Public Finance Introduction Fundamentals of Finance Lecture 8

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 Government Goods and Services per Year C G 2 G 1 B A X 2 X 1 M 0 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 Goods & Services Money Households Income Support & Subsidies Taxes, fees, charges Government Services Money Resources Output Market Government Input Market Goods & Services Money Subsidies Taxes, fees, charges Government Services Money Resources Firms

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 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.

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 Price, Benefit, and Cost A B 2. 00 = P E 1. 50 = P* 1. 00 = P 2 D A Q 1 = 10, 000 Total Social Benefit and Cost MSC C B MSB Q* = 15, 000 Q 2 = 20, 000 TSC TSB Z TSB – TSC 0 Q* Loaves of Bread per Month

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

Price, Benefit, and Cost Loss in Net Benefits Due to Monopolies MSB = P B MSC E 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. Loss in Net Benefits MSCM A D = MSB MR 0 QM Q* Output per Month

Taxes and Efficiency New Supply: MPC + T > MSC Supply : MSC = MPC E' 6 E Price 5 4 B Demand = MSB 0 3 4 Billions of Message Units per Month

Subsidies and Efficiency Supply = MSC 5 A E Price 4 C 3 Demand = MSB 0 Q* QS Bushels of Wheat per Year

Market Failure: A Preview of the Basis for Government Activity Government intervention may be warranted if there is: Ø Monopoly power; Ø Effects of market transactions on third parties (i. e. externalities); Ø Lack of a market for a good where MSB>MSC (i. e. a public good); Ø Incomplete information about goods being sold; Ø An unstable market.

Equity vs. Efficiency Equity: perceived fairness of an outcome. q Horizontal equity is achieved when equal people are treated equally. q Vertical equity is achieved when people are treated fairly along a socio-economic continuum.

Annual Well-Being of A Utility Possibility Curve UA UA 2 UA 1 Z E 1 X E 2 E 3 0 UB 1 UB 2 Annual Well-Being of B UB

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 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.

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 Price, Benefit, and Cost MPC + MEC = MSC 110 105 100 G B 10 S = MPC 10 A D = MSB 4. 5 5 Tons of Paper Per Year (Millions)

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 Price, Benefit, and Cost 45 Z 30 25 10 0 S = MSC V U H MPB + MEB = MSB 10 12 Inoculations Per Year (Millions)

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 Tax Price, Benefit, and Cost S’ = MPC + T = MSC 110 105 100 95 S = MPC G B Tax Revenue = Total External Costs T A Net Gains in Well-Being D = MSB 4. 5 5 Tons of Paper Per Year (Millions)

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

Price, Benefit, and Cost (Dollars) A Corrective Subsidy Z 45 30 25 R S = MSC V U Subsidy Payments 10 Y X D' = MPB i+ $20 = MSB D = MPB i 0 10 12 Inoculations per Year (Millions)

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 finance - introduction

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.

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 Cost 200 Marginal Cost of Allowing an Additional Person to Consume a Given Quantity of Pure Public Good 0 1 Number of Consumers

Marginal Costs of Consuming and Producing a Pure Public Good Marginal Cost of Producing a Pure Public Good is always positive! MC = AC Cost 200 0 Units of a Pure Public Good per Year

Demand For A Pure Public Good 800 Z 1 Marginal Benefit 700 Z 2 600 Z 3 500 400 Z 4 300 DA= MBA 200 DA = MBA DB = MBB 100 0 DC = MBC 1 2 3 4 Security Guards per Week 5