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Public Finance: Introduction

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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. - PowerPoint PPT Presentation
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Public Finance: Introduction Fundamentals of Finance – Lecture 8
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Page 1: Public Finance: Introduction

Public Finance:Introduction

Fundamentals of Finance – Lecture 8

Page 2: Public Finance: Introduction

Outline of the Lecture

• Individuals and Government

• Efficiency, Markets, and Governments

• Externalities and Government Policies

• Public Goods

Page 3: Public Finance: Introduction

Individuals and Government

Public finance - introduction

Page 4: 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

Page 5: Public Finance: Introduction

The Allocation between Private and Government Resources

• Private – Food– Housing– Cars – Clothing

• Government – National Defense – Public Schools– Police

Page 6: Public Finance: Introduction

A Production-Possibility Frontier

C

G2

G1

0

B

A

M X2 X1

Gove

rnm

ent G

oods

and

Ser

vice

s per

Yea

r

Private Goods and Services per Year

Page 7: Public Finance: Introduction

Distribution of Government Goods and Services

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

not applicable to goods such as national defense.

Page 8: Public Finance: Introduction

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.

Page 9: Public Finance: Introduction

Circular Flow in the Mixed Economy

Input

Market

Output Market

Government Households Firms

Subsidies Taxes, fees, charges

Government Services Taxes, fees, charges

Government Services

Income Support & Subsidies

Money

Resources

Money

Goods & Services

Money

Goods & Services

Money

Resources

Page 10: Public Finance: Introduction

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.

Page 11: Public Finance: Introduction

Efficiency, Markets, and Government

Public finance - introduction

Page 12: Public Finance: Introduction

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.

Page 13: Public Finance: Introduction

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.

Page 14: Public Finance: Introduction

Marginal Conditions for Efficiency

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

Page 15: Public Finance: Introduction

Efficient Output P

rice,

Ben

efit,

an

d C

ost

Loaves of Bread per Month 0

A

B

Tota

l Soc

ial B

enef

it a

nd C

ost

MSC

MSB

TSC TSB

2.00 = P

1.50 = P*

1.00 = P2

Q*

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

B C E

A D

Z

TSB – TSC

Page 16: Public Finance: Introduction

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.

Page 17: Public Finance: Introduction

When Does the Market Interaction Fail to Achieve Efficiency?

• Monopoly

• Taxes

• Subsidies

Page 18: Public Finance: Introduction

Loss in Net Benefits Due to MonopoliesP

rice,

Ben

efit,

and

Cos

t

Loss in Net Benefits

Output per Month 0 QM

MSB = P

MSCM

D = MSB

MSC

MR

A

E B

Q*

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.

Page 19: Public Finance: Introduction

Taxes and EfficiencyP

rice

Billions of Message Units per Month

6

5

4

E'

E

B

Demand = MSB

New Supply: MPC + T > MSC

Supply : MSC = MPC

0 3 4

Page 20: Public Finance: Introduction

Subsidies and EfficiencyP

rice

Bushels of Wheat per Year 0

5

4

3

A E

C

Demand = MSB

Q*

Supply = MSC

QS

Page 21: Public Finance: Introduction

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.

Page 22: Public Finance: Introduction

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.

Page 23: Public Finance: Introduction

Utility Possibility Curve

Ann

ual W

ell-B

eing

of A

0

UA

UA2

UA1

Annual Well-Being of B

Z

X

UB

E1

E2

E3

UB1 UB2

Page 24: Public Finance: Introduction

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.

Page 25: Public Finance: Introduction

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.

Page 26: Public Finance: Introduction

Externalities and Government Policies

Public finance - introduction

Page 27: Public Finance: Introduction

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 .

Page 28: Public Finance: Introduction

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.

Page 29: Public Finance: Introduction

Market Equilibrium, A Negative Externality and Efficiency

D = MSB

S = MPC

MPC + MEC = MSC

10

Pric

e, B

enef

it, a

nd C

ost

Tons of Paper Per Year (Millions)

110105100

4.5 5

A

BG

10

Page 30: Public Finance: Introduction

Implications of Negative Externalities

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

MSC = MPC + MEC = MSB

Page 31: Public Finance: Introduction

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.

Page 32: Public Finance: Introduction

Market Equilibrium, A Positive Externality and Efficiency

S = MSC

MPB + MEB = MSBH

Z

U

V

Pric

e, B

enef

it, a

nd C

ost

Inoculations Per Year (Millions)

10

25

30

45

10 120

Page 33: Public Finance: Introduction

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.

Page 34: Public Finance: Introduction

Corrective Taxes to Negative Externalities

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

Page 35: Public Finance: Introduction

A Corrective TaxP

rice,

Ben

efit,

and

Cos

t

Tons of Paper Per Year (Millions)

100

5

110105

95

4.5

D = MSB

S = MPC

A

S’ = MPC + T = MSC

Tax Revenue = TotalExternal Costs

T

Net Gains in Well-Being

GB

Page 36: Public Finance: Introduction

Results of a Corrective Tax

• Socially optimal levels of production are achieved.

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

Page 37: Public Finance: Introduction

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.

Page 38: Public Finance: Introduction

Corrective Subsidies

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

Page 39: Public Finance: Introduction

Subsidy Payments

A Corrective Subsidy

i

i

Y D = MPB

D' = MPB + $20 = MSB

S = MSC

Pric

e, B

enef

it, a

nd C

ost (

Dol

lars

)

Inoculations per Year (Millions) 0

45

30 25

10

10 12

Z

V R

X

U

Page 40: Public Finance: Introduction

Coase's Theorem

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

Page 41: Public Finance: Introduction

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.

Page 42: Public Finance: Introduction

Public Goods

Public finance - introduction

Page 43: Public Finance: Introduction

• 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

Page 44: Public Finance: Introduction

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.

Page 45: Public Finance: Introduction

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.

Page 46: Public Finance: Introduction

Marginal Costs of Consuming and Producing a Pure Public Good

Cost

Number of Consumers 0

200

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

1

Page 47: Public Finance: Introduction

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

Cost

MC = AC200

0

Page 48: Public Finance: Introduction

Security Guards per Week

Demand For A Pure Public Good

Z 1

Z 2

Z 3

Z4

100

200

300

400

500

600

700

800

Mar

gina

l Ben

efit

0 1 2 3 4 5

DA = MBA

DB = MBB

DC = MBC

DA= MBA


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