Market failure Redistribution- Tax or subsidy Restrict or mandate private sale or purchase Public provision Public financing of private provision

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1 8/04/2015 2:42 PM Public Finance Four Questions: o When should governments intervene?! Market failure- problem that causes an outcome that does not maximize efficiency. Increase size of the pie. " If a trade makes one person better off and one person worse off " Some situations where this does not hold " Measles Epidemic of Kids not getting immunized creating negative externality for everyone else Private value was lower than societal value " Intervention by federal government Advertising Subsidies Resulted in immunization of 90%! Redistribution- " Hard to do by anyone other than the government. Change division of the pie. o How might they intervene after deciding they need to?! Tax or subsidy " Ex: tax Smoking has health care negative externality, secondhand smoke, set fires! Restrict or mandate private sale or purchase " Marijuana, alcohol (have to be 21), smoking (have to be 18) " Health insurance, car insurance! Public provision " Provide a good by the government " Ex: parks, national park! Public financing of private provision " Medicaid# texas pays premium for private insurance o What are the effects of alternative interventions?! Direct effects

2 " Effects that would happen if people kept same behavior " Ex: see health insurance now, what would happen if there behavior the same! Indirect effects " Effects that arise because of change in behavior " Ex: doctor more often, shift salary! Application: Congressional Budget Office " Try to score implications of policy " Quantify direct and indirect effect o What does the government do?! Political economy " Comes up with decisions that affect individuals and the economy Graph: Federal spending as a percent of GDP o Growth, with large spike at WWII o Compare countries to compensate for decentralization Decentralization o 64% at federal o 37% at state o This is extent to which spending is concentrated at higher federal levels or lower levels Federal mainly deficit, state and local run a surplus most of the time State spending on health has increased greatly What do they spend money on? o Public goods (national defense, education) o Social insurance (social security, disability) Some Agencies o Food Drug Administration o Occupation Safety and Health Administration o Federal Communications Commission o Environmental Protection Agency

3 Theoretical Tools of Public Finance 8/04/2015 2:42 PM Chapter 2 in textbook Today theoretical tools- set of tools designed to understand the mechanics behind economic decision making Next class empirical tools Utility function o Bundles to compare o Maximize well being subject to constrain Indifference curves o More is better, so higher right better o Qualities:! Consumers prefer higher indifference curves! IC are downward sloping (tradeoff) o Ex: Job choice Utility function Marginal utility! Without DC would pick either Minneapolis or Phoenix o Diminishing - each additional makes an individual less happy than the previous Marginal rate of substitution o Willingness to trade off one good for another good o So how much of good on x axis will you trade for good on y axis o MRS= -Mu m /MU c Budget constraint o Representation of all bundles you can afford to buy o Always have opportunity cost o Ex:! Suppose Price movies=$8, Price of CDS=$16, I=$96! 12 on movies axis, 6 on cds axis. Connect two points! The slope of that curve is the price ratio (price of movie/price of cds)! u= (Q c Q m )! PmQm+PcQc=I! Qc/Qm=1/2! Qc=1/2Qm! 8Qm+16Qc=96

4 ! 8Qm+8Qm=96! 16Qm=96! Qm=6! Qc=3 Change in Price o Price increased when BC shifts inward b/c can buy less o Figure 2.7, C is new optimum point o Substitution effect! What bundle of good would you buy if we changed price but kept utility the same! Rotation of budget constraint o Income effect! How much are you effectively poorer from price change How to calculate point B o (3*6)= (Q c Q m ) o MRS=-Pm/Pc Types of goods o Normal goods- consume more with more income! Ex: nice dinner o Inferior goods- consume less with more income! Ex: ramen noodles Public Finance application o Ex: TANF o Consumption, leisure because both are economic goods o Maximum leisure of 2000 hours, get $0. Maximum consumption of $20000 and work 2000 o Wage rate of $10/hr o Now enter the welfare program. Two components! 1) Benefit guarantee- amount of money you will get if you do not work! 2) Phase out rate- how much of that benefit guarantee is going to be taken away if you start to work o Benefit guarantee= $5000 o Phase out rate= 50% o Depending on IC, can see how individuals respond to this

5 ! Could have person like Naomi who doesn t work b/c of other forces (kids, disability, etc.) Welfare economics o Study of determinants of well being or welfare in society Elasticity of demand o % change in Q/% change in P o (change in Q/Q)/(change in P/P)= Change in Q/Change in P * (P/Q) o dq/dp * P/Q Demand curve o Horizontal perfectly elastic. Will buy infinite at that price o Vertical perfectly inelastic. o Elastic demand has many substitutes ex: ketchup o Cross price elasticity change price to price they are asking for Supply curve o Maximize profits by minimizing marginal costs Social efficiency o Net gains society gets from all trades in a particular market o Two components:! Consumer surplus! Produce surplus How does social surplus change with government interaction? o Government puts price ceiling of Pr o Response will be to supply Qr o D + E will be DWL o New CS= A+B o Size of the surplus has decreased, pie has shrunk. But consumers are better off, producers worse off. 1 st Fundamental Theorem of Welfare Economics 2 nd Fundamental Theorem of Welfare Economics Social welfare o Level of well-being in society o How do we aggregate each individual s utility? o Social Welfare Function! Utilitarian SWF

6 8/04/2015 2:42 PM Empirical public finance- the use of data and statistical methods to measure the impact of government policy on individuals and markets Correlated- two economic variables move together Causal- two economic variable if movement of one causes movement of the other Ex: Russia sent doctors to areas with the sick. Peasants interpreted it as doctors causing sickness so killed doctors Ex: SAT prep courses on getting into Harvard. SAT prep courses lowered 63 points, Harvard dean came out and said it was bad. o But could be that the people that need help take these o People that are nervous take these tests o Many other stories Ex: infants breastfed past 12 months. These infants were less healthy. So people concluded that breastfeeding past 12 months was bad. o But why could it be otherwise?! Maybe mothers could not afford food # method of low income women, 3 rd factor could be driving both Many examples where these two get mixed up Identification problem- how do you identify which series is causing another The Problem You see two series moving together: series A and series B Ex: series a is breastfed past 12 months. Series b is malnourishment. 3 options: o A is causing B (SAT prep makes you bad) o B is causing A (less smart people take classes) o Some third factor causing both (income or some other factor) How to solve the problem? Randomized trial o Divide into treatment group and control group o Lets you make all else equal comparison o Ex: in ideal world, have identical clone o But in reality, we send one to one group and other to other group