EC355 Public Economics
Lecture 1-ish
The big questions of Public Economics (and of this module)
Lecturer: David Reinstein
Lectures: Thursday, 13:00-15:00, room
6.333
Classes (starting week 3): Friday, 11:00-
12:00, TC2.9
Email: drein@essex.ac.uk
Office Hours: Thursday 3-4pm, Friday
12:30-1:30pm
My Room: 3.204
Syllabus/Module Outline
What do you get out of this module? What are you meant
to learn (and be able to demonstrate)?
Why government? This module analyses the economic rationale for "collective choice" in a market economy.
How do we measure and judge “how good things are”? We will consider measures of social
welfare, equity and efficiency. We will evaluate the government's ability to identify and achieve "better" outcomes, particularly under a
democratic process.
What can government achieve? We will consider the economic case for interventions to redress market
failures, to redistribute resources, and to provide public goods and services.
What do governments do, and how well? This module is also applied: we will discuss and compare actual and
proposed programmes in the UK and abroad in the areas of poverty reduction, education, and health.
Learning outcomes: They should have a general appreciation of the composition of private income and wealth, the
sources and uses of public funds in the UK and abroad, and the structure of major government programmes. They should also
have a clear understanding of the characteristics of a public good (and the difficult problems associated
with providing it), and a grasp of equity and efficiency issues related to taxation and redistribution.
Key and Employability Skills: By the end of this module, students should be able to form clear, logical, economic
arguments for (or against) specific policies, and to articulate these in writing. In preparing for the final and the term paper, students
will demonstrate their ability to access and highlight key statistical and descriptive institutional
information from government and academic sources.
Public Economics
Defining the Field of Study
Public Finance/Public Economics:
Studies government taxing and spending activities and the
conditions under which government intervention is likely to
improve the welfare of citizens.
Has broadened in recent years to include analysis of how policies are made (e.g., public choice
theory), analysis of the impact of various policies, and general discussion of the provision of
public goods.
Key Questions of Public Economics
Q1: What are governments and what do they do?
“Positive” and descriptive question, and the focus of this lecture.
Q2: (Why and when) do we need government?
“Normative” question; “Market failures” – a key question of economic
theory.
Q3: What are the effects of government interventions?
A crucial empirical and econometric question; “policy analysis.”.
Q4: What actually determines government decisions?
“Positive political economy”, empirics and theory.
Q5: How to structure efficient taxation and transfers?
Related to Q3. Question of “Public Finance”.
Key Questions of Public Economics
Q1: (Descriptive)
What are governments?
What do governments do?
How does this differ by country and over time?
Governments
Government power is monopoly on force and compulsion
(with limits)
Limits: Modern democratic states are accountable to
themselves (via the constitution and the separation of
powers) and to voters (and sometimes to world bodies).
Motivation of governors (elected, appointed)?
• Benevolent or self-interested?
Governments do essentially three things:
Tax, spend, and regulate
i. Taxes Price mechanism (Price setting)
• Taxing goods: clothes, cigarettes, petrol Income and wealth effects, incentive
effects
• Subsidies: nurseries for young children
• Tax credits: childcare voucher
Tax and spend Income transfers
ii. Spending Production/ Public Provision
• The NHS service
• National Defence (the army)
iii. Regulation (and Mandate ) Lay down the law
• Maternity benefit: requires employers to provide benefit.
• Prohibition on purchasing alcohol below a certain age.
Barr: The Welfare State
Goals of the welfare state:
• Consumption smoothing
• Insurance
• Poverty relief
Government accounts
Income = taxes and charges
+ asset income
+ asset sales
+ borrowing
Expenditure = transfers + government consumption
+ subsidies
+ interest paid
+ capital expenditure
Q: Income – Expenditure =???
Comparing governments
UK magnitudes
• UK Economy:
about £1.4 trillion GDP per year = about £22,000 per capita
World economy ???
(about £40 trillion, about £6000 per capita)
• Government revenue ???
about £550 billion
less spending of about £700 billion per year
→ deficit about £150 billion (per year, 2010-11)
• National debt = about £1 trillion
Sources: http://www.statistics.gov.uk/pdfdir/oie0810.pdf, http://www.statistics.gov.uk/cci/nugget.asp?id=277, http://www.ukpublicspending.co.uk/,
http://www.hm-treasury.gov.uk/junebudget_diagrams.htm, World Bank Indicators
Table 4.4 Public sector expenditure on services by function as a per cent of GDP )
Source: (http://www.hm-treasury.gov.uk/pespub_pesa09.htm
http://www.guardian.co.uk/business/interactive/2009/sep/16/public-spending-larry-elliott
Tax revenue as percent of GDP
UK? Compare to France, Japan, Mexico, Sweden, US, Europe overall
60
France
50
Japan
40
Mexico
30 Sweden
United Kingdom
20
United States
10 OECD - Europe
0
The debt “crisis”:
Total central government debt as % of GDP
140
120 1998
2009
100
80
60
40
20
0
Mexico Canada Germany Spain United States France United Kingdom Portugal Italy Greece
Source: http://stats.oecd.org/
Health-care expenditures (2007) Source: OECD.Stat
Country UK Can. France Germ . Japan Mexico Neth. USA
Total expenditure on health, %
8 10 11 10 8 6 10 16
of gdp
Total health expenditure per
2990 3867 3593 3619 2729 824 3844 7285
capita, US$ PPP
Public expenditure on health,
82 70 78 77 82 45 46
% total expenditure on health
Pharm aceutical expenditure, %
12 17 17 15 20 28 .. 12
total expenditure on health
Pharm aceutical expenditure
365 665 595 545 548 232 .. 876
per capita, US$ PPP
Expenditure on educational institutions in tertiary education
As a percentage of GDP, 2005
Updating stats
http://stats.oecd.org/index.aspx
http://www.hm-treasury.gov.uk/
http://www.ifs.org.uk
Trends/patterns
Government expenditure (G/GDP) increase over the 20 th century,
up through the 1970’s-1980’s
– Particularly social security
– “Wagners law” – “The advent of modern industrial society will result in increasing political pressure for social progress
and increased allowance for social consideration by industry.”
Why the increase?
David’s law: “Only a change can explain a change”
– Increase in “fiscal illusion”,
– interest groups;
– government services as luxury goods,
– changing suffrage, demographic changes
• Significant cross-country differences, no trend to convergence
• Cyclical element
Development of the UK Welfare State (Barr, Ch, 2)
The Early years
Religious motivations, local authorities, preserving public order, workhouses.
1601 “Poor Law” act.
Classical liberalism (Malthus, Bentham, etc.), 1834 Poor Law Amendment Act.
Move towards intentional stigma, feared encouraging sloth, etc.
19th century: Early social legislation eroding laissez faire in Education, Public-
Health (cost spillovers/externalities recognised)
The Liberal Reforms
Motivation: Bismarck example, changed attitude to poverty (esp. Rowntree 1901
report), new liberalism/collectivism, the “national efficiency issue.”
Institutional/bureaucratic influence. Socialist threat.
Policies: Nationalisation. Education, OAP, Unemployment Insurance, Health,
Progressive taxation.
Note: Paralleled by other European and offshoot countries.
Who is this guy???
WWI, interwar, WWII and its aftermath
Action on housing after the First World War. Response to “shortages” and
previous rent-controls. “A fit country for heroes.”
Economic crisis. The collapse of unemployment insurance in the early 1930s –
move from insurance to benefit.
The Second World War and its aftermath
“Total war” led to changes in attitudes, government power, social mixing,
national interest concerns.
Outcomes: The Beveridge Report, 1942. The Education Act 1944. The National
Health Service Act 1946. The National Insurance Act 1946. The National
Assistance Act 1948.
Post-war developments
The postwar period: consolidation and extension
• Proliferation of assistance benefits in the '60s. Complexity and 'poverty traps.‟
The 1980s and early 1990s: attempted retrenchment
(„Thatcherism‟).
Driven by oil shocks, global competitive pressures, ageing population, ideology (?). Did not
ultimately reduce welfare state as share of national income, although benefits eligibility was
tightened and indexing made less generous. Push for privatisation, less progressive taxation.
After 1997: New Labour
Committed to competitive markets but also focused on reducing poverty and “social exclusion.”
Small reversal of Conservative policies (some benefits increased, slightly more progressive taxation)
Brief commercial break
(we'll be right back after a word from a man wearing a question marks suit)
Q2: The Role of government
(Why and when) do we need government?
Do we need it to do more than just protect private property? If so, why?
Do we need it to do more than just protect private property and redistribute wealth
in lump-sum transfers? If so, why?
We will review:
What is Pareto efficiency?
Why is it a goal? Why is a non-PE outcome undesirable?
What is the “Pareto frontier” and how does one derive it?
Why do most people think PE is not “enough” (consider an extreme case)?
The free-market ideal:
Concepts of efficiency
This goes back to Adam Smith and the notion of the invisible hand.
1) When there are consumers who are willing to pay a positive price for a good or
service then a firm will enter the market to produce it.
2) When a firm is producing (or pricing) inefficiently it will be compelled to
change or be driven out of business by new and more efficient companies.
→ “when this holds, we don’t need a Government” (at least not for efficiency).
This leads us to a discussion of efficiency and the two Fundamental Welfare
Theorems. (Later: more technical statement and “proof” of this)
First fundamental welfare theorem (short
version)
Given a bunch of fancy conditions* [mind the fine print!]…
a “general competitive equilibrium”
(free markets that have “reached equilibrium”, basically supply=demand
at prevailing prices)
is Pareto efficient.
*Conditions
The less technical ones include:
(0) rational agents,
(i) perfect competition/price taking,
(ii) complete markets (everything that affects utility is owned and
controlled).
More technical ones include
(iii) “convex preferences and technology” and (iv) “complete” information.
Discussion: With perfectly functioning markets and complete markets we can achieve a
Pareto efficient outcome without Government. Note that this does not mean that the
outcome is equitable or fair as it ignores the issue of equity and distribution.
Second Welfare Theorem
[Given similar conditions as for the first]
Every Pareto efficient allocation
can be achieved by a competitive economy (in equilibrium) with
complete markets and non-increasing returns to scale,
when “frictionless” lump sum transfers of endowments are
feasible.
Discussion:
Again not much to do for the Government as all that is required are lump-sum transfers.
There is no need for taxes or regulation or public sector production.
Pareto efficiency does not help us in ranking alternative allocations of resources.
We need to have a “Social Welfare Function” to embody the view of “society” to make these
judgments.
Another caveat:
To achieve the allocation that maximises a particular social welfare
function the government also needs to have perfect information
over peoples’ “endowments” and preferences.
Market failures
The principal justification for a Government. The sources of which are:
1) Non-competitive (or less competitive) markets. These can be due to natural monopolies
(increasing returns to scale or scope), historical co-incidence, rents (brands, talent, etc.)
2) Absence of markets . Classic example: insurance and the issue of adverse selection and
moral hazard through asymmetric information
3) Externalities: When the price system fails to provide appropriate signals, then this leads to
inefficiencies if one person’s or one firm’s action affects the welfare of another.
4) Public goods (and bads): Non-rival in consumption (you use it and so can I), and non-
excludable (free-riding).
5) Bounds on rationality, consistency, and calculation of consumers, markets, and firms.
Q3: What are the effects of Government
Interventions?
Field of empirical public economics: policy analysis with data and statistical
methodology
Direct and indirect effects
Key issue: identification (correlation vs causation)
Vocabulary: Time series analysis, Cross-sectional regression, panel data,
structural vs reduced form estimation. Controls for observable variables.
Instrumental variables, natural experiments, field experiments, pilot
studies. Estimating differentiated “treatment effects.”
Can we identify a causal effect from this?
Q4: What determines government
decisions?
• Public interest model (government follows welfare
economics; analogous to optimisation in welfare
economics)
• Public choice view (individuals in the public sphere
are self-interested)
Note: less focus on this in present year’s module
(Q5: Efficient taxation/transfers)
How can governments raise revenue and reallocate
wealth with the minimum “deadweight
loss”/distortion?
With omniscient government, lump-sum tax is best. But this is basically
impossible or infeasible.
“Second best”: Who and what to tax/subsidise, and at what rate?
• Central to “Public finance”
• Some treatment in this module
Learning that “goes down easy”:
On magnitudes, budgets
Small spending cuts?
01 Apr 11 Fri, 1 Apr 11, Duration: 28 mins
Tim Harford is back with a new series of More or Less, and the numbers behind the news. Are the cuts
"small"? And we introduce "The Other Census". Download 13MB (right click & "save target as")
US debt:
05 Aug 2011, Fri, 5 Aug 11, Duration: 28 mins
Tim Harford and the More or Less team unpick more numbers in the news. This week: US debt, NHS
funding and the "27 club". Download 13MB (right click & "save target as")
Slightly related: The Friday Podcast: When The U.S. Paid Off The Entire National Debt
Tuesday, April 5, 2011
On government Debt
A Euro Debt Odyssey: 02 Sep 2011 Fri, 2 Sep 11, Duration: 28 mins
In this week's More or Less: a Euro debt odyssey, the placebo effect and 70 years of social surveys.
Download 13MB
How useful is GDP?
22 Apr 2011, Fri, 22 Apr 11, Duration: 29 mins
Tim Harford and team look at GDP, school standards and the results of 'The Other Census'. Download
13MB
Tangential ... dissenting views: Libertarianism
NPR’s Planet Money The Tuesday Podcast: Better Living Through Libertarianism
NPR’s Planet Money The Tuesday Podcast: Libertarian Summer Camp
Listen to the Podcast
Next slides – technical part
Munro and Connoly, Ch 2-3 and
MH, chapter 1 and 2
Be sure to know:
Assumptions
Illustration: “Edgeworth box”
Exchange efficiency, production efficiency, efficiency of resource allocation
Welfare measurement, consumer surplus
-- Harberger triangle
Social welfare functions
-- utility possibility frontier
Principles: Pareto principle, compensation principle
Social welfare functions: Utilitarian, Rawlsian…
Assignments
Munro and Connolly, exercise 1.3,
Consider: Look at opinion pieces (in newspapers,
etc.), to find a “good” and a “bad” argument for a
particular government intervention
Access web sites, “update” statistics in book.
Questions -- Uk government by the numbers.doc
M&C Q 1.3: Examine the list of explanations for G/GDP growth. Which are public interest,
which are public choice, and which could be either?
The Baumol effect, Changing suffrage, Demographic changes,
(Increasing?) Fiscal illusion