Public Economics

Introduction to Public Economics

John Dobra, Ph.D.

University of Nevada

Do we need a public sector?

• Adam Smith’s “Invisible Hand” • “…it is only for the sake of profit that any man

employs a capital in the support of industry…” and “…he intends only his own gain…,” but in so doing is “…led by an invisible hand…” as “by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. “

• Moreover, he asserts that “I have never known much good done by those who affected to trade for the public good.”

Do we need a public sector?

• 1st theorem of welfare economics

• Any competitive equilibrium is Pareto Optimal

Edgeworth Box

Person A

Person B

Good X

Good X

Goo

d YG

ood Y

Endowment

Person B’s Quantity of Good X

Person B’s Quantity of Good Y

Person A’s Quantity of Good Y

Person A’s Quantity of Good X

Edgeworth Box

Person A

Person B

Good X

Good X

Goo

d YG

ood Y

IB1IB2

IB3

IA1

IA2

IA3

Potential gains from trade

Contract

Curve

Do we need a public sector?

• Edgeworth Box illustrates 1st theorem of welfare economics in a trade only setting

• It can (and has) been extended to include production as well in general equilibrium modeling

• Upshot: markets work as efficiently as any social planner.

Do we need a public sector?

• Two problems:

1. Equity

2. Efficiency

Equity Considerations

Person A

Person B

Good X

Good X

Goo

d YG

ood Y

IB3

IA3Equity consideration:

All points on contract curve are efficient

This first endowment is efficient, where both A and B are almost equally well off

So are these two, both of which have a great amount of inequality…in one of them, B is practically A’s slave!

Despite the fact that each of these points is efficient, society may care about equity or income distribution

Notions of Efficiency

• Pareto Efficiency

• Kaldor-Hicks Efficiency (Potential compensation principle)

• Market decisions are Pareto efficient

• Public decisions are rarely Pareto efficient, and typically the Kaldor-Hicks criteria are used

Efficiency Considerations

• Proofs of the efficiency of general equilibrium are based on a lot of assumptions!

• ∞ # of producers and consumers• Perfect Information• Rivalry and excludability in consumption• Lack of externalities• Property rights exist for all goods• Rule of law is enforced

Not ∞ producers and consumers

• Leads to monopoly/oligopoly/monopsony situation

• Pricing above marginal cost leads to inefficient outcomes and unrealized gains from trade

Rivalry and excludability in consumption

• Many goods are non-rival and/or non-excludable

• Public goods, commons goods, etc

• Consumers have incentives to “free ride”

• Leads to under-provision

Externalities

• When the actions of one individual/firm affect the profit/utility of some other individual or firm

• Actor does not bear full cost of actions that create negative externalities and does not receive full benefit of actions creating positive externalities

• Too much of the actions making negative externalities, not enough of the actions making positive externalities

Perfect Information

• If all agents do not have perfect information, markets are stifled or even eliminated!

• Lemons model.

• Leads to unrealized potential gains from trade in equilibrium (not on contract curve)

Property Rights and Rule of Law

• Without property rights for all goods, trading in those goods can not take place, and you have unrealized gains from trade.

• Rule of Law (the idea that rules are not enforced arbitrarily) allows individuals to engage in long term planning. Without it, production and growth are stunted.

Roles of the Government

• Already hinted at fundamental roles of government on last slide—to create and preserve ability for markets to even work

• Other fundamental role is to correct so-called “market failures”

Market Failure

• Market failures are common, but how bad are they?

• Markets have self-correcting mechanisms to mitigate these failures.

• Coase Theorem• Clubs• Contestable Market Hypothesis• Warrantees, Guarantees, Labeling,

Branding

Market Failure

• Market failures, while pervasive, are not all that bad.

• Still, self correction mechanisms are costly.

• Scope for government to correct market failure if:

• They can do it better than the market• They can do it more cheaply than the

market

Public Finance

• With what is public finance concerned?

• Redistribution

• Taxation

• Regulation

• Correcting Market Failures

• Laying groundwork for competitive markets.

Redistribution

• Welfare

• Unemployment benefits

• Medicare

• Old age pensions

• Minimum wage

• Education

• Subsidies

Taxation

• Income Tax

• Excise Tax

• “Sin” Tax

• Tariffs

• Sales Tax (GST)

• Stamp Duty

• Property Tax

Regulation

• Occupational Safety and Health• Environment• Anti-Trust• Drugs• Consumer Protection• Worker Protection• Utilities• Telecommunication

Correcting Market Failures

• Encouraging competition by breaking up monopolies/price fixing agreements

• Providing public goods

• Discouraging negative externality creating behaviour and encouraging positive externality creating behaviour

• Improving information asymmetry

Laying Groundwork for Competetive Markets

• Property rights

• Law and order

• Rule of law

• Enforcement of contracts

• Judicial system

• Often referred to as minimal government, minarchy, or a “nightwatchman state”

Political Compass

Political Compass

Most debates in modern democracies are around here

Where are you? Try: http://www.politicalcompass.org/

Libertarians and Classical Liberals

Public Choice

• Is all this talk about what the role of a government is simply normative analysis as positive theory?

• What about the incentives of policy makers?

“If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.”

James Madison, Federalist 51

Government failure?

• Information asymmetry• Government as a monopolist• Divergence between wants of society and wants

of politician• Corruption• Bureaucracy• Principal-Agent dilemma• Rent Seeking• Soft budget constraints/time inconsistency

Rent Seeking

D

P

QMR

MCPeff

Qeff

P*

Q*

DWL

Transfer from consumer to producer (rents)

Typically, transfers of this sort are considered to be efficient—at least by Kaldor-Hicks criterion. However, what if real resources are expended to procure this transfer? The practice of wasting resources in trying to get the transfer is called “rent seeking”

Not only is the DWL an efficiency loss, but so too is most, if not all--or even more than all--of the value of the rent. There are a lot of situations when rent seeking losses are an important consideration—monopolies, tariffs, subsidies, regulations…