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Theme 1 – The Foundation of Public Economics11F251 Financial Theory, Policy and Institutions

Defining the Field of Study:

Public Finance – Field of economics that analyzes government taxation and spending activities.

Public Sector Economics or Public Economics:

Terms that better capture the fundamental issues of this field of economics - government’s role in the allocation of real resources - that includes, but is not limited to, government’s financial behavior.

Focus on microeconomic functions of government.

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From: Rosen, Gayer: Public Finance, 10th ed., 2013:

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Welfare economics(Chapter 3 in TRESCH, R W. Public sector economics. Basingstoke: Palgrave Macmillan, 2008. ISBN 978-0-230-52223-7)

• Need systematic framework to assess the desirability of various government actions.

• Welfare economics is concerned with the social desirability of alternative economic states.

– Distinguishes cases when private markets work well from cases where government intervention may be warranted.

• Relies heavily on basic microeconomic tools, particularly indifference curves.

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Pure exchange economy

• Economy with

– 2 people (Adam & Eve)

– 2 commodities (Apples & Figs)

– Fixed supply of commodities (e.g., on a desert island)

• An Edgeworth Box depicts the distribution of goods between the two people.

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I1

good X

good Y

BLBL

BL - Budget Line

X11

YY1

II11 – – indiference curve

Y

XY,X P

PMRS

Figure 1.1

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Pure exchange economy

• Each point in the box in Figure 1.1 represents an allocation between Adam and Eve.

– Each point in the box fully exhausts the resources on the island. Adam consumes what Eve doesn’t.

– Adam’s consumption of apples and figs increases as we move toward the northeast in the box.

– Eve’s consumption of apples and figs increases as we move toward the southwest in the box.

• At point v in the figure, Adam’s allocation of apples is Ox, and of figs is Ou. Eve consumes O’v of apples, and O’w of figs.

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Pure exchange economy

• Assume that Adam and Eve each have conventionally shaped indifference curves.

• Adam’s happiness increases as he consumes more; therefore his utility is higher for bundles toward the northeast in the Edgeworth Box.

– We can therefore draw “standard” indifference curves for Adam in this picture. Adam would get even higher utility by moving further to the northeast, outside of the Edgeworth Box, but he is constrained by the resources on the island.

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Pure exchange economy

• Similarly, Eve’s happiness increases as she consumes more; therefore her utility is higher for bundles toward the southwest in the Edgeworth Box.

– Eve’s indifference curves therefore are “flipped around.” Her utility is higher on E3 compared E2 or E1.

Figure 1.2

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Pure exchange economy

• Suppose some arbitrary point in the Edgeworth Box is selected, for example point g in Figure 1.3.

• This provides an initial allocation of goods to Adam and Eve, and thus some initial level of utility.

Figure 1.3

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Pure exchange economy

• We can now pose the following question: Is it possible to reallocate apples and figs between Adam and Eve to make Adam better off, while Eve is made no worse off?

• Allocation h in Figure 1.3 is one possibility. We are “moving along” Eve’s indifference curve, so her utility remains unchanged. Adam’s utility clearly increases.

• Clearly, other allocations achieve this same goal, such as allocation p.

• Once we reach allocation p, we cannot raise Adam’s utility any more, while keeping Eve’s utility unchanged.

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Pure exchange economy

• An allocation is Pareto efficient if the only way to make one person better off is to make another person worse off.

– Often used as the standard for evaluating desirability of an allocation of resources.

– Pareto inefficient allocations are wasteful.

• A Pareto improvement is a reallocation of resources that makes one person better off without making anyone else worse off.

Figure 1.4

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Pure exchange economy

• Many allocations are Pareto efficient. Figure 1.5 illustrates three of them -- allocations p, p1 and p2.

– Among these Pareto efficient allocations, some provide Adam with higher utility than others, and the opposite ones provide Eve with higher utility.

Figure 1.5

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Pure exchange economy

• In fact, there are a whole set of Pareto efficient points in the Edgeworth Box.

• The locus of all the set of Pareto efficient points is called the contract curve.

• Figure 1.6 illustrates the contract curve.

Figure 1.6

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Edgeworth box

AA

IIA

EE

..IIEE

..YYEE

XXAA

YYAA

XXEE

FF

EE

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Pure exchange economy

• Figure 1.6 shows that each of the Pareto efficient points is where an indifference curve of Adam is tangent to an indifference curve of Eve.

• Mathematically, the slopes of Adam’s and Eve’s indifference curves are equal.

• The (absolute value of) slope of the indifference curve indicates the rate at which the individual is willing to trade one good for another, know as the marginal rate of substitution (MRS).

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Pure exchange economy

• Pareto efficiency requires:

MRS MRSa fAdam

afEve

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Production economy

• In pure exchange economy, assumed supplies of commodities were fixed.

• Now consider scenario where quantities can change.

• The production possibilities curve shows the maximum quantity of figs that can produced with any given quantity of apples.

Figure 1.7

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Production economy

• For apple production to be increased, fig production must necessarily fall.

• The marginal rate of transformation (MRT) of apples for figs (MRTaf) shows the rate at which the economy can transform apples to fig leafs.

– It is the absolute value of the slope of the production possibilities curve.

• The marginal rate of transformation can be written in terms of marginal costs:

MRTMC

MCa fa

f

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Efficiency with variable production

• With variable production, efficiency requires:

MRT MRS M RSa f a fAdam

afE ve

MC

MCMRS MRSa

fa fAdam

afE ve

• If this were not the case, it is possible to make one person better off with an adjustment production. Rewriting in terms of marginal costs, we then have:

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Y

P

X

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First fundamental theorem of welfare economics

• Assume that

– All producers and consumers act as perfect competitors (e.g., no market power)

– A market exists for each and every commodity

• Under these assumptions, the first fundamental theorem of welfare economics states that a Pareto efficient allocation will emerge.

• Implication: Competitive economy automatically allocates resources efficiently, without central planning.

• Conclusion: Free enterprise systems are amazingly productive.

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Second fundamental theorem of welfare economics

• Note that Pareto efficiency (and the first fundamental welfare theorem) does not fairness.

– Either the northeast or southwest corner of the Edgeworth Box is Pareto efficient, but very unequal distribution.

• Society may care about more than Pareto efficiency.

• From the contract curve in the Edgeworth Box, could map the derive the relationship between Adam’s and Eve’s utilities, on the utilities possibilities curve.

Figure 1.8

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Second fundamental theorem of welfare economics

• The frontier of the utilities possibilities curve is, by definition, attainable. Similar to a budget constraint.

• Could postulate a social welfare function, which embodies society’s views on the relative well-being of Adam and Eve:

W F U UAdam Eve ( , )• Could then maximize society’s preferences, or demonstrate that

some Pareto-inefficient bundles are preferred to some Pareto-efficient ones.

Figure 1.9

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Second fundamental theorem of welfare economics

• The second fundamental theorem of welfare economics states that society can attain any Pareto-efficient allocation of resources by making a suitable assignment of initial endowments and then allowing free trade.

• No adjustments to prices.

• Issues of efficiency and distributional fairness can be separated.

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The Market Assumptions

Best market structure → Perfect competition(1) Many, many consumers and firms(2) Homogenous product(3) Perfect information for buyers and sellers(4) Free entry and exit in Long-run

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Market failures

Theory suggests potential power of markets, but … do markets always function well? Theorems will be violated when there are market failures:Distribution branchAddresses failures to achieve end-results or process equityAllocation branchAddresses failures to achieve Pareto Optimal outcomesStabilization branchAddresses failures in macroeconomic policy

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The Distribution Branch

- How to compare C and D?- Both are Pareto Optimal - Allocation Branch is satisfied

- What about distribution?- D is more equitable- C is less equitable- Economy must decide

which it prefers- How can economy move from

C to D? - Tax 2 and redistribute to 1

- Will Market ever do this on its own? - No. It must be done by government (issue of end-results

equity)

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Violations of the Market Assumptions I.

There are several potential reasons that markets fail in allocation …

Externalities- Consumption by individual or production by firm that affects

utility function or production function of at least one other individual or firm- Can be positive (utility increasing) or negative (cost

increasing)- Examples: Positive - education, urban renewal, public

health, R&D, etc; Negative - air pollution, noise pollution, etc.

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Violations of the Market Assumptions II

Nonexclusive (Public) goods- A good for which, once someone buys, it everyone is able

to enjoy the full amount of the services provided by the good

- Examples: national defense, highways, parks, pools, golf clubs, etc.

- Problem: If you can consume a good whether you pay for it or not, you have no incentive to contribute to production (the free-rider problem) which results in under-production

- Solution: Government provides more efficient level of production which is financed through collection of taxes

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Violations of the Market Assumptions III.

1. Property Rights and Enforceable Contracts - Problem: If property rights are not protected (i.e. I can steal what

you produce) there is no incentive to undertake economic activity- Solution: Government regulation and enforcement

2. Decreasing Costs/Economies of Scale- Goods for which the average cost of production decreases as

quantity produced increases over a large scale- Example: Public utilities, public transportation, telecomms, etc.- Problem: Efficient production results with one (or few) large firms.

- Such a market has incentive to act as monopoly which results in under-production

- Solution: Government grants monopoly and regulates production to get more efficient outcome

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Violations of the Market Assumptions IV.

3. Private/Asymmetric Information: - One party in a two-party transaction possesses more

information than the other- Firms may possess more information

- Example: Product quality, drug safety/effectiveness, etc.

- Individuals may possess more information- Example: Individual health, personal risk-avoidance,

etc.- Problem: Party possessing more information can take

advantage of other party which results in inefficient outcome- Solution: Government creates oversight bodies that regulate

functioning of such markets to create more efficient outcome