Topic #1: Introduction to Public Finance Market Failure and Public Finance PROF. ANDREEA STOIAN, PHD LECTURE 2

Topic #1: Introduction to Public Finance Market Failure and Public Finance PROF. 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 outcomes Students 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 the government in the economy in order to proper understand it It develops principles for understanding the role of government in the economy and its impact on resource use and the wellbeing 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)

COL IRL KOR CRI CHE RUS LTU LVA USA JPN ISR EST LUX POL CZE GBR ISL ESP DEU NLD SVK SVN PRT NOR HUN SWE ITA AUT BEL DNK GRC FRA FIN Government size OECD, 2015 60 50 40 30 20 10 0

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 programs that help people go to college, buy a new house, and build their wealth o o Plans invest in people Investing more in public schools and expecting more in return

Government and circular flow of income and expenditures Output market Households Government Firms Input market

? 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 Externalities Asymmetric information

Market failure (III) Market Individual well being Social responsibility Pareto optimality Market Government Pareto optimality

Competitive market equilibrium Market fails in delivering the most efficient outcome to society Government intervene in achieving the most efficient outcome for the society Market failure (IV) Should be the most efficient outcome for society when all individuals would make collective decisions Due to choices based on individual rationality 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 Collective (social) needs Private goods Market 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 Pure public 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 private 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

Classifying goods Excludable, Rival Non-rival, Nonexcludable Nonexcludable, Rival............ Non-rival, Excludable

Congestable and price-excludable goods Congestible 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 Priceexcludable Are those with benefits can be priced Their provision results in positive externalities

Provision of goods Pure private goods Priceexcludable public goods Market&Government Market&Government Market&Government Market&Government Congestible public goods Pure public goods

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 = σn k=1 MB k = MB i + σ n 1 j=1 MB j

Example: Optimal quantity and voluntary contributions Number of security guards per week 1 2 3 4 MB A $300 $250 $200 $150 MB B 250 200 150 100 MB C 200 150 100 50 MB i $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

1. 2. 3. The free-rider problem 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 Free riding can be a reasonable strategy for any one individual, provided that no penalty exists and that only few individuals choose this strategy 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 contribute 10,5 0,0

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