Public Economics Flashcards
W1 - What is public economics?
The study of the role of the government in the economy.
W1 - What are the four ways the government is instrumental the economy?
- In charge of regulatory structure.
- Taxes: 35% - 50% of National Income income in advanced economies are collected this way.
- Expenditures: Taxes fund PUBLIC GOODS and the WELFARE STATE.
- Macro-economic stabilisation through central bank, fiscal stimulus and bailout policies.
W1 - What are some examples of public goods?
Infrastructure
Public Order & Safety, Defence
W1 - What are some examples of the welfare state?
Education
Retirement Benefits
Health Care
Income support
W1 - Examples of the macro-economic stabilisation through central banks?
Interest Rate
Inflation Control
W1 - How would an economists (micro) perspective of individual behaviour limit us?
It focuses on purely self interested and economically rational agents.
It doesn’t take into account the role of social interactions
W1 - Patrilocal?
A pattern of marriage in which the couple settle in the Husband’s home and community.
W1 - Bigger View on Government - How do we bridge the gap between early historical social interactions and the government?
The government has adopted some of the roles of the community, such as taking care of the young (education), sick (health care) and old (retirement benefits).
W1 - Economists View of Government?
Examples for:
Education
Retirement Benefits
Healthcare
Markets are not always the best replacement for social institutions.
Education is primarily government funded. Student loans work in theory but end up being a lifetime burden, with for-profit education tending to be a scam.
Retirement Benefits: In practice, saving for retirement works, but most are unable to do so.
Health care relies heavily on government/ community support everywhere. People are not able to afford or shop rationally for health care.
W1 - What are the three overarching questions in public economics?
1) When should the government intervene in the economy?
2) Why do governments choose to intervene in the way that they do?
3) What is the effect of those interventions on economic out-comes?
W1 - According to the traditional view of economists, when should governments intervene in the economy?
1) Market Failures: To prevent inefficient outcomes as a result of market forces.
(Thus increasing the size of the pie)
2) Redistribution: Markets tend towards inequality which is an issue as we are “social beings”.
People are willing to pool their resources (taxation and charitable donation) to help reduce inequality.
(Thereby changing the allocation of the pie)
W1 - 4 Types of Market Failures with examples and how they are corrected?
1) Externalities
Example: Greenhouse Carbon Emissions.
Solution: Corrective Taxation for example.
2) Imperfect competition: Example: monopoly)
Solution: Requires regulation
3) Imperfect or Asymmetric Information
Example: Health
insurance markets are subject to death spirals.
Solution:
4) Individual failures
Example: People do not behave as \fully rational
individuals.
Example: Myopic people may not save enough for retirement.
W1 - In terms of an individual and societal impact, what would the efficient outcome be?
When only individual impact is accounted for, what is this an example of?
The outcome that maximises the total social value (being value to the individual and society) at the given cost of this.
When only individual impact is accounted for, this is an example of a negative externality, a type of market failure.
W1 - When is there a presence of efficiency costs?
Example?
If there is a tradeoff between efficiency for equity or another parameter.
Example: Redistribution through taxes and the reduced incentives to work, creating an equity-efficiency tradeoff.
W1 -See BA 1. Analyse the graph.
The different parts of the distribution diverged from each other
Bottom 50%: their incomes are more or less CONSTANT (only 1% income growth!)
Despite the increase in average national income, we see that this gain is realised primarily by the top earners
W1 - What are 4 ways the government might intervene to correct over or under production of goods or services?
1) Tax or Subsidize Private Sale or Purchase:
Tax goods that are overproduced (e.g. carbon tax) and subsidized goods underproduced (e.g.,
flu shots subsidies)
So tax and subsidise.
2) Restrict or Mandate Private Sale or Purchase:
Restrict the private sale or purchase of overproduced goods (e.g. fuel efficiency requirements), or mandate the private purchase of underproduced goods (e.g., auto insurance)
Restrict or mandate though quotas or laws.
3) Public Provision:
The government can provide the good directly, in order to potentially attain the level of consumption that maximizes social welfare (example is National Defence).
So government provision
4) Public Financing of Private Provision:
Government pays for the good but private sector supplies it (e.g., privately pro-vided health insurance paid for by US government in Medicare-Medicaid).
Public funding to private companies.
W1 - What are the two types of effects that we look at with regards to government intervention?
Provide an explanation.
1) Direct Effects: The effects of government interventions
that would be predicted if individuals did not change their behaviour in response to the interventions.
Direct effects are are relatively easy to compute
2) Indirect Effects: The effects of government interventions that arise only because individuals change their behaviour in
response to the interventions. These are sometimes called unintentional effects.
These effects are estimated.
Both effects must be accounted when assessing the effectiveness of intervention.
W1 - What are the effects of increasing top income tax rates.
Direct Effect: Mechanical raising of tax revenue.
Indirect Effect: Top earners might try to avoid/ evade taxes, reducing tax revenue relative to the mechanical outcome.
W1 - Political Economy?
Example?
The theory of how the political process produces decisions that affect individuals and the economy.
Example: How the level of taxes and spending is set though voting and voters’ preferences.
W1 - Public Choice?
Examples?
A sub-field of political economy.
From a Libertarian perspective, it focus on government failures.
Example: The failure of G in achieving its aims
I.e overaddressing issues (issues that aren’t there in the first place) OR using tools that do not productively address the issues at hand
W1 - Normative Public Economics?
Example?
Normative Statements express a value judgment about whether a situation is desirable or undesirable. …
Normative statements are characterised by the modal verbs “should”, “would”, “could” or “must”.
Analysis of how things should be.
Should the government intervene in health insurance market?
How high should taxes be.
W1 - Positive Public Economics?
Analysis of how things really are.
Does the government provided health care crowd out private health care insurance?
Do higher taxes reduce labour supply?
W1 - The difference between normative and positive analysis?
Positive analysis is primarily empirical (data outputs) and normative analysis is primarily theoretical (theory).
W1 - What are the 4 key facts about taxes and spending?
Hint:
- Growth
- Size
- Growth.
- Government spending and taxes.
1) Government Growth: Size of government relative to National Income grows dramatically over the process of development from less than 10% in less developed economies (similar to pre-industrialisation levels) to 30-50% in most advanced economies.
2) Government Size Stable in richest countries after 1980.
3) Government Growth is due to the expansion of the welfare state: (a) public education, (b) public retirement benefits, (c) public health insurance, (d) income support programs
4) Govt spending > Taxes: Most rich countries run deficits and have significant public debt (relative to GDP), particularly during Great Recession of 2008-10.
W1 - What are the parts that make up the public welfare state?
(a) public education
(b) public retirement benefits
(c) public health insurance
(d) income support programs
W1 - BA 2. Analyse the graph.
Since 1980s, the size of the fiscal state is relatively stable
Q: interpret this graph (key features):
- -> very low levels of fiscal state before WWI
- -> almost identical across all countries
- -> increase in welfare state (spike in graph)
- -> leveling out since the 1980s
W1 - BA 3. Analyse the graph.
1870s: largely defensive expenditure
- this has stayed relatively stable over time as a fraction of GDP
- The other expenditure streams emerged after WWI and diverged into significant streams after WWII
NOTE: ageing society has lead to a larger fraction of income (GDP) being spent on pension premiums
OECD Anagram meaning?
Organisation of Economic Cooperation and Development.
Empirical Tools - Define Empirical Public Finance
The use of data and statistical methods to measure the impact of government policy on individuals and markets.
For example, how an incase of taxes affects work behaviour.
Empirical Tools - Correlation?
When two economic variables move together.
Empirical Tools - Causality?
Two economic variables are causally related if the movement of one causes movement of another.
Empirical Tools - What is the problem involving the distinction between correlation and causality called?
This is known as the identification problem.
Empirical Tools - Identification problem - What are the three ways that A and B could be correlated??
A is causing B
B is causing A (reverse causality)
A third factor is causing both.
Empirical Tools - What is a randomised trial?
The ideal type of experiments designed to test causality, whereby a group of individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not.
Empirical Tools - Bias definition in relation to correlation and causation.
Any source of difference between treatment and control groups that is correlated with the treatment but is not due to the treatment.
Empirical Tools - What are two examples of randomised trials?
Oestrogen Replacement Therapy
Welfare Reform. (TANF - Temporary Assistance For Needy Families)
Empirical Tools - Randomised Trials: Oestrogen Replacement Therapy Information?
A trial tracked over 16’000 women ages 50-79 who were recruited to participate in the trial of 40 clinical centres in the US. The trial was supposed to last 8.5 years but stopped after 5.2 as it was clear that ERT did in fact raise the risk of heart disease.
Empirical Tools - Randomised Trials: Welfare Reform?
Tests the effect of welfare reform on labour supply. These tests were implemented by a number of states.
Empirical Tools - What are the two reasons we need to beyond randomised trials?
Randomised trials can suffer from the following:
External Validity: The results are only valid for the sample of individuals who volunteer to be either treatments of controls, and this sample may be different from the population at large. (e/g. A trial in Sweden vs US may generate different results.
Attrition: Individuals may leave the extra experiment before it is complete. Reduction in the size of samples over time, which, if not random, can lead to bias estimates.
Empirical Tools - Observational Data?
Data generated by individuals behaviour observed in the real world, not in the context of deliberately designed experiments.
Empirical Tools - Time series analysis?
Analysis of the co-movement of two series over time.
Empirical Tools - Cross-sectional regression analysis?
Statistical analysis of the relationship between two or more variables exhibited by main individuals at one point in time.
Empirical Tools - What may two concerns be with randomised trials completed by the government with policy?
They can be expensive to implement and complete.
Ethical Concerns: If the policy has a positive societal impact, it may be unethical to neglect a group as it could be enhancing societal welfare.
Empirical Tools - BA 4. What are two ways this graph can be interpreted?
- Maximum monthly benefit has fallen over time, increasing the opportunity cost of not working in the labour force –> hence, more hours worked by single mothers
2) more single mothers have been working in the labour force due to labour-market shifts (i.e. shift from production to services), hence fewer mothers are eligible for maximum monthly benefit –> reduction
Empirical Tools - Problems with Time Series (2)?
Causation.
When there is a general decline in a variable over time, is is difficult to infer causation.
Other factors can blur the causal interpretation.
Empirical Tools - When is time series analysis useful?
When there are sharp simultaneous changes in prices of a good.
For example, tobacco.
Empirical Tools - Regression line?
The line that measures the best linear approximation to the relationship between any two variables.
Empirical Tools - What can we say about OLS and its estimate of the coefficient of the independent variable β?
What are the implications if it is not true.
What needs to be included in the error term?
OLS regression estimates β without bias if the error term is not correlated with X.
“X causes Y” is not true if we do not have a strong control over factors that could impact X.
Any possible factors that could influence X and Y’s comovement and X should be included in the error term.
Empirical Tools - βhat = .5(.1).
Interpret the above.
βhat is the estimated β.
Within the Parenthesis is the standard errors.
βhat = .5(.1) should be understood as β is in confidence interval (.5 - 2.1), .5 + 2.1) with a probability of 95%.
When the estimated coefficient is more than twice the standard error, we can conclude that it is significantly positive, i.e. is above zero with probability 95%.
Empirical Tools - How can we use control variables, Z, in cross-sectional regression analysis to be confident that the identification assumption holds?
Z can include factors that may be different between two groups being studied.
If, when we add Z variables, the β estimate changes a lot, we cannot be confident that the identification assumption holds.
Empirical Tools - What are Quasi-Experiments (Natural Experiments)?
Example
Changes in the environment that create nearly identical treatment and control goops for studying the effect of that environmental change.
This enables economists to take advantage of quasi-randomisation created by external forces.
Example: One state reduces welfare benefits whilst a comparable state does not.
Empirical Tools - Quasi-Experiments - Simple Difference Estimator?
D = Y [T, After] - Y [C, After]
It is the difference in average outcomes between the treatment and control after the change.
The above assumes that the C and T were identical before:
Y [T, Before] - Y [C, Before] = 0
When this is the case, we can be fairly confident that D estimates the causal effect.
Empirical Tools - Difference-In-Difference Estimator?
DD =
(Y[T, After] - Y[C, After] ) - (Y[T, Before] - Y[C, Before] )
This measures whether the difference between treatment and control changes after the policy change.
DD identifies the causal effect of the treatment if, absent the policy change, the difference between T and C would have stayed the same. This is known as the PARALLEL TREND ASSUMPTION.
Empirical Tools - What problems may exist with quasi-experiments?
- No certainty of that all bias has been removed from the treatment-control comparison.
- Robustness checks should be used to ensure the effect is causal, so for instance, going over other possibilities such as further policies implemented etc.
Empirical Tools - What are two examples of ideal quasi-experiments?
For and against DD.
1) Effects of Lottery winnings on labour supply. (Imbens, Rubin, Sacerdote)
Random assignment, conditional on playing. DD convincing.
2) Effects of the 1987 EITC expansion (tax credit for low income workers with kids.) on labour supply (Eissa and Liebman)
Compares singles mothers to single females. No compelling break in graph around 1987, DD not convincing.
Empirical Tools - Effects of the 1987 EITC expansion (tax credit for low income workers with kids.) on labour supply (Eissa and Liebman). problem with DD in this case?
The two groups are not comparable. Fertility is an outcome of the labour supply and it is a choice, so the difference is not confiding.
Empirical Tools - Structural Estimates?
Derived directly from theories.
Builds a theoretical model of individual behaviour and then estimates the parameters of the model. Estimates of the features that drive individual decisions, such as income and substitution effects or parameters of the utility.
Bad: These models may not be good for understanding causal estimates.
Good: Good for understanding policy variation.
Empirical Tools - Reduced form estimates?
Measures of the total impact of an independent variable on a dependent variable, without decomposing the source of that behaviour response in terms of underlying parameter of the utility functions.
Empirical Tools - Structural estimates vs reduced form estimates.
Reduced form estimates are more convincing and transparent but structural estimates are more directly useful to make predictions for alternative policies.
Empirical Tools - Conclusion of lecture.
Policy questions require us to establish if a causal relationship exists between the policy in question and the outcome of interest.
The best way to distinguish causality is through randomly assigning treatment and control group.
This approach is not always applicable, so we turn to time series, analysis, cross-sectional regression analysis and quasi-experimental analysis.
Each has its weaknesses, but careful consideration of the problem at hand can often lead to a sensible solution to the bias problem.
Theoretical Tools Definition?
The set of tools designed to understand the mechanisms behind economic decision making.
Empirical Tools Definition?
The set of tools designed to analyse data and answer questions raised by theoretical analysis.
Theoretical Tools - Utility Mapping of Preferences positives and negatives?
Economists model individuals’ choices using the concepts of utility function maximisation subject to budget constraint.
This is a narrow view of human behaviour that works reasonably well for consumption choices, but likely less well for work behaviour.
Theoretical Tools - Utility function definition and equation?
A utility function is some mathematical function translating consumption into utility.
U = (X|1|, X|2|, X|3|, …),
where X|n| are the is the quantity of good n.
Theoretical Tools - Indifference Curves definition and two assumptions?
A graphical representation of all bundles of goods that make an individual equally well off.
Assumptions:
1) Consumers prefer higher indifference curves.
2) Indifference curves are always downward sloping, representing DIMINISHING MARGINAL UTILITY.
Theoretical Tools - Marginal Utility Definition (and formula)?
The additional increment to utility obtained by consuming an additional unit of a good.
MU|1| = 𝛿u/𝛿X|1|
It is the derivative of utility with respect to X|1| keeping X|2| constant.
Theoretical Tools - Marginal Rate of Substitution (and formula)?
The MRS is equal to the (minus) slope of the indifference curve, being the rate at which the consumer will trade the good on the vertical axis for the good on the horizontal axis.
MRS|1,2| = MU|1| / MU|2|
The above shows the amount that the individual is indifferent between 1 unit of good 1 and MRS|1,2| of good 2. AKA how many x is required to give up 1 y.
It is the minus slope as we are staying how much more x we require to give up 1 y. It is expressed interims of y, which is decreasing (so is negative)
Theoretical Tools - Budget Constraint (and formula)?
A mathematical representation of all the combinations of goods an individual can afford to buy if they spend their entire income.
Y = p|1|X|1| + p|2|X|2|
where p|i| is the price of the good I, and Y is disposable income.
We can rearrange the above to attain:
X|2| = Y/ p|2| - p|1|/p|2| * X|1|,
where the slope of the budget contracts is -p|1|/p|2|
Theoretical Tools - Utility Maximisation?
With reference to budget constraint and utility preference.
Individuals maximize utility subject to the budget constraint, such that
MRS|1,2| = p1/p2
At this optimal, the individual is indifferent between buying 1 extra unit of good 1 for $ p|1| and buying p|1|/ p|2| extra units of good 2, also for $p|1|
Theoretical Tools - Utility Maximisation?
Implies that
X|2|/X|1| = p|1|/ p|2|
Theoretical Tools - Demand Function?
Individual maximisation generates demand functions X|1|(p,Y)
Theoretical Tools - Income and Substitution Effects general?
Measures how X|1|(p,Y) (the demand functions) vary with p and Y.
Theoretical Tools - Income Effects?
The effect of giving extra income (Y) on the demand for goods.
How X|1|(p, Y) varies with y.
Theoretical Tools - Income Effects: Normal and Inferior goods explanations?
Normal goods: Goods for which demand increases as income Y rises: X|1|(p, Y) increases with Y (most goods are normal)
Inferior goods: Goods for which demand falls as income Y rises: X|1|(p, Y ) decreases with Y (example: you use public transportation less when you are rich enough to buy a car)
Theoretical Tools - Price Effects: Normal and Inferior goods explanations?
1) Substitution effect: Holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good.
On a diagram, this amount will be the original amount of good 1 or two, minus the amount at the point along the same indifference curve with the new budget constraint transposed onto it.
2) Income effect: A rise in the price of a good will typically cause an individual to choose less of all goods because her income can purchase less than before.
On a diagram, this amount will be the substitution effect amount of good 1 or two, minus the amount where the indifference curve hits the new budget constraint.
Theoretical Tools - Price Effects?
How does X|1|(p, Y) vary with p|1|
Theoretical Tools - Aggregate Demand?
Each individual has a demand for each good dependent on price. Aggregating across all individuals, we get aggregate demand D(p) for the good.
Theoretical Tools - Elasticity of Demand (and mathematically)?
The % change in demand caused by a 1% incase in the price of a good.
ε^D = %Δ in quantity demanded / %Δ in price.
Theoretical Tools - What are the 5 properties of Elasticity of Demand?
1) Typically negative, since quantity demanded typically falls as price rises.
2) Typically not constant along a demand curve.
3) With vertical demand curve, demand is perfectly inelastic
( ε= 0).
4) With horizontal demand curve, demand is perfectly elastic
(ε = -∞).
5) The effect of one good’s prices on the demand for another good is the cross-price elasticity. Typically, not zero.
Theoretical Tools - Elasticity of Supply mathematically?
ε^S = %Δ in quantity supplied / %Δ in price.
Theoretical Tools - Economic surplus?
The net gains to society from all trades in a particular market. It is the consumer surplus + the producer surplus.
Theoretical Tools - Consumer surplus and producer surplus?
The benefit that consumer/ producer derives from consuming/ producing a good above and beyond the cost of buying/ producing that good.
Theoretical Tools - First Fundamental Theorem of Welfare Economics (general)?
The competitive equilibrium where supply equals demand maximises total economic surplus, sometimes called efficiency.
It is blind of distributional aspects and just focuses on maximising economic surplus.
Theoretical Tools - Deadweight Loss?
Diagrammatically?
The reduction in economic surplus from denying trades for which benefits exceed costs when quantity differs from the efficient quantity.
Key rule: Dead-weight loss triangle points to the efficient allocation and grows outward from there. It points the way the production and consumption levels should go.
Theoretical Tools - What are the 4 assumptions to ensure the 1st welfare theorem holds in private markets and is PARETO EFFICIENT?
- No Externalities.
- Perfect Competition (individual firms are price takers)
- Perfect Information.
- Agents are rational.
If any of the above do not hold, G intervention may be desirable.
Theoretical Tools - Pareto Efficiency?
Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off.
