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Summary Economic Policy and Public Finance
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Summary Economic Policy and Public Finance - Radboud University Book: Pubic Finance, Harvey S. Rosen and Ted Gayer
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Summary Economic Policy and Public FinanceChapter 1. Introduction
Government is a necessity but at the same time it has undesirable aspects.
Public finance is the field of economics that analyses government taxation and spending.
Public finance and ideology
Organic view of government
This view conceives of society as a natural organism. Each individual is a part of this organism, and the
government can be thought of as its heart. The community is stressed above the individual.
Mechanistic view of government
Government is a contrivance created by individuals to better achieve their individual goals. The individual
rather than the group is at center stage.
Government at a glance
The size of government
One measure for the size of the government is the number of workers in the public sector. The number of
public sector employees is useful information, for some purposes, but is does not cast light on the central issue.
A more sensible approach is to measure the size of government by the volume of its annual expenditures, of
which there are basically three:
Purchases of goods and services.
Transfers of income to people, businesses, or other governments.
Interest payments.
,Chapter 4. Public goods
Public goods defined
A pure public good is defined as follows:
Consumption of the good is nonrival – once it is provided, the additional resource cost of another
person consuming the good is zero.
Consumption of the good is nonexcludable – to prevent anyone from consuming the good is either
very expensive or impossible.
A private good is a commodity that is rival and excludable in consumption.
Several aspects of our definition of public good are worth nothing:
Even though everyone consumes the same quantity of the good, it need not be valued equally by all.
Classification as a public good is not an absolute; it depends on market conditions and the state of the
technology.
o In many cases it makes sense to think of publicness as a matter of degree. A pure public good
satisfied the definition exactly. Consumption of an impure public good is to some extent rival
or excludable.
A commodity can satisfy one part of the definition of a public good and not the other.
Some things that are not conventionally thought of as commodities have public good characteristics.
Private goods are not necessarily provided exclusively by the private sector.
o Publicly provided private goods are rival and excludable commodities that are provided by
governments.
Government provision of a good does not necessarily mean that it also must be produced by the
government.
Efficient provision of public goods
Horizontal summation is the process of creating a market demand curve by summing the quantities demanded
by each individual at every price. This is for private goods.
This is the efficient provision of a private good. The
market is in equilibrium when supply and demand
are equal.
At equilibrium:
MRSAdam = MRSEve = MRS
Deriving the efficiency condition
If the sum of individuals’ willingness to pay for an additional unit of a public good exceeds its marginal cost,
efficiency requires that the unit be purchases; otherwise, it should not. Hence, efficiency requires that provision
of a public good be expanded until the point at which the sum of each person’s marginal benefit for the last
unit just equals the marginal cost.
For a public good, the group willingness to pay is found by vertical
summation of the individual demand curves. This is the process of
creating an aggregate demand curve for a public good by adding the
prices each individual is willing to pay for a given quantity of the
good.
At equilibrium:
MRSAdam + MRSEve = MRT
With a private good, everyone has the same MRS, but people can
consume different quantities. Therefore, demands are summed
horizontally over the differing quantities. For public goods, everyone
,consumes the same quantity, but people can have different MRSs. Vertical summation is required to find the
group willingness to pay.
Problems in achieving efficiency
People may have incentives to hide their true preferences for a public good. The incentive to let other people
pay for a public good while you enjoy the benefits is called a free rider.
Even if consumption is excludable, market provision of a nonrival good is likely to be inefficient. This can be
solved by perfect price discrimination: when a producer charges each person the maximum he or she is willing
to pay for a good. Even if a nonrival commodity is excludable, private provision is unlikely to be efficient.
The free rider problem
The government can prevent the free rider problem if the government can find out everyone’s true
preferences, and then, using its coercive power, force everybody to pay for public goods.
However, free ridership is not a given; it is an implication of the hypotheses that people maximize a utility
function that depends only on their own consumption of goods.
Privatization
Privatization means taking services that are supplied by the government and turning them over to the private
sector to provide or produce.
Public versus private provision
Sometimes publicly provided goods can be obtained privately. What criteria should be used to select the
amount of each input? There are several considerations.
Relative wage and materials costs. If the public and private sectors pay different amounts for labor and
materials, then the less expensive sector is to be preferred on efficiency grounds.
Administrative costs. Under public provision, any fixed administrative costs can be spread over a large
group of people. The larger the community, the greater is the advantage to being able to spread these
costs.
Diversity of tastes. Private provision is more efficient because people can tailor their consumption to
their own tastes. The benefits of diversity must be weighted against any possible increases in
administrative costs.
Distributional issues. Commodity egalitarianism is the idea that some commodities ought to be made
available to everybody.
Public versus private production
People can agree that public provision of certain services makes sense, but still disagree over whether they
should be produced publicly or privately.
Comparison is difficult because the quality of the services provided by each may be different.
Central argument: private contractors produce inferior products.
Incomplete contracts. The government can write a contract with the private provider, completely
specifying the quality of the service that the government wants. However, it is sometimes impossible
to write a complete contract.
When costs are lower in the private than the public sector and relatively complete contracts can be
written, a strong case can be made for private production.
Market environment. A privately owned monopoly may produce very inefficient results from society’s
standpoint, while a publicly owned operation that faces a lot of competition may produce quite
efficiently.
, Chapter 11. Social security
Why have social security?
Consumption smoothing and the annuity market
Social security works as follows: During their working lives, members of the system and their employers make
contributions via a tax on payrolls. Upon retirement, members are eligible for monthly payments based in part
on their contributions. The payments are fixed in real terms and last as long as the recipient lives. In effect,
social security provides insurance against the possibility of living longer than expected and hence prematurely
using up all the assets accumulated for retirement.
Annuity is an insurance plan that charges a premium and then pays a sum of money at some regular interval
for as long as the policyholder lives. This avoids outliving your savings.
Consumption smoothing: reducing consumption in high-earning years in order to increase consumption in low-
earning years.
Adverse selection and the annuity market
Asymmetric information causes a failure in the annuities market. The annuity seller’s profit depends on the
buyer’s life expectancy. The price that the seller charges had to take into account the buyer’s life expectancy.
The longer the buyer lives, the less money the seller makes. Eventually the seller gets an adverse selection of
buyers, only long life expectancy wants an annuity.
Other justifications
Several considerations other than adverse selection may justify social security:
Lack of foresight and paternalism. Most people would not accumulate enough assets to finance an
adequate level of consumption during their retirement. The paternalistic argument is that people
should be forced to save and thus the government must provide a mandatory annuity plan so that
people will be adequately provided for in their retirement years.
Moral hazard. The possibility of a government bail out leads to an inefficiently low amount of private
saving moral hazard.
Economize on decision making and administrative costs. If public decision makers can select an
appropriate annuity program for everyone, individuals do not have to waste resources on making their
own decisions. The counterpoint is that the government might not choose the right kind of policy for
each person. The administrative costs for annuities can be lower if everyone participates in social
security. The government program could be cheaper than private plans.
Income distribution. Under social security, people with high lifetime earnings tend to receive
proportionally smaller returns on their taxes than people with low lifetime earnings. Private annuities
don’t distribute income.
Improve the economic status of the aged.
Structure of social security
Basic components
Pay-as-you-go financing
The fully funded plan was scrapped almost immediately. Is a pension system in which an individual’s benefits
are paid out of deposits that have been made during his or her working life, plus accumulated interest.
The system was converted to a pay-as-you-go (or unfunded) plan, in which benefits paid to current retirees
come from payments made by current workers. The reasons of the switch were:
Elderly lost their savings during the Great Depression.
There was a fear that the government spent the savings on other government programs rather than
the promised retirement benefits.
Explicit transfers
In 1939, social security not only provides insurance for outliving one’s retirement savings, it also transfers
income across individuals. Supplemental Security Income (SSI) is a welfare program that provides a minimum
income guarantee for the aged and disabled.
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