Chapters 1 to 4

1
Chapters 1 to 4

• Outline
• The Four Questions of Public Finance
• Utility maximization
• Labor supply example
• Efficiency
• Social welfare functions
• Correlation versus causation
• Discounting

2
Question 1 When Should the Government Intervene
in the Economy?

• Normally, competitive private markets provide
  efficient outcomes for the economy.
• In many circumstances, it is hard to justify
  government intervention in markets. Two common
  justifications are
• Market failures
• What is a market failure?
• Redistribution
• Shifting resources from some groups to others.

3
When Should Government Intervene? An example of
market failure

• In 2003, there were 45 million people without
  health insurance in the United States, or 15.6
  of the population.
• Lack of insurance could cause negative
  externalities from contagious diseasethe
  uninsured may not take account of their impact on
  others.
• Measles epidemic from 1989-1991, caused by low
  immunization rates for disadvantaged youth, was a
  problem.
• Government subsidized vaccines for low-income
  families as a result.

4
When Should the Government Intervene?
Redistribution

• Of the uninsured, for example, roughly
  three-quarters are in families with incomes below
  the median income level in the United States.
• Society may feel that it is appropriate to
  redistribute from those with insurance (who tend
  to have higher incomes) to those without
  insurance (who tend to have lower incomes).
• Redistribution often involves efficiency losses.
• The act of redistribution can change a persons
  behavior. Taxing the rich to distribute money to
  the poor could cause both groups to work less
  hard.

5
Question 2 How Might the Government Intervene?

• If the government wants to intervene in a market,
  there are a number of options
• Using the price mechanism with taxes or
  subsidies.
• Tax credits that lower the effective price of
  health insurance.
• Mandate that either individuals or firms provide
  the good.
• Pay-or-play mandates that require employers to
  provide health insurance, such as Californias
  Health Insurance Act.
• Public Provision
• The Medicare program for U.S. senior citizens.
• Public Financing of Private Provision
• Medicare prescription drug cards, where private
  companies administer the drug insurance.

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Question 3 What Are the Effectsof Alternative
Interventions?

• Much of the focus of empirical public finance is
  assessing the direct and indirect effects of
  government actions.
• Direct effects of government actions assume no
  behavioral responses and examine the intended
  consequences of those actions.
• Indirect effects arise because some people change
  their behavior in response to an intervention.
  This is sometimes called the law of unintended
  consequences.

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Question 4 Why Do Governments Do What They Do?

• Positive (as opposed to normative) question.
• Governments do not simply behave as benign actors
  who intervene only because of market failure and
  redistribution.
• Tools of political economy helps us understand
  how governments make public policy decisions.
• Just as market failures can lead to market
  inefficiency, there are a host of government
  failures that lead to inappropriate government
  intervention.

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Chapter 2Review (Quickly) Economics 301

• Constrained Utility Maximization is based on
• Preferences (indifference curves), and
• Budget sets.
• Start with a discussion of preferences.
• A utility function is a mathematical
  representation U f(X1, X2, X3, )
• Where X1, X2, X3 and so on are the goods consumed
  by the individual,
• And f() is some mathematical function.

9
QCD (quantity of CDs)
Bundle C gives higher utility than either A
or B
Bundle C gives 4 utils and is on a higher
indifference curve
Higher utility as move toward northeast in the
quadrant.
A and B both give 2 utils and lie on the
same indifference curve
A
C
2
B
IC2
1
IC1
QM (quantity of movies)
0
1
2
10
Constrained Utility Maximization Marginal utility

• With the utility function, U QMQC, the marginal
  utility is
• Take the partial derivative of the utility
  function with respect to QM to get the marginal
  utility of movies.
• Normally, preferences exhibit diminishing
  marginal utility, as would be the case if U
  (QMQC)1/2 , since

11
Constrained Utility MaximizationMarginal rate
of substitution

• Marginal rate of substitutionslope of the
  indifference curve is called the MRS, and is the
  rate at which consumer is willing to trade off
  the two goods.
• Direct relationship between MRS and marginal
  utility.
• MRS shows how the relative marginal utilities
  evolve over the indifference curve.

12
Constrained Utility MaximizationBudget
constraints

• The budget constraint is a mathematical
  representation of the combination of goods the
  consumer can afford, given income.
• Assume there is no saving or borrowing.
• In the example, denote
• Y Income level
• PM Price of one movie
• PC Price of one CD

13
QCD (quantity of CDs)
This indifference curve gives much higher
utility, but is not attainable.
This bundle of goods gives the highest utility,
subject to the budget constraint.
3
This indifference curve is not utility-maximizing,
because there are bundles that give higher
utility.
2
1
QM (quantity of movies)
0
1
2
3
14
Constrained Utility MaximizationPutting it
together Constrained choice

• Thus, the marginal rate of substitution equals
  the ratio of prices
• At the optimum, the ratio of the marginal
  utilities equals the ratio of prices. But this
  is not the only condition for utility
  maximization.
• The second condition is that all of the
  consumers money is spent

15
The Effects of Price ChangesSubstitution and
income effects

• A change in price consists of two effects
• Substitution effectchange in consumption due to
  change in relative prices, holding utility
  constant.
• Income effectchange in consumption due to
  feeling poorer after price increase.
• Figure 11 illustrates this.

16
Income and Substitution Effects (price of rooms
rises)
Meals
SE Find a hypothetical budget line with the new
price ratio just tangent to the original IC.
Income effect
Substitution effect
Rooms
17
QCD (quantity of CDs)
Raising PM even more gives another (PM,QM)
combination with even less movies demanded.
Initial utility-maximizing point gives one
(PM,QM) combination.
Raising PM gives another (PM,QM) combination with
fewer movies demanded.
QM (quantity of movies)
QM,1
QM,2
QM,3
18
PM
Various combinations of points like these create
the demand curve.
At a high price for movies, demanded QM,3
At a somewhat lower price for movies, demanded
QM,2
PM,3
At an even lower price for movies, demanded QM,1
PM,2
PM,1
Demand curve for movies
QM
QM,3
QM,2
QM,1
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EQUILIBRIUM AND SOCIAL WELFARE Elasticity of
demand

• A key feature of demand analysis is the
  elasticity of demand. It is defined as
• That is, the percent change in quantity demanded
  divided by the percent change in price.
• Demand elasticities are
• Typically negative number.
• Not constant along the demand curve (for a linear
  demand curve).
• It is easy to define other elasticities (income,
  cross-price, etc.)

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EQUILIBRIUM AND SOCIAL WELFARE Supply curves

• We do a similar drill on the supply side of the
  market. Firms have a production technology (we
  might write it as)
• We can construct isoquants, which represent the
  ability to trade off inputs, fixing the level of
  output.
• Firms also have an isocost function, which
  represent the cost of various input combinations.
• Firms maximize profit (minimize cost) when the
  marginal rate of technical substitution equals
  the input price ratio.
• Also MRMC at the profit-maximizing level of
  output.

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EQUILIBRIUM AND SOCIAL WELFARE Equilibrium

• In equilibrium, we horizontally sum individual
  demand curves to get aggregate demand.
• We also horizontally sum individual supply curves
  to get aggregate supply.
• A firms supply curve is the MC curve above
  minimum average variable cost.
• Competitive equilibrium represents the point at
  which both consumers and suppliers are satisfied
  with the price/quantity combination.
• Figure 21 illustrates this.

22
PM
Supply curve of movies
Intersection of supply and demand is equilibrium.
PM,3
PM,2
PM,1
Demand curve for movies
QM
QM,3
QM,2
QM,1
23
EQUILIBRIUM AND SOCIAL WELFARE Social efficiency

• Measuring social efficiency is computing the
  potential size of the economic pie. It
  represents the net gain from trade to consumers
  and producers.
• Consumer surplus is the benefit that consumers
  derive from a good, beyond what they paid for it.
• Each point on the demand curve represents a
  willingness-to-pay for that quantity.

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EQUILIBRIUM AND SOCIAL WELFARE Social efficiency

• Producer surplus is the benefit derived by
  producers from the sale of a unit above and
  beyond their cost of producing it.
• Each point on the supply curve represents the
  marginal cost of producing it.

25
EQUILIBRIUM AND SOCIAL WELFARE Social efficiency

• The total social surplus, also known as social
  efficiency, is the sum of the consumers and
  producers surplus.
• Figure 25 illustrates this.

26
PM
Providing the first unit gives a great deal of
surplus to society.
The surplus from the next unit is the difference
between the demand and supply curves.
Supply curve of movies
Social efficiency is maximized at Q, and is the
sum of the consumer and producer surplus.
The area between the supply and demand curves
from zero to Q represents the surplus.
P
This area represents the social surplus from
producing the first unit.
Demand curve for movies
QM
0
Q
1
27
EQUILIBRIUM AND SOCIAL WELFARE Competitive
equilibrium maximizes social efficiency

• The First Fundamental Theorem of Welfare
  Economics states that the competitive
  equilibrium, where supply equals demand,
  maximizes social efficiency.
• Any quantity other than Q reduces social
  efficiency, or the size of the economic pie.
• Consider restricting the price of the good to
  PltP.
• Figure 26 illustrates this.

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PM
Supply curve of movies
This triangle represents lost surplus to society,
known as deadweight loss.
The social surplus from Q is this area,
consisting of a larger consumer and smaller
producer surplus.
With such a price restriction, the quantity falls
to Q, and there is excess demand.
P
P
Demand curve for movies
QM
Q
Q
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EQUILIBRIUM AND SOCIAL WELFARE The role of equity

• Societies usually care not only about how much
  surplus there is, but also about how it is
  distributed among the population.
• Social welfare is determined by both criteria.
• The Second Fundamental Theorem of Welfare
  Economics states that society can attain any
  efficient outcome by a suitable redistribution of
  resources and free trade.
• In reality, society often faces an
  equity-efficiency tradeoff.

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Chapter 3 Empirical Approaches to Policy
Analysis

• Empirical public finance is the use of data and
  statistical methodologies to measure the impact
  of government policy on individuals and markets.
• Key issue in empirical public finance is
  separating causation from correlation.
• Correlated means that two economic variables move
  together.
• Casual means that one of the variables is causing
  the movement in the other.

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THE IMPORTANT DISTINCTION BETWEEN CORRELATION AND
CAUSATION

• One interesting, tragic example given in the book
  describes some Russian peasants.
• There was a cholera epidemic. Government sent
  doctors to the worst-affected areas to help.
• Peasants observed that in areas with lots of
  doctors, there was lots of cholera.
• Peasants concluded doctors were making things
  worse.
• Based on this insight, they murdered the doctors.

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The Problem

• In the Russian peasant example, the possibilities
  might be
• Doctors cause peasants to die from cholera
  through incompetent treatment.
• Higher incidence of illness caused more
  physicians to be present.
• Peasants thought the first possibility was
  correct.

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MEASURING CAUSATION WITH DATA WED LIKE TO HAVE
RANDOMIZED TRIALS

• Randomized trials are one often effective way of
  assessing causality.
• Trials typically proceed by taking a group of
  volunteers and randomly assigning them to either
  a treatment group that gets the intervention,
  or a control group that is denied the
  intervention.
• With random assignment, the assignment of the
  intervention is not determined by anything about
  the subjects.
• As a result, with large enough sample sizes, the
  treatment group is identical to the control group
  in every facet but one the treatment group gets
  the intervention.

34
The Problem of Bias

• Bias represents differences between treatment and
  control groups that is correlated with the
  treatment, but not due to the treatment.
• An example of bias in 1988 the SAT scores of
  Harvard applicants who took test preparation
  courses were lower than those of students who did
  not. This would bias straightforward effort to
  study the effects of SAT classes on test scores.
• By definition, such differences do not exist in a
  randomized trial, since the groups, if large
  enough, are not different in any consistent
  fashion.

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Why We Need to Go Beyond Randomized Trials

• Randomized trials present some problems
• They can be expensive.
• They can take a long time to complete.
• They may raise ethical issues (especially in the
  context of medical treatments).
• The inferences from them may not generalize to
  the population as a whole.
• Subjects may drop out of the experiment for
  non-random reasons, a problem known as attrition.

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Time Series Analysis

• Time series analysis documents the correlation
  between the variables of interest over time.
• It is difficult to identify causal effects when
  there are slow moving trends and other factors
  are changing.
• Sharp changes in a policy variable over time, may
  create opportunities for valid inference.

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Cross-Sectional Regression Analysis

• Cross-sectional regression analysis is a
  statistical method for assessing the relationship
  between two variables while holding other factors
  constant.
• Cross-sectional means comparing many
  individuals at one point in time.
• An example
• Where the control variables account for race,
  education, age, and location

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Quasi-Experiments

• Economists typically cannot set up randomized
  trials for many public policy discussions. Yet,
  the time-series and cross-sectional approaches
  are often unsatisfactory.
• Quasi-experiments are changes in the economic
  environment that create roughly identical
  treatment and control groups for studying the
  effect of that environmental change.
• This allows researchers to take advantage of
  randomization created by external forces.

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An Example of a Quasi-Experiment

• New Jersey raises their state minimum wage.
  Pennsylvania does not.
• We are interested in the effect of the minimum
  wage on employment.
• We could look at the employment of low-skilled
  workers in NJ before and after the minimum wage
  increase.
• But other things in the economy might be
  occurring.
• So, we can see how employment changed in PN over
  the same interval.
• The difference in employment in NJ, before and
  after, compared to the difference in employment
  in PN, before and after, may reveal the causal
  effect of minimum wages changes, if NJ and PN are
  identical (similar?) in other respects.

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Structural Modeling

• Both randomized trials and quasi-experiments
  suffer from two drawbacks
• First, they only provide an estimate of the
  causal impact of a particular treatment. It is
  difficult to extrapolate beyond the changes in
  policy.
• Second, the approaches often do not tell us why
  the outcomes change. For example, the approaches
  do not separate out income and substitution
  effects in the TANF example used in the book.
• Structural estimation attempt to estimate the
  underlying parameters of the utility function.

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Chapter 4 A Couple Tools and Definitions

• Government debt is the amount that a government
  owes to others who have loaned it money.
• It is a stock variable the debt is an amount
  owed at any point in time.
• Government deficit is the amount by which
  spending exceeds revenues in a given year.
• It is a flow variable the deficit flow is added
  to the previous years debt stock to produce a
  new stock of debt owed.

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Real vs. Nominal

• The debt and deficit are often expressed in
  nominal valuesthat is, in todays dollars.
• Inflation changes the real value of the debt or
  deficit, however, because prices change.
• The consumer price index (CPI) measures the cost
  of purchasing a typical bundle of goods. It
  increased 91 between 1982 and 2003.
• Inflation reduces the burden of the debt, as long
  as that debt is a nominal obligation to
  borrowers.
• Rising prices leads to what is known as the
  inflation tax on the holders of the debtthe
  payments are worth less because of rising prices.
• In 2003, the national debt was 3.91 trillion and
  inflation was 1.9. The inflation tax was
  therefore 74 billion, which would reduce the
  conventionally measured deficit from 375 billion
  to 301 billion.

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Background Present Discounted Value

• To understand budgeting, you must understand the
  concept of present discounted value (PDV).
• Receiving a dollar in the future is worth less
  than receiving it today, because you have
  foregone the opportunity to earn interest.
• PDV takes future payments and expresses them in
  todays dollars.
• It does so by discounting payments in some future
  period by the interest rate.

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Background Present Discounted Value

• A stream of payments would be discounted as
• Where B0 through Bt represent a stream of benefit
  obligations, r is the interest rate, and t is the
  number of periods.
• For example, 1,000 received 7 years from now is
  only worth 513 with a 10 interest rate
• A constant payment received indefinitely has the
  PDVP/r