Transcript Document

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
G2
G1
B
A
X2
X1
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 = P2
D
A
Q1 = 10,000
Total Social Benefit
and Cost
MSC
C
B
MSB
Q* = 15,000
Q2 = 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:
 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.
Annual Well-Being of A
Utility Possibility Curve
UA
UA2
UA1
Z
E1
X
E2
E3
0
UB1
UB2
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
S = MSC
V
U
H
MPB + MEB = MSB
0
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.
Price, Benefit, and Cost
A Corrective Tax
S’ = MPC + T = MSC
S = MPC
G
110
105
100
95
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
Z1
Marginal Benefit
700
Z2
600
Z3
500
400
Z4
300
DA= MBA
200
DA = MBA
DB = MBB
100
0
DC = MBC
1
2
3
4
Security Guards per Week
5