Topic #1:

Introduction to Public FinanceMarket Failure and Public FinancePROF. ANDREEA STOIAN, PHD | LECTURE 2

Content

Introduction to

Public Finance

Market failure

Public goods

Externalities

Income distribution

Stabilizing, regulatory and control

role of the government

Learning outcomesStudents will be able to:

• Describe how government affects the circular flow of income and expenditure in a

mixed economy

• Define public goods and discuss their characteristics

• Explain the difference between pure public goods and pure private goods

• Describe the provision of government goods and services through political institutions

• Discuss cooperative methods of supplying pure public goods and the characteristics of

the Lindahl equilibrium

• Analyze the free-rider problem

• Define an externality, and explain how positive and negative externalities can prevent

efficiency from being achieved

• Describe how corrective taxes and subsidies can be used to internalize externalities

• Explain the Coase theorem and its significance

The goal of Public Finance

Content

The study of the role of thegovernment in theeconomy in order to properunderstand it

It develops principles forunderstanding the role ofgovernment in theeconomy and its impact onresource use and the well-being of citizens

Definition “Is the field of economics that

studies government activities and the alternative means of financing government expenditures

you will learn about the economic basis for government activities

You will understand the impact of government expenditures, regulations, taxes, and borrowing on incentives to work, invest, and spend income

David Hyman (2005)

0

10

20

30

40

50

60

CO

L

IRL

KO

R

CR

I

CH

E

RU

S

LTU

LVA

USA

JP

N

ISR

EST

LUX

PO

L

CZE

GB

R

ISL

ESP

DEU

NLD

SV

K

SV

N

PR

T

NO

R

HU

N

SW

E

ITA

AU

T

BEL

DN

K

GR

C

FR

A

FIN

Government size

OECD, 2015

What is the role of the

government?

Candidate 1

The role of the

government is not to

create wealth. The role of

the government is to

create an environment in

which the entrepreneur is

willing to take risk and to

be able to get a return on

the risk taken.

Candidate 2

o Set in motion programsthat help people go tocollege, buy a newhouse, and build theirwealth

o Plans invest in people

o Investing more in publicschools and expectingmore in return

Government and circular flow of

income and expenditures

Government

Output market

Firms

Input market

Households

?Problem that causes

the market economy

to deliver an outcome

that does not maximize

efficiency

Market

failure

Market failure (I)

Markets

Individual well-being

Invisible hand

Efficient allocation

(Pareto optimality)

Market failure (II)

Monopoly ExternalitiesAsymmetric information

Market failure (III)

MarketIndividual well being

Social responsibilityPareto optimality

Market Government Pareto optimality

Market failure (IV)C

om

pe

titiv

e m

ark

et

eq

uili

briu

m

Should be the most efficient outcome for society when all individuals would make ‘collective decisions’

Ma

rke

t fa

ils in

de

live

rin

g t

he

m

ost

eff

icie

nt

ou

tco

me

to

so

cie

ty

Due to choices based on ‘individual rationality’

Go

ve

rnm

en

t in

terv

en

e in

a

ch

iev

ing

th

e m

ost

eff

icie

nt

ou

tco

me

fo

r th

e s

oc

iety

By making collective decisions aiming at the ‘social welfare’

Supplementary reading:

http://www.econlib.org/library/Buchanan/buchCv3c4.html#Ch. 4, Individual Rationality

in Social Choice

Market failure (II)

People’s needs

Individual needs

Private goods

Market

Collective (social)

needs

Public goods Government Market

Public goods

Definition Goods with benefits that cannot be

withheld from those who do not pay and are shared by large groups of consumers are public goods.

Public goods are usually made available politically through the ballot box as people vote to decide how much to supply rather than through the marketplace, where those who care to pay the price can buy as much as they like for their own exclusive use.

Government provision of public goods implies that the goods are freely available to all rather than being sold in markets.

The costs of making the good available are usually financed by taxes.

Characteristics

Non-rival in consumption

a given quantity of a public good

can be enjoyed by more than one

consumer without decreasing the

amounts enjoyed by rival

consumers

Non-excludable

it is too costly to develop a means

of excluding those who refuse to

pay from enjoying the benefits of a

given quantity of a public good

Pure public goods vs.pure private

goods

•a given quantity is consumed by all members of a community as soon as it is produced for, or by any one member

•the marginal cost of distributing a pure public good to an additional consumer is zero for a given amount of the public good

Pure public goods

•are rival in consumption and their benefits are easily excluded from those who choose not to pay their market price

•a unit of a pure private good can be enjoyed only by a single consumer

The more units of a given mount available to be consumed by one person, the less is available to rival consumers

Pure private goods

Classifying goods

•Non-rival,

•Non-excludable

•Non-rival,

•Excludable

•Non-excludable, Rival

•Excludable, Rival

.............. ..............

............................

Congestable and price-excludable

goods

• Are those for which crowding or congestion reduces the benefits to existing consumers when more consumers are accommodated

• The marginal cost of accommodating an additional consumer is not zero after the point of congestion is reached

Congestible

• Are those with benefits can be priced

• Their provision results in positive externalitiesPrice-excludable

Provision of goods

•Pure public goods

•Congestible public goods

•Price-excludable public goods

•Pure private goods

Market&Government Market&Government

Market&GovernmentMarket&Government

Demand for public goods

Market demand for a Pure Private Good is

derived by adding quantities demanded at each

price.

Demand for a Pure Public Good is derived by adding how

much people will be willing to pay at each quantity

Efficient output of a pure public

good

The socially optimal level of the public

good requires that we set the Marginal

Social Benefit of that good equal to its

Marginal Social Cost. MSB = MSC

𝑀𝑆𝐵 = σ𝑘=1𝑛 𝑀𝐵𝑘 =𝑀𝐵𝑖 + σ𝑗=1

𝑛−1𝑀𝐵𝑗

Example:

Optimal quantity and voluntary contributions

Number

of

security

guards

per

week

1 2 3 4

MBA $300 $250 $200 $150

MBB 250 200 150 100

MBC 200 150 100 50

𝑀𝐵𝑖$750 $600 $450 $300

Lindhal equilibrium

through voluntary

contributions

The amount contributed per unit of the public

good by each person must be adjusted so that

each individual desires the identical amount of

the public good

The sum of the amounts contributed by each

member of the community per unit must equal

the marginal social cost of producing the

public good

All individuals must agree voluntarily, with no

coercion whatsoever, on the cost-sharing

arrangement and the quantity of good

The equilibrium must occur under the

unanimous consent

It ensures the efficient outcome

Provision of the local goods

The free-rider problem1

. •A free-rider is a person who seeks to enjoy the benefits of a public good without contributing anything to the cost of financing the

•The free-rider problem stems from the incentive people have to enjoy external benefits financed by others, with no cost to themselves

2. •Free riding can be a

reasonable strategy for any one individual , provided that no penalty exists and that only few individuals choose this strategy

3. • If all members of the

community choose the free-rider strategy , then no production of the public good would be forthcoming

Prisoners’ dilemma

Strategy B contributes B does not

contribute

A contributes 5,5 5,10

A does not

contribute10,5 0,0

online.ase.ro PROFESSOR’S QUESTION