Public Economics Lecture Notes PDF

 Last week Pareto efficiency and it’s three aspects....

 Last week Pareto efficiency and it’s three aspects. How to prove if they occur. Public Economics Fundamental theorems of welfare economics. Topic 1 Part 2: Economic rationale for state intervention: efficiency and equity Chloe McCallum 1 2 This week Why governments intervene and how. Equity. Government intervention Public goods. 3 4  Government intervention: efficiency reasons No need for government intervention if: (market failure) There is perfect competition, perfect information, rational behaviour and Imperfect competition complete markets. Efficiency grounds - Public goods Externalities There are no concerns about the distribution of resources, or they can be Increasing returns to scale addressed by lump sum taxation. Equity grands - Imperfect information including future information Non-rational behaviour Incomplete markets 5 6 Perfect competition Public goods and externalities Price takers → large number of individuals and firms with no entry barriers, Markets will fail to provide public goods due to non-rivalness in fails in the presence of monopoly, monopsony or oligopoly. consumption, non-excludability and non-rejectability Intervene with price subsidy or regulation (e.g. maximum price) Intervention: public provision. Equal power → different income are allowed, discrimination is not Intervene with regulation (e.g. safety legislation in factories) Externalities: Act of individual A imposes a cost or of benefit to individual B Market clearing output will exceed efficient output when there is an external cost, vice versa for external benefit. Intervention: regulation or a Pigovian tax/subsidy eg.. factory polluting into river 7 8  Increasing returns to scale Imperfect information Average cost will exceed marginal cost at all levels of output Agents may have imperfect knowledge of quality of goods and their prices, Long run losses → competitive firms leave industry. and about the future. Leading to monopoly or no industry. Quality → intervention of regulation such as hygiene laws for food minimum - Standard Intervene by subsidy, public production or both. When information is very deficient and/or complex market solutions may be less efficient → public production/allocation e.g. health care small company sand no chance of competing with large Price → regulation e.g. to publish price list - firm = munipoly 9 10 Imperfect information Non-rational behaviour Intertemporal utility maximisation requires perfect information about the Agents have the capacity to formulate utility maximising plans and future. translate the plans into action. Ge Market solution is to offer insurance, but information failures may render private markets inefficient. Intervention through public finance e.g. insurance against unemployment or ill health.. g. - Don't know aboutthe , job en Bounded rationality → whether people can form these utility maximising plans Too complicated to matie theCalculation - Intervene by regulation to simplify choices. Bounded willpower → know the best interest but do not act on it e.g. losing weight, quit smoking, saving for old age. Intervene by commitment/auto-enrolment. & g T Organ donation. 11 - have to opt-out 12 Incomplete markets Government intervention: equity reasons Capital markets may fail to provide loans (e.g. student loans) loan is from - Gov Vertical equity – redistribution of income or consumption from rich to poor Incomplete contracts – individual nor government can monitor quality (towards equality) effectively. e g health care-How do we know it was done Cash well -.. In-kind education overriding consumer preferences education freed into people - - who don't want , Intervene often through public production. Horizontal equity – equal treatment/minimum standards, equal access and equality of opportunity. 13 14 Vertical equity Horizontal equity In-kind redistribution – overriding consumer sovereignty/preferences for Minimum standards – form of regulation e.g. food hygiene, safety at work, efficiency reasons building codes. When information is poor and an agent’s decisions are likely to be better Equal access – e.g. know-how such as understanding value of education, (e.g. merit goods) knowing legal rights, your social/professional networks and social capital. Only feasible if the individual cannot subvert the agents choice: Intervene by legislation (against discrimination), subsidies (legal aid) or Commodity is not easily tradeable can't spend fod vouchers - on alcohol public production (free compulsory education. Commodity is not easily fungible sometimes work well , sometimes doesn't Not easy to reject the good When assumptions do not fail, income transfers rather than minimum standards or equal access. 15 16 Types of intervention 1. Regulation a. quality of supply (e.g. hygiene laws for food) b. quantity of demand (e.g. compulsory schooling, car insurance) c. price (e.g. minimum wage) or Max Task 2. Finance a. Subsidies – partial e.g. rent for public housing or full e.g. free prescription b. Taxes - redistributing 3. Public production e.g. education and in some countries, healthcare 17 18 Example Alex has 10 oranges, Bobby has 2 oranges. Seems inequitable → transfer 4 oranges from Alex to Bobby, but one gets lost in the process. Equity Now, Alex has 6 and Bobby 5. Most inequity is eliminated but total number has been diminished. Trade off between equity and efficiency. - admin costs distortionary - 19 20  Alex’s Analysing social choices utility How does society choose a point Alex’s along the utility possibilities curve? utility Determines trade-offs: relationship between number of orange’s and Alex’s level of utility → utility function. Bobby’s Extra utility Alex gets from an utility extra orange → marginal utility. 21 22 Analysing social choices Analysing social choices Alex’s utility As individual consumes more of When some agent has very little any good, extra gain of having one Alex’s income their utilities can be extra unit becomes smaller → utility increased a lot with a small decreasing marginal utility. decrease in others’ utilities and vice versa. e.g. point A to B. decreasing marginal utility Bobby’s utility 23 24 Analysing social choices Utilitarian social welfare function Evaluating trade-offs → Social welfare function: level of social welfare Society’s goal is to maximise the sum of individual utilities corresponding to a particular set of levels of utility attained by members of society. SW = U1 + U2 + … + UN Social indifference curves: combination of utility of the members of society that yield equal levels of welfare to society. Utilities of all individuals are given equal weight and summed Social welfare function provides a basis for ranking any allocation of If marginal utility of money decreases with income, utilitarian criteria value resources → choose the allocation with higher social welfare. redistribution from rich to poor. Can take a variety of different shapes, we focus on two. 25 26 Utilitarian social indifference curve Rawlsian social welfare function Society is willing to trade one unit of Society’s goal is to maximise the well-being of its worst-off member Alex’s utility against one unit of Alex’s utility SW = min(U1,U2, … ,UN) Bobby’s utility. Utility of individuals weighted equally More distributive than utilitarian criteria: society wants to extract as much to each other, not oranges (or £). tax revenue as possible from middle and rich to make transfers to poor as large as possible. If Alex has a lower income than Bobby, the increase in his utility from 1 more Society is better off if you improve the worst-off individual’s welfare, gains orange (or £) will be greater than the Bobby’s utility nothing from improving any other individual’s welfare. decrease in utility for Bobby. 27 28 Rawlsian social indifference curve Two caveats If Alex is worse off than Bobby, Social welfare functions assume we can compare in a numerical way the anything that increases Alex utility, Alex’s level of utility of the members of a society. increases social welfare. utility Money utility different + - Makes no difference how many Preferences of each individual can be described but whose preferences oranges are lost in the process (i.e. does the social welfare function represent? inefficient transfer process) as long as Alex gets something. No increase in welfare of a better off Bobby’s utility individual can compensate society for a decrease in welfare of worst off. 29 30 Social choice in practice Measuring benefits Government identify and measure net benefits for different groups. Willingness to pay: how much an individual is willing to pay to be in one Pareto improvement → project should be undertaken. situation rather than another. Some gain, some lose → efficiency measured by summing gains or losses What you’re willing to pay is different to what you have to pay. for each individual, equity by some measure of social inequality. Net positive losses and increased inequality → no. Net positive gains and reduction of inequality → go ahead. If mixed: trade-off evaluated using a social welfare function. How much extra inequality will society accept for an increase in efficiency? 31 32  Number of sweatshirts Willingness to pay (£) Marginal utility (utility) 0 0 / Willingness to pay and utility 1 50 50 2 95 45 3 135 40 4 170 35 5 200 30 6 228 28 7 254 26 8 278 24 9 301 23 10 323 22 11 344 21 12 364 20 13 383 19 14 401 18 33 34 Mu decreases Ordinary and compensated demand curves Ordinary and compensated demand curves If sweatshirts cost £29, buy 5 sweatshirts. Ordinary demand curve → need to know how many units the individual Marginal benefit > cost until then. would buy at each price. As price is lowered, demand more, and are better off. Marginal utility curve can be thought of as a demand curve. Certain type: compensated demand curve. As prices are lowered: i) substitute the cheaper good for other goods (substitution effect) Compensated demand curve: how much an individual is willing to pay for ii) money left over now due to lower prices, some is used to buy an extra unit of the good. sweatshirts (income effect) Given one more unit, always kept at the same level of utility. Compensated demand curve = ordinary demand curve – income effect 35 36 Consumer surplus Measuring aggregate social benefits and inefficiency Consumer surplus: difference We have talked about individual benefits until now. between what an individual is Social benefits = sum of benefits received by all individuals. willing to pay and what they have to pay. Used for government projects. Net efficiency = sum of benefits (i.e. total WTP) – total cost Difference between Can also calculate consumer surplus of elimination of an inefficiency (e.g. compensated and ordinary a tax or monopoly) demand curve is negligible so look at the area under the ordinary demand curve. 37 38 Example Example Consider a tax on cigarettes and £80 is raised. Deadweight loss or excess burden of tax = revenue raised – lump sum tax Ask each individual how much they would be willing to pay to have the tax Measure of inefficiency. eliminated. Taxes apart from lump sum → deadweight loss as individuals forgo more- £100 is one answer preferred consumption for in favour of less preferred to avoid tax payment. Lump sum tax of £100 to eliminate the tax, have to pay £100 regardless of what they do and leaves their welfare unchanged. 39 40 Deadweight loss Approaches to social choice Calculate deadweight loss using Compensation principle: if aggregate willingness to pay > cost, project should compensated demand curve. be undertaken. Issue: distributional concerns – what if cost borne by some individuals > their Cost of producing cigarettes is C0 willingness to pay. Some individuals WTP is less than the cost Tax raises price to C0+t - D Trade-off across measures: government identifies impacts on major groups Consume Q0 with tax and Q1 when Tax rather than individuals. revenue. different eg. income groups tax has been removed and replaced E with lump sum. Weighted net benefits: how to assess changes with different net gains for different groups? → social welfare function. Weights are assigned to net gains of different groups, effects on higher income groups weighted less heavily. are utilitarian or Walrasian you 41 42 Quantifying distributional effects Poverty index: UK Often more complex than quantifying efficiency effects. Relative low income: households with income below 60% of Poverty index: measure of share of population whose income is below a the median income for critical threshold below 60% of Median the current year..9 2. Poverty gap: how much income would we need to give to the poor to bring them up to this threshold? How for below are they Index only looks at how many people, gap considers how far below the threshold they are. Source: Institute for fiscal studies 43 44 Measurement issues Measuring welfare: income Two issues: Focus on monetary income as non-monetary is mostly unmeasurable. ↑ e 1. How do we define individual welfare, poverty and inequality?. job Satisfaction g. 2. How do measure these in practice? Income unit matters – individual vs. family. Narrower the unit, greater the measure of poverty and inequality. 45 46 Measuring poverty Lecture Finished Again, issues of measuring income are relevant. e.g. whose income (individual vs. household) and sizes of households. Concept: absolute or relative Appendix Absolute → income is too low to keep you alive and healthy. Relative → a person is poor if they feel poor, so it depends in part what you see around you. Can't afford internet but majorly of population has it Remember: poverty and inequality are different measures. 47 48 Measuring inequality: Individuals Measuring inequality: Aggregate Income depends on endowment (e.g. human capital, inherited wealth), What is the unit – individual, family, household? tastes (for work and leisure, savings, consumption) and luck. Inequality of what – income, wealth, power? Choose to work less hours based on tastes (i.e. like cheaper things). Most studies based on money income of households or tax units. More job satisfaction (i.e. non-monetary) Information on income by type or level of income, or recipient might be limited. Paid more due to more skills acquired: if same opportunity to acquire skills then no reason to suspect inequality. Estimation is usually based on income group so neglects dispersion within Age: A (aged 20) earns twice as much as B (aged 40) but when A is 40 each group. they will earn the same amount as B does now. 49 50 Social justice and social theories Libertarian Natural right libertarians – argue that state intervention is morally wrong Social justice – a goal relating to the way in which resources should be apart from limited circumstances (e.g. Nozick) distributed or shared. Empirical libertarians – argue against state intervention as it will reduce welfare (e.g. Friedman, Hayek) Different definitions depending on theory of society. Theory of society offers principles that enable choosing between different Both groups: social arrangements. Analyse society based on individual members rather than the group Heavy weight to individual freedom Analysing the welfare state, three broad types are important: libertarian, Strongly support private property and the market mechanism liberal and collectivist. Hence very limited role for the state in taxation and redistribution 51 52 Liberal Collectivist Utilitarianism – distribute goods so to maximise the total utility of the Sees industrial society as consisting of social classes defined in terms of members of society their relation to means of production. Private property has only a limited role. Societies are analysed in terms of individual members Primary concern of the state is the allocation and distribution of resources Private property is not an end in itself but a means towards the according to individual needs. achievement of a policy goal In certain circumstances redistributing income is an appropriate function of Democratic socialists are an intermediate case – to some extent share the the state same views of egalitarian aims, their analysis has a lot in common with liberal thinking. 53 54 In reality Theories blur into each other but it is useful to discuss them as separate entities when comparing the implications for policy. More information in Chapter 2 of Barr (6th edition) or Chapter 3 (4th edition). 55