Public Economics

Course Coordinator & Lecturer: Dr. Christian Seel

Course Website: http://eleum.unimaas.nl/

Some Administrative Issues

Lecture notes are posted on Eleum before or after the lectures

Old exams with answer keys are posted on Eleum
For students not enrolled in Micro II: General Equilibrium
Theory lecture slides from Micro II and repetition material on
QM1 and QM2 are posted on Eleum

Changes to Last Year

New book
Experiments included in the tutorials
New presentation topics/papers
Exercises substantially revised
Lectures revised - simplified notation and some examples

Changes to Last Year

New book
Experiments included in the tutorials
New presentation topics/papers
Exercises substantially revised
Lectures revised - simplified notation and some examples
Comments are welcome!

Course Structure/Evaluation

5 lectures, 12 tutorials
Final Exam 60%, an exam grade of at least 5.5 is
necessary to pass the course
Participation in the tutorials 20%
Presentation 20%
To pass the course, you should (i) miss at most 2 tutorial
meetings (or 3 with a block assignment) and (ii) pass the
exam with a grade of at least 5.5 and (iii) obtain a final grade
of at least 5.5

Presentations

Group presentations (individual grading) 40 minutes, precise

rules to be given by your tutor (Christine Gutekunst, Florian Heine
or Riccardo Saulle)
Global Warming
Global Terrorism
Foreign Aid
Drug Use
World Inequality

Course Literature

J. Hindricks and G.D. Myles (2013), Intermediate Public

Economics, Second Edition, MIT Press
Usage: More of a background reading; only parts which are
covered in the lectures and/or tutorial questions are relevant
Advantages: Intuitive, up-to-date, contains a lot of
explanatory text, better than alternatives
Lecture notes

Exam

Structure similar to last years exam and the Micro II exam

7 open questions; 100 points in total
Most questions close to the tutorial exercises
One question about the theoretical concepts
Presentations are only relevant as a background reading; no
questions about a particular presentation

Outline of Lecture 1

What is Public Economics and why should I learn it?

Welfare Economics
Fundamental Theorems and Applications

What is Public Economics?

Public Economics is a study of the decisions made within the

public sector and their influence on the allocation of resources.
What is to be produced? Private goods vs. public goods.
How is it to be produced? Public vs. private production.
For whom is it to be produced? Redistribution, taxes,
subsidies.
How are these decisions made? Unanimity, Majority?

Questions in Public Economics

Does it economically make sense to introduce fees for driving

on highways or do we need more highways?
Should the European Union set quota for fishing?
How can environmental regulations be agreed upon and
enforced on a multinational level? What are fair
benchmarks for such regulations?
Do we need a system to support the poor?

Questions in Public Economics

Should global poverty be a public concern? Who should

handle it?
What institutions may help in curbing infectious diseases?
Is the current pension system sufficient or should it be
reformed?
How to deal with international terrorism?

Potential Workplaces

Governmental institutions
Ministries
Other governmental institutions (advisory boards)
(International) Non-profit organizations: U.N., World Bank,
...
Lobbyist

What is Government?

An institution that can legally use coercion to enforce its aims.

Even large multinational companies do not have this option
Different governments: Federal, State, Municipal

The Role of Government

Historically:
Competition and profit motive is sufficient to serve (also) the
public interests: Adam Smiths invisible hand
Doctrine of laissez-faire (John Stuart Mill)
Following mass unemployment and exploitation of workers:
State ought to play a bigger role (Karl Marx, Charles Dickens)
Keynesian policy

The Role of Government Nowadays

Widespread agreement that both private enterprises and

markets as well as the government are important for the
economic well-being
Disagreement about the optimal size of government

The Size of Government

How to measure the size of government?

The Size of Government

How to measure the size of government?

Number of Civil Servants?
Level of government expenditure?
Common definition: Government expenditure relative to the
size of the Gross Domestic Product (GDP)
Definition as a fraction makes the size of government
comparable across states, drastic differences in several data
sources

The Size of Government

What do think are countries with a relatively high/low level of

government expenditure? USA? The Netherlands? Sweden?

The Size of Government

What do think are countries with a relatively high/low level of

government expenditure? USA? The Netherlands? Sweden?
Sweden is the primary example of a country with a large
government (Swedish Welfare State), but the value decreased
in the last years
The Netherlands have a medium level of government
expenditures
The USA historically have a low level of government
expenditure, but they catch up in recent years

Positive vs. Normative Approach

Positive Approach
Tells us how the economy is
Example for questions in a positive analysis: Tax on Beer
Does the price of beer rise?
Does the demand for beer decrease?
Does the number of car accidents decrease?

Positive vs. Normative Approach

Normative Approach
Tells us how the economy should be
Example for questions in a normative analysis: Tax on Beer
Should the tax on beer be adopted?
Requires value judgments

Positive vs. Normative Approach - Tools

Positive Approach:
Theory
Interviews, survey studies, econometric studies
Experiments (field, laboratory)
Normative Approach:
Welfare Economics

Welfare Economics

Conditions under which markets perform well

Efficiency, equity/fairness
If conditions are not satisfied: rationale for the existence of
governments or (international) organizations
How should the intervention be done?

Pure Exchange Economy

A pure exchange economy is one in which households is

given some endowment of goods and are allowed to trade
(exchange) these goods with each other.
No production (simplifying assumption; straightforward to
extend the model to include production; similar efficiency
notion).
Introduction of prices that determine the value of their initial
endowment, and the exchange rate between the different
goods.
In the following, we restrict attention to two consumers and
two goods.

Pure Exchange Economy with 2 Consumers and 2 Goods

Total resources available in the economy

Good X: Endowment of individual A of good X + endowment
of individual B of good X
Good Y: Endowment of individual A of good Y + endowment
of individual B of good Y
We can represent this situation in an Edgeworth Box, which
graphs the set of all feasible allocations of commodities
between agents.

Edgeworth Box - Initial Endowment

100

Good X

Initial
Endowment

Good Y

Good Y

Good X

100

Edgeworth Box - Indifference Curves

100

Good X

Initial
Endowment

Good Y

Good Y

Good X

100

Pareto Efficiency

Pareto improvement: A reallocation of commodity bundles

among agents resulting in at least one agent being made
better off without any loss incurred by another agent.
Pareto efficient allocation: No Pareto improving trade is
possible.

Edgeworth Box - Pareto Efficient Allocation

100

Good X

B
Pareto
Efficient
Allocation

Initial
Endowment

Good Y

Good Y

Good X

100

Edgeworth Box - Contract Curve

Contract Curve: The locus of all Pareto efficient allocations.

The contract curve is independent of the initial allocation.

Edgeworth Box - Contract Curve (Brown)

100

Good X

Good Y

Good Y

Good X

100

Edgeworth Box

Pareto improvement: A reallocation of commodity bundles

among agents resulting in at least one agent being made
better off without any loss incurred by another agent.
Pareto efficient allocation: No Pareto improving trade is
possible.
Contract Curve: The locus of all Pareto efficient allocations.

Walrasian Equilibrium

A Walrasian Equilibrium or Competitive Equilibrium consists of

a price vector and an allocation of goods such that:
Each consumer maximizes his utility given the price vector
and his initial endowment.
All commodity markets clear, i.e., aggregate demand is equal
to aggregate supply.

Edgeworth Box - Competitive Equilibrium

100

Good X

Price
Vector
Competitive
Equilibrium

Initial
Endowment

Good Y

Good Y

Good X

100

First Welfare Theorem

First Theorem of Welfare Economics: The allocation of

commodities in a competitive equilibrium is Pareto efficient.
Assumptions required: A complete market exists for every
commodity; perfect competition (price-taking); no public goods;
no externalities

Social Welfare

Each point on the contract curve yields a combination of

utilities uA (xA , yA ) and uB (xB , yB ).
Which allocation is socially optimal?
Requires value judgments
Let us represent the possible utility combinations, i.e., the
utility possibility frontier in a graph.

Utility Possibility Frontier

Utility Possibility Frontier

All points on the utility possibility frontier are Pareto efficient

Which one is socially most desirable?
Requires value judgments

Social Welfare Function

A Social Welfare Function represents societys norms regarding

equity.
Bergson-Samuelson individualistic Social Welfare Function:
W [UA (XA ), UB (XB )] with dW
dUi > 0 for i = A, B
Individualistic: only arguments are individual utility functions;
dW
dUi > 0 is the marginal social welfare weight on individual i

Social Welfare Function

The Social Planner maximizes the Social Welfare function

Which Social Welfare Function?
How to find (agree on) the Social Welfare function
Requires cardinal interpersonal utility comparisons!

Social Welfare Function - Examples

Additive SWF: W = UA + UB
Maximizes aggregate happiness; distribution does not matter
Rawlsian SWF: W = min{UA , UB }
Maximizes happiness of the worst-off person; making the
worst-off person a little worse off and all others much better
off does not improve welfare!

Additive Social Welfare Function - Graph

Rawlsian Social Welfare Function - Graph

Second Welfare Theorem

Second Theorem of Welfare Economics: With convex

preferences (and production technologies), any Pareto
efficient allocation can be attained as a competitive
equilibrium with the appropriate (non-distortionary)
redistribution of initial resources.
Assumptions: Same as for the first theorem + convexity +
non-distortionary redistribution + complete information about
preferences!

Distortionary Redistribution

In reality, redistribution typically requires some cost (more

workers for tax authority, social unrest, . . . )
Restricts the set of solutions to the government
Government targets the second-best since the first best is
not attainable anymore

Distortionary Redistribution

Takehome Message Welfare Theorems

First Welfare Theorem: positive result for many markets

If conditions fail, there might be a reason for government
intervention
There could also be private responses (e.g., as we saw in
Micro, warranties)
Second Welfare Theorem: can be seen as a negative result,
since assumptions (non-distortionary redistribution and
complete information on preferences) are very strong

More Rationales for Public Intervention

Failure of perfect competition (monopoly or oligopoly)

Non-existence of markets or incomplete markets; e.g., some
insurance markets
Merit goods (individuals might not know their optimal
quantities; e.g., education, drugs)
Public Goods (Lecture 2)
Externalities (Lecture 3)

Summary

Repetition: pure-exchange economy, competitive equilibrium,

contract curve
Welfare Theorems and their underlying
assumptions/interpretation
Social Welfare Functions (most prominent examples: Rawlsian
and additive) require interpersonal utility comparisons and
make value judgments
Rationales for government intervention