distribution of Government Goods and Services

• Nonmarket rationing:– Prices and willingness to pay those prices are

not applicable to goods such as national defense.

The Mixed Economy Markets and Politics

• Pure Market Economy– Virtually all goods and services are supplied by

for-profit private firms. – Supply and demand determine price.

Circular Flow in the Mixed Economy

Market

Output Market

Government Households Firms

Subsidies Taxes, fees, charges

Government Services Taxes, fees, charges

Government Services

Income Support & Subsidies

Resources

Goods & Services

Resources

How Much Government is Enough?

• The question of how much government is enough is an important one in any society. It is the tradeoff between public and private goods. When government gets bigger, it comes at the expense of less private consumption.

Efficiency, Markets, and Government

Positive and Normative Economics

• Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”

• Normative Economics: designed to formulate recommendations on what should be.

Normative Evaluation of Resource Use: The Efficiency Criterion

Pareto Optimality:The efficiency criterion is satisfied when resources are used over any given period of time in such a way as to make it impossible to increase the well-being of any one person without reducing the well-being of any other person.

Marginal Conditions for Efficiency

• Total Social Benefit • Total Social Cost • Net Benefit = TSB – TSC • Maximum Net Benefit occurs where MSB = MSC

Efficient Output P

Loaves of Bread per Month 0

TSC TSB

2.00 = P

1.50 = P*

1.00 = P2

Q1 = 10,000 Q* = 15,000 Q2 = 20,000

TSB – TSC

Conditions under which the Market is Pareto Optimal

• All productive resources are privately owned.• All transactions take place in markets and in each separate

market many competing sellers offer a standardized product to many competing buyers.

• Economic Power is dispersed in the sense that no buyers or sellers alone can influence prices.

• All relevant information is freely available to buyers and sellers.

• Resources are mobile and may be freely employed in any enterprise.

When Does the Market Interaction Fail to Achieve Efficiency?

• Monopoly

• Taxes

• Subsidies

Loss in Net Benefits Due to MonopoliesP

Loss in Net Benefits

Output per Month 0 QM

MSB = P

D = MSB

The monopolistic firm maximizes profits by producing QM units per month. At that output level, the marginal social benefit of the good exceeds its marginal social cost. Additional net benefits equal to the area ABE are possible if output were increased to Q*units per month.

Taxes and EfficiencyP

Billions of Message Units per Month

Demand = MSB

New Supply: MPC + T > MSC

Supply : MSC = MPC

Subsidies and EfficiencyP

Bushels of Wheat per Year 0

Demand = MSB

Supply = MSC

Market Failure: A Preview of the Basis for Government Activity

Government intervention may be warranted if there is: Monopoly power; Effects of market transactions on third parties

(i.e. externalities); Lack of a market for a good where MSB>MSC

(i.e. a public good); Incomplete information about goods being sold; An unstable market.

Equity vs. Efficiency

Equity: perceived fairness of an outcome.

Horizontal equity is achieved when equal people are treated equally.

Vertical equity is achieved when people are treated fairly along a socio-economic continuum.

Utility Possibility Curve

Annual Well-Being of B

UB1 UB2

Positive Analysis Trade-off Between Equity and Efficiency

• When making choices about public policy issues we are usually faced with the inevitable situation that you make one person worse off while making another better off. (Taxes must be paid by some in order that public goods can be purchased and these benefits accrue to others.) Some economists attempt to overcome this with the Compensation Criteria.

Compensation Criteria

• An attempt is made to compare the dollar value of the gain to the gainers and the dollar value of the loss to the losers.

• If the gainers gain more than the losers lose then the gainers can pay the losers enough to compensate the losers for their loss.

• Everyone can be made at least as well off as they were without the change as long as there is compensation.

Externalities and Government Policies

Externalities

• Externalities are costs or benefits of market transactions not reflected in prices.– Negative externalities are costs to third

parties.– Positive externalities are benefits to third

parties .

Externalities and Efficiency

• The marginal external cost is the value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.

Market Equilibrium, A Negative Externality and Efficiency

D = MSB

S = MPC

MPC + MEC = MSC

Tons of Paper Per Year (Millions)

110105100

Implications of Negative Externalities

• Market equilibrium occurs where MPC = MSB• Efficiency Requires that

MSC = MPC + MEC = MSB

Positive externalities

• The marginal external benefit is the value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.

Market Equilibrium, A Positive Externality and Efficiency

S = MSC

MPB + MEB = MSBH

Inoculations Per Year (Millions)

10 120

Internalization of Externalities

An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.

Corrective Taxes to Negative Externalities

• Setting a tax equal to the MEC will internalize a negative externality.

A Corrective TaxP

Tons of Paper Per Year (Millions)

110105

D = MSB

S = MPC

S’ = MPC + T = MSC

Tax Revenue = TotalExternal Costs

Net Gains in Well-Being

Results of a Corrective Tax

• Socially optimal levels of production are achieved.

• The tax revenue is sufficient to pay costs to third parties.

Using a Corrective Tax

• The greenhouse effect and a “Carbon Tax” – If it is accepted that the greenhouse effect is

caused by burning carbon-based fuels, a carbon tax can be imposed to limit greenhouse gasses to their socially optimal levels.

– It is called a carbon tax because the amount of the tax would depend on the amount of carbon in the fuel.

Corrective Subsidies

• Setting a subsidy equal to MEB will internalize a positive externality

Subsidy Payments

A Corrective Subsidy

Y D = MPB

D' = MPB + $20 = MSB

S = MSC

Inoculations per Year (Millions) 0

Coase's Theorem

• By establishing rights to use resources government can internalize externalities when transactions or bargaining costs are zero.

Limitations of Coase’s Theorem

• Transactions costs are not zero in many situations.

• However you allocate the property right, the distribution of income is affected.

Public Goods

• Public Goods are goods for which exclusion is impossible. – One example is National Defense: A

military that defends its citizenry from invasion does so for the entire public.

Public Goods

Characteristics of Public Goods

• Nonexclusion: The inability of a seller to prevent people from consuming a good when they do not pay for it.

• Nonrivalry: The characteristic that if one person “consumes” a good, another person’s pleasure is not diminished nor is another person prevented from consuming it.

Pure Public Goods and Pure Private Goods

• Pure Public Good: There is no ability to exclude and there is no rivalry for the benefits.

• Pure Private Good: There is a clear ability to exclude and there is rivalry for the benefits.

Marginal Costs of Consuming and Producing a Pure Public Good

Number of Consumers 0

Marginal Cost of Allowing anAdditional Person to Consume aGiven Quantity of Pure Public Good

Marginal Cost of Producing a Pure Public Good is always positive!

Marginal Costs of Consuming and Producing a Pure Public Good

Units of a Pure Public Good per Year

MC = AC200

Security Guards per Week

Demand For A Pure Public Good

0 1 2 3 4 5

DA = MBA

DB = MBB

DC = MBC

DA= MBA

Public Finance: Introduction

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