Public Economics Flashcards
What are the three aspects of efficiency that are required for Pareto efficiency? Explain them briefly
- Exchange efficiency - whatever goods produced have to go to the individuals that value them the most
- Production efficiency - given society’s resources, the production of one good cannot be increased without decreasing the production of another
- Product mix efficiency - the goods produced correspond to those desired by individuals
What is marginal rate of substitution?
The amount of one commodity that an individual is willing to give up in exchange for one unit of another commodity (the slope of the indifference curve)
Why do competitive markets have exchange efficiency?
All consumers face the same prices in a competitive economy, and each sets their MRS equal to the price ratio (the slope of the budget constraint)
Explain exchange efficiency (equation)
The MRS (the slope of the indifference curve) of two goods is the same for all individuals
Explain production efficiency (equation)
The MRTS for any two inputs is the same for all firms
Why do competitive markets have production efficiency?
Each firm will take the prices of L and K as given and seek to maximise profits. They will seek to produce a given output at minimum costs, they therefore operate where their isoquant is tangent to the least cost isocost line
What is marginal rate of technical substitution?
The amount of one input (i.e. capital) required to compensate for a decrease in the input of another input (labour) by one unit (the slope of the isoquant)
Explain product mix efficiency (equation)
The marginal rate of transformation is equal to the marginal rate of substitution
Why do competitive markets have product mix efficiency?
The MRT = relative prices of the two goods. The MRS also = relative prices of the two goods. Therefore MRT = MRS
What is marginal rate of transformation?
How much extra of one commodity can we have if we reduce the production of another by one (the slope of the PPF)
What are the two fundamental theorems of welfare economics?
- Every competitive market is Pareto efficient
- Every Pareto efficient resource allocation can be attained through competitive markets, with the appropriate initial redistributions
What are the implications of the first welfare theorem?
- Guarantees competitive markets exhausts all gains from trade
- Arguments for competitive markets: they economise on the information
- Competitive markets will be Pareto efficient
What are the implicit assumptions of the first welfare theorem?
- It assumes that a market exists for every commodity; problem: Lemons!
- The first theorem is only of interest if a competitive equilibrium exists
- It assumes individuals and firms behave competitively (need large numbers)
What are the conditions for a competitive market equilibrium? What are the conditions for continuous function?
Aggregate excess demand function must be continuous.
Each individual’s demand function is continuous, which requires that consumers have convex preferences, and producers have convex sets
What are the implications of the second welfare theorem?
- Problems of distribution and efficiency can be separated (but VERY difficult)
- If we can determine socially desirable utility combination, the best distribution can be achieved to allow the market to reach the combination
- Second best. If the efficiency conditions for FB cannot be met, we disregard Pareto conditions. The SB may come about because of redistribution effects, and the UPF will shift inwards
Why would the government intervene if one of these FAIL? (Efficiency reasons)
1. Perfect competition
2. Complete markets
3. No market failures
4. Perfect information
5. Intertemporal utility maximisation
- Agents must be price-takers and they must have equal power
- Markets will fail in supply of public goods. Missing markets may arise. Capital markets may fail
- This assumption can be violated with public goods, externalities, and increasing returns to scale
- Efficiency in perfectly competitive markets contingent on perfect information
- Information failures may render private insurance markets inefficient
Name the types of equity
- Vertical equity - redistribution of equity from rich to poor
- Horizontal equity - equal treatment for equals
Name three types of government intervention
- Regulation - for markets operating under imperfect information
- Finance - subsidies/taxes
- Production - the state can produce goods/services itself
What does a social indifference curve measure?
The combinations of utilities of 2 individuals in which society is indifferent
What does a social welfare function measure?
The level of social welfare corresponding to a particular set of levels of utility attained by members of society
Name two problems with measuring social welfare
- Interpersonal comparisons - we cannot measure the level of utility or change in utility
- Whence social welfare functions - you can describe each individual’s preferences, but not society’s
What is the substitution effect? Income effect? How does it relate to compensated/uncompensated demand curves?
If the price of one good is lowered, individuals will substitute the cheaper goods for other goods (SE). Because of the lower price the individual is better off for the same utility. They have money left over, and spend it on the same good which increases demand (IE).
The ordinary demand curve is slightly flatter than the compensated demand curve
What is the consumer surplus? How is it measured?
The difference between what an individual is willing to pay and what they have to pay. It is measured by the area under the (compensated) demand curve
What is deadweight loss/excess burden?
A measure of how inefficient a tax is. It is the difference between between a tax itself and the lump-sum tax
How does the poverty index measure poverty?
It measures the fraction of the population whose income lies below a critical threshold
How does the poverty gap measure poverty?
It counts the number of individuals who are below the poverty threshold
Name three government approaches to social choices
- Compensation principle - if WTP > cost, then undertake the project
- Trade-offs across measures - in practice, the government measures the impact on each major group
- Weighted net benefits - weights are assigned to the net gains of different groups. Effects on higher income groups are weighted less heavily
What are public goods?
Goods that are non-rival, and non-excludable
Name ways the government can charge for public goods (as well as + and -)
- User fees: + Those who benefit bear the costs. - Results in underconsumption and transaction costs
- Uniform provision: + Saves on transaction costs. - Leads to under/overconsumption, high demanders may supplement public consumption
- Queuing: + Goods allocated not necessarily on basis of wealth. - Alternative basis of allocation may be undesirable (time wasted)
What is the Samuelson Condition?
The amount of private good that all individuals are willing to give up to get one more unit of public good is PRECISELY the amount that they must give up to get one more unit
What is the preference revelation problem?
The consumer has no incentive to reveal their true preferences
What is the main reason for the preference revelation problem?
Asymmetric information - the individual knows their true preferences for public goods, but this information is not revealed to the government. Arises for public goods and publicly provided goods.
How does non-excludability arise?
The nature of the good or government policy
Explain the types of taxes and their positives and negatives on preference revelations
- Benefit taxation: + Hidden information to government. Consumers understate preferences to reduce tax. - Dominant strategy: free-riding
- Lump-sum taxation: + Hidden information to government. - Incentive for individuals to overstate preferences for public good as no effect on tax
- Proportional/progressive taxation: Over/understatement will occur where consumer believes desired level of provision lies relative to the economy’s PE level
What is an externality?
When an individual/firm undertakes an action that has an effect on another individual/firm for which the latter doesn’t pay/isn’t paid
What are the consequences of externalities?
- Overproduction of goods generating negative externalities
- Undersupply of goods generating positive externalities
Explain private solutions to externalities
- Internalizing externalities
- Assigning property rights (Coase Theorem)
- Using the legal system
Explain the failures of private solutions to externalities
- Free-rider problems
- Imperfect information problems
- Transaction costs
- Additional problems with litigation
Explain public sector solutions to externalities
- Corrective/Pigouvian taxes
- Regulation
- Fines and taxes
- Subsidizing pollution abatement
Compare regulation and taxation in effectiveness in reducing the effects of externalities
Regulations require information of MSC of pollution, and costs of pollution abatement. Private producers have an incentive to overstate the abatement costs.
Taxation has less information requirements. You only need MSC of pollution.
Conclusion: Taxes preferable to regulation as costs of pollution vary but benefits are certain
Name the pros and cons of marketable permits
+ Over fines: With fines, the government doesn’t know the level of pollution the firm will choose. With tradable permits, you don’t bear the risk of excess pollution.
- Making the initial assignment: Equity problem - you can’t just make firms produce a certain proportion of what they were doing.
- The question of location. Tradable permits only work where the location of pollutant makes no difference
Name reasons why people have different views on how much should be spent on public goods?
- Different tastes
- Incomes. Richer individuals have higher incomes so prefer to spend more on PGs.
- Taxes. Tax price: additional amount an individual pays when expenditures increase by 1 dollar.
How would you calculate an individual’s tax payment? Is it effective?
Tax price x total government expenditures.
Income and price effects means the net effect is ambiguous
Define a progressive tax system
When tax payments increase more than proportionately with income.
Explain the economic effects of proportional and uniform income taxation.
Proportional - income and price effects
Uniform - income effect only
Explain the problems of aggregating preferences in the private and public sector.
Private - no need to balance interests of one group over another. If an individual WTP price that > MC production, it pays.
Public - Decisions made collectively. Since different people want different things, how can a social decision be made?
What is the voting paradox?
Easy if 2 alternatives. If >2, then if 2 voters vote against each other, you never get a clear winner.
How do you avoid the voting paradox?
Democracies organise their decision making as a sequence of votes. The final determination depends on the outcome of the last vote, with no further contests.
Are there voting rules that will ensure a determinate outcome for any vote?
NO - Arrow’s impossibility theorem: there is no rule that would satisfy the following 4 (desirable) characteristics:
- Transitivity (cyclical voting without this)
- Nondictatorial choice. A meaningful mechanism must ensure that the outcomes do not simply reflect the preferences of a single individual
- Independence of irrelevant alternatives. A decision between 2 should not depend on a third alternative
- Unrestricted domain. The mechanism must work regardless of set of preferences and no matter range of alternatives.
Are there circumstances under which simple majority voting will yield a determinate outcome?
YES. There are some conditions - Single-peakedness.
Explain an example of non single-peaked preferences.
Problem of a rich individual’s attitudes towards public education.
If levels of expenditure below minimum level, send kids to private school. Then, any increase in expenditure simply increases his taxes. His utility will decrease with it, until he decides to send his kids to public school.
For increases beyond that, some benefits. But beyond a certain point, increase in taxes is way bigger than benefits
How do you obtain single-peakedness?
Restrict to voting on one issue at a time
Why does the outcome of majority voting correspond to the preferences of the median voter?
When individuals are ranked by preferred levels of expenditure, the median voter will be the one that half prefer less and half prefer more.
Why does the median voter determine the level of PG expenditures?
Party A chooses G1>Gm. If party B takes a position between that, it will get more than 50% of voters, wins. Party A will then choose between those two, and gets more than 50%. This process repeats until both parties stand for the same position: that of the median voter Gm.
What is the fraction of the total PG marginal benefits (MB) accrued to the median voter?
If MB uniform: median voter gets 1/N of MB. Therefore, bears 1/N of the costs.
But with proportional/progressive taxation: smaller share of costs than benefits, votes for excessive expenditures.
How are special interest groups able to exercise power?
- Attempt to make biased information about issues readily available.
- Attempt to provide information on citizens preferences.
- Direct and indirect bribery of politician.
Explain reasons for placing a high priority on strong education
- Improvements in human capital (skills/experience)
- Larger fraction of population to college: reducing inequality and enhancing opportunity
What is the main output of educational expenditure?
Higher productivity
Explain the two models of education.
- Human capital model. Demand for education in terms of production and utility benefits. Production: higher future income. Utility: Consumption, increase skills, so wages too.
This is all akin to human capital investment. - Screening model: Firms seek higher ability labour: asymmetric information. This allows for signalling. Social returns are more than private returns
Why is school education publicly provided and financed?
Not a PG…
Important externalities with an educated citizenry: large private return.
- Perfect information. (a) About nature of product (OFSTED). Solutions: School guides.
(b) About prices/future: uncertainty not a major problem. - Competitive markets. (a) For supply: problem of monopoly in rural provision
(b) For finance of education: imperfect capital markets, need collateral. - Externalities. Productive and cultural
How efficient is the UK education system?
Macro-efficiency. Quantification of the efficient volume of resources is impossible
Micro-efficiency. Empirical evidence suggests that school productivity has declined
Implications. Intervention regarding age is schooling is needed earlier to avoid polarization; quality of parenting deserves more attention
How equal is the UK education system?
Role of income. School attendance involves parental expenditure. Too many children are leaving school at 16 because their family needs earnings. Inequality of achievement too. Middle class parents can move to nicer areas.
Supply: More competitive pressure on schools - greater demand - more pupils - more funds - best achievement at minimum costs through cream skimming.
However, redistribution effects unclear
Explain the voucher schemes for school reform
Parents receive education voucher for each child (Friedman) (Jenks).
Education is privately produced, and competitive, so school is responsive to parental demand. Parents who choose a private school receive tax relief.
Intervention to increase efficiency and equity by regulation. Support says it increases efficiency.
Name the roles of government in higher education
Funding. Taxpayer subsidies justified by external benefits
Promoting access. Improving information and quality, providing money
Ensuring quality assurance. Regulation
Setting incentives. Competition
Organizing student loans. Provision of targeted subsidies
What are the two forms of taxation?
Direct taxes. On individuals/corporations. Income tax etc.
Indirect taxes. On a variety of goods/services. Custom duties etc.
What are the desirable characteristics of any tax system?
- Economic efficiency. Tax system shouldn’t interfere with efficient allocation of resources
- Administrative simplicity. Easy/inexpensive
- Flexibility. Respond easily to changed economics circumstances
- Political responsibility. Individuals can ascertain what they are paying, and evaluate that it reflects their preferences
- Fairness. Should be fair in treatment of unequal individuals
Explain the behavioural effects of taxation
Income taxation affects decisions concerning work, savings, education, and consumption
Risk-taking, allocation of resources, rate of growth in long-run
Level of investments in firms, form of investment
Explain the financial effects of taxation
Affects whether people save money themselves or pension plan.
If restrict pension plan, may invest differently
Explain the organisational effects of taxation
Corporations vs unincorporated. Tilt tax system in favour of either to encourage/discourage activity
Explain the general equilibrium effects of taxation
Taxes can affects multiple parts of an economy. By changing behaviours, you affect amount saved which affects the equilibrium of consumption/spending
Explain taxation announcement effects
Some effects of the tax may be felt even before it is imposed, simply upon announcement.
Can affect asset values
Anticipation can affect supply of assets
What is the difference between distortionary and non-distortionary taxation?
Non-distortionary. The individual is not expected to react at all (lump sum taxes)
Distortionary. Individuals will attempt to lower tax liability, usually by working or saving less (commodities, incomes)
Explain corrective taxation
Use to correct some market failure (usually externalities)
It raises revenue and improves the efficiency of resource allocations
Explain the types of administrative costs of administering a tax system
Direct costs. Running the IRS
Indirect costs. Cost borne by taxpayers (time spent filling out, costs of record keeping etc.)
Explain the factors that affect the administrative costs of running a tax system
- What records would be kept in absence of taxation
- Complexity of the tax system. Costs of administering it, how many different rates
- Taxing some categories of income may be more expensive than taxing others. Capital more expensive than labour. Costs of taxing per £ of revenue from small businesses is more than large businesses
Explain the automatic stabilisation mechanism of taxes
If economy goes into recession, decrease in tax revenues is desirable.
During stable prices: a progressive tax structure for automatic stabilisation
Explain the political difficulties of adjusting tax rates for brackets
Which rates? Proportionate? Rich or poor?
If you adjust property tax, low political difficulty. Adjustments are made annually.
Explain the vertical equity problems with taxes
Who should pay a higher rate, writing tax rules, deciding how much more the rich should pay
Explain factors that could affect how much you should be taxed
- Income. Good measure of ability to pay. But doesn’t tell how much eg. leisure the worker has
- Consumption. Savings should be exempt from taxation?
- Lifetime income. This is the present DV of the individual’s wage income. It is the same as the individual’s lifetime consumption
Explain the benefit approach to taxation
Maybe individuals should support the government proportional to the benefit they receive from public service.
Unattractive however as impossible to determine different individual’s utility, and also very distortionary
Explain the general framework for choosing among tax systems
Look at efficiency. Want a PE tax system.
Choose among the possible PE TSs using a social welfare function.
Then either:
Utilitarian. Taxes should be such that the MU of income should be the same for all individuals. But income depends on effort. This may imply horizontal inequity
Rawlsian. Increase tax revenue on all to the point where T revenues are maximised
Explain the limitations of the social welfare function approach
Individuals do differ, in many attributes.
The SWF does not allow us to compare the utility of two individuals, which you need to design a tax system
How efficient/equal is the school voucher system?
Depends on whether parents make well informed choices on schools.
Schools face incentives to screen-out low-achieving applicants.
Major distributional effects, the subsidies to private schools help the rich get richer
Allowing parents top up vouchers increases disparities
What is the tax burden? How is it measured?
The true economic weight of a tax.
It is the difference between the individual’s real income before and after the tax (taking full account of how wages and prices may have adjusted)
What is the incidence of a tax?
Who actually pays, in the sense that their real income is lowered?
Explain how actual incidence may be different from intended incidence
Consider social security tax, and corporation income tax. As a result of either, wages/demand may fall or prices might rise.
If wages/demand fall, the tax has been shifted backward (to a factor of production, labour)
If prices rise, the tax has been shifted forward (to the consumers)
It is believed that most of the employer-paid portion of the social security tax is shifted backward - employees bear the full burden of the tax.
What does/doesn’t affect the incidence of a tax?
Does:
Shape of demand and supply curves
Doesn’t:
Onto whom the tax is legally imposed (consumers or producers)
What is meant by the market supply curve?
The total amount that all firms are willing to supply at each price - the sum of the supply curves of each firm
What is meant by the firm’s supply curve?
The amount the firm is willing to supply at each price
Does it matter whether a tax is levied on consumers or producers?
No.
Use graphs to explain why:
y=price
x=quantity
If producers: SC is shifted up by the amount of tax, so the price does too, and quantity goes down
If consumers, demand shifts down by the amount of tax, so the quantity does too, and the price increases.
Explain Friedman’s and Jenks’ types of school voucher system
‘Pure’ voucher scheme (Friedman):
- Value of voucher = average cost of place in a state school
- Topping up is allowed, if voucher doesn’t fully cover fees
- Parents and schools are unconstrained. Parents can spend voucher at any school, public or private, and schools have unrestricted freedom in choice of pupils
‘Constrained’ voucher scheme (Jenks):
- Voucher covers full average cost of state education
- Topping up is not allowed, but low income parents receive a larger voucher, giving extra resources to schools with larger numbers of disadvantaged children
- Schools where demand exceeds supply are constrained in tat they must allocate at least half of their places by ballot
Explain the characteristics of a specific tax compared to an ad-valorem tax
With a specific tax, it is the same regardless of the quality of a product. So, the tax is a higher percentage of the price for lower-quality goods than higher ones - discriminatory. However, it is easier to monitor quantity than the price
What is the elasticity of demand?
The percentage change in quantity of the good consumed due to a percentage change in its price
Explain the tax incidence when labour is taxed
Doesn’t matter who it is taxed on, consumers (firms) or producers (individuals), depends on elasticity of demand and supply for labour. If the supply of labour is inelastic, most of the burden falls on workers
Explain why some economists believe that the supply curve of labour is backward-bending
Individuals decide that at the higher standards of living they can attain with higher wages, they prefer to work less. So, higher wages decreases the supply of labour. In this case, a tax on labour means a reduction in the wage rate greater than the tax itself.
Why must the uniform income tax and the uniform output tax be the same
The value of income and the value of output must be the same
What is a sales tax, and a value-added tax?
Sales tax - tax at the end of the production process
Value-added tax - tax imposed at each stage of the process
They are both the same as a uniform income tax
What general remarks can we say about taxes?
Corporations don’t bear taxes, people do: shareholders, workers, consumers
Because of general equilibrium responses, the impacts of corporation taxes are felt throughout the economy
Effects may vary depending on the period of analysis and on assumptions abut the economy’s structure
