EC355 Public EconomicsLecture 1

The big questions of Public Economics (and of this module)

Lecturer: Giovanni Mastrobuoni

Lectures: Thursday 12-2:00pm 5A.303

Classes (starting week 3): Thursday 2-4pm, same room

Email: gmastrob@essex.ac.uk

Office Hours: Tuesday 2-4pm or by appointment

My Room: 5B.219

Vilfredo Pareto (1848 – 19 August 1923)

Italian engineer, sociologist, economist, political scientist and philosopher. He made several important contributions to economics, particularly in the study of income distribution and in the analysis of individuals' choices. He was also responsible for popularising the use of the term "elite" in social analysis.

He introduced the concept of Pareto efficiency and helped develop the field of microeconomics. He was also the first to discover that income follows a Pareto distribution, which is a power law probability distribution. The Pareto principle was named after him and built on observations of his such as that 80% of the land in Italy was owned by 20% of the population.

Syllabus

http://courses.essex.ac.uk/ec/ec355/module_outline/ec355co_2013-14.pdf

What we are going to cover?

Why government? This module analyses the economic rationale for "collective choice" in a market economy.

How do we measure and judge “how good things are”? We will consider measures of social welfare, equity and efficiency. We will evaluate the government's ability to identify and achieve "better" outcomes, particularly under a democratic process.

What can government achieve? We will consider the economic case for interventions to redress market failures, to redistribute resources, and to provide public goods and services.

What do governments do, and how well? This module is also applied: we will discuss and compare actual and proposed programmes in the UK and abroad in the areas of poverty reduction, education, and health.

What do you get out of this module?

Learning outcomes: They should have a general appreciation of the composition of private income and

wealth, the sources and uses of public funds in the UK and abroad, and the structure of major government programmes. They should also have a clear understanding of the characteristics of a public good (and the difficult problems associated with providing it), and a grasp of equity and efficiency issues related to taxation and redistribution.

Key and Employability Skills: By the end of this module, students should be able to form clear, logical, economic

arguments for (or against) specific policies, and to articulate these in writing. In preparing for the final and the term paper, students will demonstrate their ability to access and highlight key statistical and descriptive institutional information from government and academic sources.

Who cares?http://www.essex.ac.uk/economics/current_students/ug/ug_bulletin.aspx

Government Economist Fast Stream Scheme 2013 is now recruiting

Are you interested in working in the Civil Service? The Economist Fast Stream Scheme opens for applications in February 2014

For more information and to apply visit http://www.civilservice.gov.uk/networks/ges.

“Fast Stream Economists

For those who wish to pursue a career as a Fast Stream Economist, a firm grasp of the fundamental core macro

and micro economic principles, and the ability to apply economics to practical problems are a must. What’s more,

you’ll need to be able to communicate complex economics ideas simply to non-economists. You will not however

require knowledge of advanced economic techniques."

Public Economics

Defining the Field of Study

Public Finance/Public Economics, Hindriks & Miles (MS):

“The study of economic efficiency, distribution, and government policy.”

Studies government taxing and spending activities and the conditions under which government intervention is likely to improve the welfare of citizens.

Has broadened in recent years to include analysis of how policies are made (e.g., public choice theory), analysis of the impact of various policies, and general discussion of the provision of public goods.

Key Questions of Public EconomicsQ1: What are governments and what do they do? “Positive” and descriptive question, and the focus of this lecture.

Q2: (Why and when) do we need government? “Normative” question; “Market failures” – a key question of economic theory. The positive analysis (understanding the effects of policies) is a prerequisite:

Q3: What are the effects of government interventions?A crucial empirical and econometric question; “policy analysis.” The limit is often in the information that the government has (e.g. tax evasion).

(Q4: What actually determines government decisions?) “Positive political economy”, empirics and theory.

(Q5: How to structure efficient taxation and transfers?) Related to Q3, those interventions need to be financed. Question of “Public Finance”.

Key Questions of Public Economics

Q1: (Descriptive)

What are governments?

What do governments do?

How does this differ by country and over time?

Governments

Government power is monopoly on force and compulsion (with limits)

Limits: Modern democratic states are accountable to themselves (via the constitution and the separation of powers) and to voters (and sometimes to world bodies).

Motivation of governors (elected, appointed)?• Benevolent or self-interested?

Governments do essentially three things: tax, spend, and regulate

i. Taxes Price mechanism (Price setting)• Taxing goods: clothes, cigarettes, petrol Income and wealth effects, incentive

effects• Subsidies: nurseries for young children• Tax credits: childcare voucher

Tax and spend Income transfers

ii. Spending Production/ Public Provision• The NHS service• National Defence (the army)

iii. Regulation (and Mandate ) Lay down the law• Maternity benefit: requires employers to provide benefit.• Prohibition on purchasing alcohol below a certain age.

The Welfare StateGoals: insure against risks (age, unemployment,

health, etc.)

• Consumption smoothing

• Insurance

• Poverty relief

The State• National security

• Public order

• Public services

Trends of the welfare state since its beginning

pensions, unemployment insurance, child benefits, income support

Adjusting for inflation

Adjusting for GDP

Compared to the rest of the world

Government accountsIncome = taxes

+ asset income

+ asset sales

Expenditure = transfers + government consumption

+ subsidies

+ interest paid

+ capital expenditure

Q: Income – Expenditure =???

Comparing governments

• UK Economy:

about £1.4 trillion GDP per year = about £22,000 per capita

World economy ???

(about £40 trillion, about £6000 per capita)

• Government revenue ???

about £550 billion

less spending of about £700 billion per year

→ deficit about £150 billion (per year, 2010-11)

• National debt = about £1 trillion Sources: http://www.statistics.gov.uk/pdfdir/oie0810.pdf,

http://www.statistics.gov.uk/cci/nugget.asp?id=277, http://www.ukpublicspending.co.uk/, http://www.hm-treasury.gov.uk/junebudget_diagrams.htm, World Bank Indicators. (See also http://www.debtbombshell.com/)

UK magnitudes

http://www.guardian.co.uk/business/interactive/2009/sep/16/public-spending-larry-elliott

Trends in total spending

Trends in defence spending

Trends in education spending

Trends in health spending

Tax revenue as percent of GDP

0

10

20

30

40

50

60

France

Japan

Mexico

Sweden

United Kingdom

United States

OECD - Europe

UK? Compare to France, Japan, Mexico, Sweden, US, Europe overall

The debt “crisis” – (update to 2012: )Total central government debt as % of GDP

Mexico Canada Germany Spain United States France United Kingdom Portugal Italy Greece

0

20

40

60

80

100

120

140

19982009

Source: http://stats.oecd.org/

Country UK Can. France Germ. Japan Mexico USA

8 10 11 10 8 6 10 16

2990 3867 3593 3619 2729 824 3844 7285

82 70 78 77 82 45 46

12 17 17 15 20 28 .. 12

365 665 595 545 548 232 .. 876

Health-care expenditures (2007) Source: OECD.StatNeth.

Total expenditure on health, % of gdp

Total health expenditure per capita, US$ PPP

Public expenditure on health, % total expenditure on health

Pharmaceutical expenditure, % total expenditure on health

Pharmaceutical expenditure per capita, US$ PPP

Expenditure on educational institutions in tertiary education

As a percentage of GDP, 2005

Updating stats

http://stats.oecd.org/index.aspx

http://www.hm-treasury.gov.uk/

http://www.ifs.org.uk

Trends/patternsGovernment expenditure (G/GDP) increase over

the 20th century, up through the 1970’s-1980’s – Particularly social security

– “Wagners law” – “The advent of modern industrial society will result in increasing political pressure for social progress and increased allowance for social consideration by industry.”

Why the increase? • Insurance (from various risks) is a luxury good.

• Changing suffrage, demographic changes.

• Increased scope for redistribution (equity considerations….Political Model)?

• Increased market failures (efficiency considerations)?

• Increase in “fiscal illusion” (“The politician should make taxes appear to be less of a burden than they really are,” Amilcare Puviani).

• Baumol’s law (G is a labor intensive sector, little scope for substitution effects).

• Interest groups.

Political model

Utility of (H) individuals• t tax, G public good, y income• G budget constraint:

Optimal level:

… income inequality + median voter

Bureaucracy

• B budget rises with output y• Under the condition that B<C (Lagrange…

another Italian ;) ).

Other models

• Budget setting • Monopoly power • Corruption (rent-seeking)

• Predatory regulation

• Asymmetric information• Etc. etc.• Evidence?? Hard because of lack of

data. Country level regressions are hardly conclusive

Q2: The Role of government

(Why and when) do we need government? Do we need it to do more than just protect private property? If so, why?

Do we need it to do more than just protect private property and redistribute wealth in lump-sum transfers? If so, why?

We will review:

What is Pareto efficiency?

Why is it a goal? Why is a non-PE outcome undesirable?

What is the “Pareto frontier” and how does one derive it?

Why do most people think PE is not “enough” (consider an extreme case)?

The free-market ideal:

Concepts of efficiency

This goes back to Adam Smith and the notion of the invisible hand.

1) When there are consumers who are willing to pay a positive price for a good or service then a firm will enter the market to produce it.

2) When a firm is producing (or pricing) inefficiently it will be compelled to change or be driven out of business by new and more efficient companies.

→ “when this holds, we don’t need a Government” (at least not for efficiency).

This leads us to a discussion of efficiency and the two Fundamental Welfare Theorems. (Later: more technical statement and “proof” of this)

First fundamental welfare theorem (short version)

Given a bunch of fancy conditions* [mind the fine print!]…

a “general competitive equilibrium” (free markets that have “reached equilibrium”, basically supply=demand at prevailing prices)

is Pareto efficient.

*Conditions The less technical ones include:

(0) rational agents,

(i) perfect competition/price taking,

(ii) complete markets (everything that affects utility is owned and controlled).

More technical ones include

(iii) “convex preferences and technology” and (iv) “complete” information.

Discussion: With perfectly functioning markets and complete markets we can achieve a Pareto efficient outcome without Government. Note that this does not mean that the outcome is equitable or fair as it ignores the issue of equity and distribution.

Second Welfare Theorem

[Given similar conditions as for the first]

Every Pareto efficient allocation

can be achieved by a competitive economy (in equilibrium) with complete markets and non-increasing returns to scale,

when “frictionless” lump sum transfers of endowments are feasible.

Discussion:

Again not much to do for the Government as all that is required are lump-sum transfers.

There is no need for taxes or regulation or public sector production.

Pareto efficiency does not help us in ranking alternative allocations of resources.

We need to have a “Social Welfare Function” to embody the view of “society” to make these judgments.

Another caveat:

To achieve the allocation that maximises a particular social welfare function the government also needs to have perfect information over peoples’ “endowments” and preferences.

Market failuresThe principal justification for a Government. The sources of which are:

1) Non-competitive (or less competitive) markets. These can be due to natural monopolies (increasing returns to scale or scope), historical co-incidence, rents (brands, talent, etc.)

2) Absence of markets . Classic example: insurance and the issue of adverse selection and moral hazard through asymmetric information

3) Externalities: When the price system fails to provide appropriate signals, then this leads to inefficiencies if one person’s or one firm’s action affects the welfare of another.

4) Public goods (and bads): Non-rival in consumption (you use it and so can I), and non-excludable (free-riding).

5) Bounds on rationality, consistency, and calculation of consumers, markets, and firms.

Q3: What are the effects of Government Interventions?

Field of empirical public economics: policy analysis with data and statistical methodology

Direct and indirect effects

Key issue: identification (correlation vs causation)

Vocabulary: Time series analysis, Cross-sectional regression, panel data, structural vs reduced form estimation. Controls for observable variables. Instrumental variables, natural experiments, field experiments, pilot studies. Estimating differentiated “treatment effects.”

Q4: What determines government decisions?

• Public interest model (government follows welfare economics; analogous to optimisation in welfare economics)

• Public choice view (individuals in the public sphere are self-interested)

Note: Public choice is not a core part of this module

(Q5: Efficient taxation/transfers)

How can governments raise revenue and reallocate wealth with the minimum “deadweight loss”/distortion?

With omniscient government, lump-sum tax is best. But this is basically impossible or infeasible.

“Second best”: Who and what to tax/subsidise, and at what rate?

• Central to “Public finance”

• Some treatment in this module

Next slides – technical part

readMH, chapter 1, 2, 3 and 4

Assignments

1. Examine the list of explanations for G/GDP growth? Can you think of any additional one?

2. Consider: Look at opinion pieces (in newspapers, etc.), to find a “good” and a “bad” argument for a particular government intervention

3. Access web sites, “update” statistics in book/slides.