Public Economics

Chikako YamauchiAssistant Professor, GRIPS

Lecture 1

Some Basic MicroeconomicsRosen & Gayer, Textbook Appendix

Introduction to Public Economics

We use a microeconomic framework to understand the role of the government in the economy: the way that the government affects the allocation of resources and the distribution of income in the economy Macroeconomic roles: how taxes, governmental

spending and monetary policies affect the overall level of unemployment and price level -> Macroeconomics, Finance

Regulatory roles: how regulations on market structure affect firms profitability and consumers welfare -> Industrial Organization

Introduction to Public Economics We study (1) Government expenditures and (2)

Taxation Should government collect taxes and arrange

public spending?

1. We work with the assumption that the free market generally is able to produce the best economic results. However, in some cases the market will not function properly, which creates an opportunity for the government to intervene and correct any problems.

2. For the government to act, it needs funding, and so we will also study how government tax policy affects the real allocation of resources and distribution of incomes.

Some Basic Microeconomics: Supply, Demand and Equilibrium

Supply and Demand

S & D demonstrates how a voluntary market leads to desired outcomes

Provides us with a framework for thinking about how the price and output of a commodity are determined in a free and competitive market

DemandWhat factors affect the amount of goods people are willing

and able to consume in a given period of time?

1. price: increase P - decrease Q2. income:

normal goods: increase income increase Qinferior goods: increase income decrease Q

3. price of related goodssubstitutes: coffee and teacomplements: coffee and cream

4. tastes: how much people like the good

Demand Demand schedule:

Holding other factors constant (income, price of related goods, tastes) it shows the relationship between price and quantity demanded.

A change in price causes movement along the demand curve

What if one of the other factors changes?

If one of the other factors changes, it causes a shiftin the demand curve. For example, an increase in the price of tea causes people to consume more coffee at each possible price of coffee.

Remember: A change in price does not shift the curve

Demand

SupplyWhat factors affect the amount of goods people are willing

and able to produce in a given period of time?

1. price: increase P - increase Q2. price of inputs: increased cost of production decrease

Q3. conditions of production / state of technology: increased

tech. increase Q

Supply schedule: Holding other factors constant (price of inputs, technology level) it shows the relationship between price and quantity supplied.

Supply

Equilibrium

Price in which quantity supplied = quantity demanded

What happens if there are extra supply (Qs > Qd) or extra demand (Qd > Qs)?

What happens to the original equilibrium if supply curve shifts towards left due to an increase in the cost of production?

Qs > Qd: downward pressure on prices as firms are forced to compete

Qd > Qs: upward pressure on prices as consumers are willing to pay a higher price to get the limited good

Any factor that shifts supply or demand will lead to a new equilibrium price and quantity.

Equilibrium

Elasticity Demand and supply curves can be flat or steep Elasticity measures the shape of supply and

demand curves Price elasticity of demand: the absolute value of

the percent change in quantity demanded divided by the percentage change in price

Horizontal demand curve: infinitely elastic, a small change in P causes a huge change in Q. Elastic demand: price affects quantity

Vertical demand curve: increase in price has no change in Q Inelastic demand: price doesnt affect Q, people are

willing to consume regardless of price

%

%

QP

Some Basic Microeconomics: Choice theory

Choice Theory The fundamental problem in Economics is that resources

available to people are limited relative to their wants Choice theory shows how people make sensible

decisions in the presence of scarcity Assume that people derive satisfaction (utility) from

consuming commodities or goods and services Assume more is always better Assume people are never satiated: some utility is always

derived from more consumption

Lets consider 2 goods: marshmallows (M) and donuts (D)

b provides more utilitythan a, while g provides less utility.

Points in the white area are unclear: more of one good but less of the other. Some pointsprovide more utility, andothes provide less utility.

Each point has an associated level of utility

Choice Theory

From (a), if I take one M, how many D are needed? Suppose 2, then (j).

U0 is an indifference curve showing all the points with the same level of utility.

Choice Theory Indifference curve shows all points producing the same utility

Starting at (a), if I take one donut, how many M are needed for the same utility?

Suppose 2 M are needed, then (i) is on same curve

Slope of Indifference Curve & Diminishing Marginal Rate of substitution

Different points on the indifference curve can be flat or steep

Rate of trading one good for another: how many M for 1 D?

Diminishing Marginal Rate of Substitution: at (i), one has lots of M and few D, so is willing to give up more M for 1 D (big slope); but at (ii), this person already has lots of D, so not willing to give up as much M for more D (small slope)

MDM DMRS

Indifference Map The entire collection of

indifference curves

Shows everything about a persons preferences

Moving upward and rightward increases utility

Utility is maximized by getting to the highest possible indifference curve

Budget constraint shows rate at which the market allows a person to substitute D for M.

Suppose a persons income is 60, M costs 3 each, and D costs 6 each.

Purchases must satisfy equation:3M+6D

Budget Constraint

More generally: PM M + PD D = I

If M is on vertical axis, then: Y-intercept is I / PM X-intercept is I / PD

DM

MD

Iy PPSlope Ix PP

Falling Income

Decreasing income causes a parallel shift in the budget line

The slope is the same, but different intercepts

Changing Price Causes the budget line to

pivot along the axis of the good whose price changes

Suppose PD increases from 6 to 12

3M+12D=60 if M=0, then D=5

Now PD/PM=12/3=4 trade 4M for 1D

Some Basic Microeconomics: Consumer equilibrium

Consumer Equilibrium

Indifference Curves: show what consumer wants to do

Budget constraint: show what consumer is able to do

Goal of consumer: maximize utility given the budget constraint

Consumer Equilibrium What point does consumer

choose to maximize utility given budget constraint?

(i) consumer cant afford it, though it has higher utility

Consumer Equilibrium What point does consumer

choose to maximize utility given budget constraint?

(ii) consumer is not spending all of the income. We are not considering savings, so resources are wasted

Consumer Equilibrium What point does consumer

choose to maximize utility given budget constraint?

(iii) feasible point, but consumer can do better by going to a higher indifference curve. At (iii), willing to give up many D for another M, and this can be done at an affordable price

Consumer Equilibrium What point does consumer

choose to maximize utility given budget constraint?

(E) best possible point, highest utility possible with given budget constraint

U1 is tangent to budget constraint

How can we characterize the condition at E?

Consumer Equilibrium

Marginal rate of substitution = price ratio In equilibrium, the rate you are willing to

trade must equal the rate that you can trade; otherwise, there would be an opportunity to do better

DDM

M

PMRSP

Consumer Equilibrium After Changing Prices

Suppose that marshmallows become cheaper The new consumer equilibrium depends on each

consumers tastes, i.e., shape of indifference curves

Some change Big change No change

Derivation of Demand Curve We can use Choice Theory to find optimal

consumption level of M for different prices of M. This in turn allows us to plot the demand curve.

Substitution and Income Effects Suppose the price of donuts

increased Increase in PD has 2 effects:

Makes D relatively less attractive

Reduces real income

Increasing PD moves equilibrium from E1 to E2

This change can be decomposed into substitution and income effects

Substitution and Income Effects Hypothetical situation: suppose that

we are at E2, and PD goes back to its original level. In order for us to stay on the same indifference curve, some of our income needs to be taken away.

EC is hypothetical equilibrium

D1 to DC: income effect, decrease D because of income decline

DC to D2: substitution effect because of change in relative prices while being compensated for lower real income

Some Basic Microeconomics: Consumer & Producer Surplus

Consumer and Producer Surplus

Consumer surplus: the area under the demand curve and above the horizontal line at the market price.

Producer surplus: amount of income individuals receive in excess of what they would require to supply a given number of units of a factor

Consumer Surplus The demand curve

shows the maximum amount that individuals would be willing to pay for the good

If the actual price is lower than that, it contributes to consumer surplus

When the price decreases, consumersurplus increases

Producer Surplus When we work, we want to be

paid at least a certain rate (reservation wage), which increases as we work longer

The wage exceeding our reservation wage contributes to producers surplus (note that workers are the producer of labor!)

When the wage rae falls, it reduces producer surplus