Lecture 2Introduction to Public Finance

ANDREEA STOIAN, PHD

PROFESSOR OF FINANCE

DEPARTMENT OF FINANCE AND CEFIMO

BUCHAREST UNIVERSITY OF ECONOMIC STUDIES

Why Study Public Finance?

Role of the government in economy

CANDIDATE 1

The role of the government is notto create wealth. The role of thegovernment is to create anenvironment in which theentrepreneur is willing to takerisk and to be able to get a returnon the risk taken.

CANDIDATE 2

oSet in motion programs thathelp people go to college, buy anew house, and build theirwealth

oPlans invest in people

oInvesting more in public schoolsand expecting more in return

The goal of Public Finance

The study of the role of thegovernment in the economy inorder to proper understand it.

Four questions of Public Finance

WHEN should government intervene

in the economy?

HOW might the government intervene?

WHAT is the effect of those interventions in

the economy?

WHY do governments choose to intervene in the way what they do?

WHEN?

MARKET FAILURE

Problem that causesthe market economy todeliver an outcomethat does not maximizeefficiency

REDISTRIBUTION

The shifting of resourcesfrom some groups insociety to others

Market failure

Market failure (I)

Peoples’ needs

Individual needs

Private goods

Market

Social needs

Public goods

Government

Market failure (II)C

om

pet

itiv

e m

arke

t eq

uili

bri

um

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

Mar

ket

fails

in d

eliv

erin

g th

e m

ost

ef

fici

ent

ou

tco

me

to s

oci

ety

Due to choices based on ‘individual rationality’

Go

vern

men

t in

terv

ene

in a

chie

vin

g th

e m

ost

eff

icie

nt

ou

tco

me

for

the

soci

ety

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

Redistribution

Redistribution (I)

Distribution

Equity-Efficiency trade

off

Size

Thomas Piketty – Capital in the Twenty-First Century

The Regulatory Role of the GovernmentAnother critical role that government plays in all nations is that of regulating economic and social activities.

Example of the regulatory role of the government in economic activities

• Give an example!

Example of the regulatory role of the government in social activities

• Give an example!

The Stabilization Role of the Government

Intervene in the economy in order to stimulate/reduce the activity

• Give an example!

Smoothing the business cycle

• Give an example!

Prevent large disequilibrium

• Give an example!

HOW?

Government

Restricting or

mandating

Public provision

Public financing

and private provision

Taxes and subsidies

WHAT?

Empirical public finance

Direct Effects: that would be predicted if individuals did not change behaviour in response

to the intervention

Indirect Effects: that arise only because individuals change

their behaviour in response to the interventions

WHY?

Normative

• How should government intervene?

• Question concerned with how things should be done

Positive

• Why do governments do what they do?

• Question concerned with the things are the way they are

Political economy

• The theory of how the political process produces decisions that affect individuals and the economy

• Government failures