Chapters 1 to 4 Outline The Four Questions of Public Finance Utility maximization Labor supply...

Chapters 1 to 4

Outline The Four Questions of Public Finance Utility maximization Labor supply example Efficiency Social welfare functions Correlation versus causation Discounting

Question 1: When Should the Government Intervene in the

Economy?

Normally, competitive private markets provide efficient outcomes for the economy.

In many circumstances, it is hard to justify government intervention in markets. Two common justifications are: Market failures

What is a market failure? Redistribution

Shifting resources from some groups to others.

When Should Government Intervene? When Should Government Intervene? AAn example of market failuren example of market failure

In 2003, there were 45 million people without health insurance in the United States, or 15.6% of the population.

Lack of insurance could cause negative externalities from contagious disease–the uninsured may not take account of their impact on others.

Measles epidemic from 1989-1991, caused by low immunization rates for disadvantaged youth, was a problem. Government subsidized vaccines for low-

income families as a result.

When Should the Government Intervene? Redistribution

Of the uninsured, for example, roughly three-quarters are in families with incomes below the median income level in the United States. Society may feel that it is appropriate to

redistribute from those with insurance (who tend to have higher incomes) to those without insurance (who tend to have lower incomes).

Redistribution often involves efficiency losses. The act of redistribution can change a person’s

behavior. Taxing the rich to distribute money to the poor could cause both groups to work less hard.

Question 2: How Might the Government

Intervene? If the government wants to intervene in a market,

there are a number of options: Using the price mechanism with taxes or subsidies.

Tax credits that lower the “effective price” of health insurance.

Mandate that either individuals or firms provide the good.

“Pay-or-play” mandates that require employers to provide health insurance, such as California’s Health Insurance Act.

Public Provision The Medicare program for U.S. senior citizens.

Public Financing of Private Provision Medicare prescription drug cards, where private companies

administer the drug insurance.

Question 3: What Are the Effects

of Alternative Interventions? Much of the focus of empirical public

finance is assessing the “direct” and “indirect” effects of government actions.

Direct effects of government actions assume “no behavioral responses” and examine the intended consequences of those actions.

Indirect effects arise because some people change their behavior in response to an intervention. This is sometimes called the “law of unintended consequences.”

Question 4: Why Do Governments Do What They

Do?

Positive (as opposed to normative) question. Governments do not simply behave as benign

actors who intervene only because of market failure and redistribution.

Tools of political economy helps us understand how governments make public policy decisions. Just as market failures can lead to market

inefficiency, there are a host of government failures that lead to inappropriate government intervention.

Chapter 2:Review (Quickly) Economics 301

Constrained Utility Maximization is based on Preferences (indifference curves), and Budget sets.

Start with a discussion of preferences.

A utility function is a mathematical representation U = f(X1, X2, X3, …) Where X1, X2, X3 and so on are the goods

consumed by the individual, And f(•) is some mathematical function.

Figure 2 Utility From Different Bundles

QM (quantity of movies)

QCD

(quantity of CDs)

0 1 2

1

2A

B

C

IC1

IC2

“A” and “B” both give 2 “utils” and lie on the same

indifference curve

Bundle “C” gives higher utility than either “A” or “B”

Bundle “C” gives 4 “utils” and is on a

higher indifference curve

Higher utility as move toward

northeast in the quadrant.

Constrained Utility Constrained Utility Maximization: Marginal utilityMaximization: Marginal utility

With the utility function, U = QMQC, the marginal utility is:

Take the partial derivative of the utility function with respect to QM to get the marginal utility of movies. Normally, preferences exhibit diminishing

marginal utility, as would be the case if U = (QMQC)1/2 , since

MUU

QQQ

MCM

1

2M

CQ

M M

QUMU

Q Q

Constrained Utility Maximization:

Marginal rate of substitution Marginal rate of substitution—slope of the

indifference curve is called the MRS, and is the rate at which consumer is willing to trade off the two goods.

Direct relationship between MRS and marginal utility.

MRS shows how the relative marginal utilities evolve over the indifference curve.

, when CMM C

C M

QMUMRS U Q Q

MU Q


Budget constraints

The budget constraint is a mathematical representation of the combination of goods the consumer can afford, given income.

Assume there is no saving or borrowing. In the example, denote:

Y = Income level PM = Price of one movie PC = Price of one CD

Y P Q P QM M C C

Figure 8 Utility Maximization


QCD

(quantity of CDs)

0 1 2

1

2

3

3

This indifference curve is not utility-maximizing, because there are bundles that give higher utility.

This indifference curve gives much higher utility, but is not attainable.

This bundle of goods gives the highest utility, subject to the budget

constraint.


Putting it together: Constrained choice

Thus, the marginal rate of substitution equals the ratio of prices:

At the optimum, the ratio of the marginal utilities equals the ratio of prices. But this is not the only condition for utility maximization. The second condition is that all of the consumer’s

money is spent

MRSMU

MU

P

PM

C

M

C

The Effects of Price Changes:

Substitution and income effects

A change in price consists of two effects:

Substitution effect–change in consumption due to change in relative prices, holding utility constant.

Income effect–change in consumption due to feeling “poorer” after price increase.

Figure 11Figure 11 illustrates this.

Income and Substitution Effects (price of rooms

rises)

Meals

RoomsSubstitution effect

Income effect

SE: Find a hypothetical budget line with the new price ratio just tangent to the original IC.

Figure 18

Derive Demand Curves: First, Increase in the Price of Movies


QCD

(quantity of CDs)

QM,1QM,2QM,3

Raising PM even more gives another (PM,QM) combination with even less

movies demanded.

Raising PM gives another (PM,QM) combination with fewer movies demanded.

Initial utility-maximizing point gives one (PM,QM) combination.

Figure 19

Deriving the Demand Curve for Movies: Second, plot the optimal price-quantity pairs

QM

PM

QM,3

Demand curve for movies

At a high price for movies, demanded QM,3

PM,3

At a somewhat lower price for movies, demanded QM,2

QM,2

PM,2

At an even lower price for movies, demanded QM,1

QM,1

PM,1

Various combinations of points like these create the

demand curve.

EQUILIBRIUM AND SOCIAL WELFARE Elasticity of

demand A key feature of demand analysis is the

elasticity of demand. It is defined as:

That is, the percent change in quantity demanded divided by the percent change in price.

Demand elasticities are: Typically negative number. Not constant along the demand curve (for a linear demand

curve). It is easy to define other elasticities

(income, cross-price, etc.)

DD

D

QQ

PP

EQUILIBRIUM AND SOCIAL WELFARE: Supply curves

We do a similar drill on the supply side of the market. Firms have a production technology (we might write it as)

We can construct isoquants, which represent the ability to trade off inputs, fixing the level of output.

Firms also have an isocost function, which represent the cost of various input combinations. Firms maximize profit (minimize cost) when the marginal rate of

technical substitution equals the input price ratio. Also MR=MC at the profit-maximizing level of output.

Q f L KM M M ,

EQUILIBRIUM AND SOCIAL WELFARE Equilibrium

In equilibrium, we horizontally sum individual demand curves to get aggregate demand.

We also horizontally sum individual supply curves to get aggregate supply. A firm’s supply curve is the MC curve above minimum

average variable cost. Competitive equilibrium represents the point at

which both consumers and suppliers are satisfied with the price/quantity combination.


Figure 21 Equilibrium with Supply and Demand

QM

PM

QM,3


PM,3

QM,2

PM,2

QM,1

PM,1

Supply curve of movies

Intersection of supply and demand is equilibrium.

EQUILIBRIUM AND SOCIAL WELFARE

Social efficiency

Measuring social efficiency is computing the potential size of the economic pie. It represents the net gain from trade to consumers and producers.

Consumer surplus is the benefit that consumers derive from a good, beyond what they paid for it.

Each point on the demand curve represents a “willingness-to-pay” for that quantity.


Social efficiency

Producer surplus is the benefit derived by producers from the sale of a unit above and beyond their cost of producing it.

Each point on the supply curve represents the marginal cost of producing it.


Social efficiency

The total social surplus, also known as “social efficiency,” is the sum of the consumer’s and producer’s surplus.


Figure 25 Social Surplus

QM

PM

0


Q*

P*


Providing the first unit gives a great deal of surplus to “society.”

1

Social efficiency is maximized at Q*, and is the sum of the

consumer and producer surplus.

The surplus from the next unit is the difference

between the demand and supply curves.

This area represents the social surplus from

producing the first unit.

The area between the supply and demand curves from zero to

Q* represents the surplus.

EQUILIBRIUM AND SOCIAL WELFARE Competitive equilibrium

maximizes social efficiency

The First Fundamental Theorem of Welfare Economics states that the competitive equilibrium, where supply equals demand, maximizes social efficiency.

Any quantity other than Q* reduces social efficiency, or the size of the “economic pie.”

Consider restricting the price of the good to P´<P*.


Figure 26 Deadweight Loss from a Price Floor

QM

PM


Q*

P*


Q´

P´

The social surplus from Q’ is this area, consisting of a

larger consumer and smaller producer surplus.

With such a price restriction, the quantity falls to Q´, and there is

excess demand.

This triangle represents lost surplus to society, known as “deadweight

loss.”


The role of equity Societies usually care not only about how

much surplus there is, but also about how it is distributed among the population.

Social welfare is determined by both criteria.

The Second Fundamental Theorem of Welfare Economics states that society can attain any efficient outcome by a suitable redistribution of resources and free trade.

In reality, society often faces an equity-efficiency tradeoff.

Chapter 3: Empirical Approaches to Policy

Analysis

Empirical public finance is the use of data and statistical methodologies to measure the impact of government policy on individuals and markets.

Key issue in empirical public finance is separating causation from correlation. Correlated means that two economic variables

move together. Casual means that one of the variables is

causing the movement in the other.

THE IMPORTANT DISTINCTION BETWEEN CORRELATION AND

CAUSATION

One interesting, tragic example given in the book describes some Russian peasants. There was a cholera epidemic. Government

sent doctors to the worst-affected areas to help. Peasants observed that in areas with lots of

doctors, there was lots of cholera. Peasants concluded doctors were making

things worse. Based on this insight, they murdered the

doctors.

The Problem

In the Russian peasant example, the possibilities might be: Doctors cause peasants to die from

cholera through incompetent treatment.

Higher incidence of illness caused more physicians to be present.

Peasants thought the first possibility was correct.

MEASURING CAUSATION WITH DATA WE’D LIKE TO HAVE:

RANDOMIZED TRIALS

Randomized trials are one often effective way of assessing causality.

Trials typically proceed by taking a group of volunteers and randomly assigning them to either a “treatment” group that gets the intervention, or a “control” group that is denied the intervention. With random assignment, the assignment of the

intervention is not determined by anything about the subjects.

As a result, with large enough sample sizes, the treatment group is identical to the control group in every facet but one: the treatment group gets the intervention.

The Problem of Bias

Bias represents differences between treatment and control groups that is correlated with the treatment, but not due to the treatment. An example of bias: in 1988 the SAT scores of Harvard

applicants who took test preparation courses were lower than those of students who did not. This would bias straightforward effort to study the effects of SAT classes on test scores.

By definition, such differences do not exist in a randomized trial, since the groups, if large enough, are not different in any consistent fashion.

Why We Need to Go Beyond Randomized Trials

Randomized trials present some problems: They can be expensive. They can take a long time to complete. They may raise ethical issues (especially in the

context of medical treatments). The inferences from them may not generalize to

the population as a whole. Subjects may drop out of the experiment for

non-random reasons, a problem known as attrition.

Time Series Analysis

Time series analysis documents the correlation between the variables of interest over time. It is difficult to identify causal effects

when there are slow moving trends and other factors are changing.

Sharp changes in a policy variable over time, may create opportunities for valid inference.

Figure 2

Cross-Sectional Regression Analysis

Cross-sectional regression analysis is a statistical method for assessing the relationship between two variables while holding other factors constant.

“Cross-sectional” means comparing many individuals at one point in time.

An example: Where the control variables account for

race, education, age, and location

HOURS TANF CONTRO Li i i i

Quasi-Experiments Economists typically cannot set up randomized

trials for many public policy discussions. Yet, the time-series and cross-sectional approaches are often unsatisfactory.

Quasi-experiments are changes in the economic environment that create roughly identical treatment and control groups for studying the effect of that environmental change. This allows researchers to take advantage of

randomization created by external forces.

An Example of a Quasi-Experiment

New Jersey raises their state minimum wage. Pennsylvania does not. We are interested in the effect of the minimum

wage on employment. We could look at the employment of low-skilled

workers in NJ before and after the minimum wage increase.

But other things in the economy might be occurring. So, we can see how employment changed in PN over

the same interval. The difference in employment in NJ, before and

after, compared to the difference in employment in PN, before and after, may reveal the causal effect of minimum wages changes, if NJ and PN are identical (similar?) in other respects.

Structural Modeling Both randomized trials and quasi-experiments

suffer from two drawbacks: First, they only provide an estimate of the causal

impact of a particular treatment. It is difficult to extrapolate beyond the changes in policy.

Second, the approaches often do not tell us why the outcomes change. For example, the approaches do not separate out income and substitution effects in the TANF example used in the book.

Structural estimation attempt to estimate the underlying parameters of the utility function.

Chapter 4: A Couple Tools and Definitions

Government debt is the amount that a government owes to others who have loaned it money. It is a stock variable; the debt is an amount owed

at any point in time. Government deficit is the amount by which

spending exceeds revenues in a given year. It is a flow variable; the deficit flow is added to

the previous year’s debt stock to produce a new stock of debt owed.

Real vs. Nominal

The debt and deficit are often expressed in nominal values–that is, in today’s dollars.

Inflation changes the real value of the debt or deficit, however, because prices change. The consumer price index (CPI) measures the

cost of purchasing a typical bundle of goods. It increased 91% between 1982 and 2003.

Inflation reduces the burden of the debt, as long as that debt is a nominal obligation to borrowers.

Rising prices leads to what is known as the “inflation tax” on the holders of the debt–the payments are worth less because of rising prices.

In 2003, the national debt was $3.91 trillion and inflation was 1.9%. The inflation tax was therefore $74 billion, which would reduce the conventionally measured deficit from $375 billion to $301 billion.

Background: Present Discounted Value

To understand budgeting, you must understand the concept of present discounted value (PDV).

Receiving a dollar in the future is worth less than receiving it today, because you have foregone the opportunity to earn interest.

PDV takes future payments and expresses them in today’s dollars.

It does so by discounting payments in some future period by the interest rate.

Background: Present Discounted Value

A stream of payments would be discounted as:

Where B0 through Bt represent a stream of benefit obligations, r is the interest rate, and t is the number of periods.

For example, $1,000 received 7 years from now is only worth $513 with a 10% interest rate:

A constant payment received indefinitely has the PDV=P/r

PDV B

B

r

B

r

B

rt

t

01 2

21 1 1. . .

5 1 3 1 6

1 0 0 0

1 0 1 0

1 0 0 0

1 9 4 87.. .

Chapters 1 to 4 Outline The Four Questions of Public Finance Utility maximization Labor supply...

Documents

Transcript of Chapters 1 to 4 Outline The Four Questions of Public Finance Utility maximization Labor supply...