Lecture Notes on Public Finance (Public Economics)

Introduction to Public Finance

• Public finance, also known as public economics, is the study of the role of government in the economy.
• The focus is on government budgets, deficits, and debt, not on municipal bonds.

Key Questions in Public Economics

1. When should the government intervene in the economy?
2. How might the government intervene?
3. What are the potential effects of different interventions?

Reasons for Government Intervention

Redistribution

• Optimal allocation of resources is not always achieved by competitive equilibrium.
• Redistribution may be required to achieve societal preferences.
• Lump-sum taxes (theoretically) can be used but are impractical in reality.

Market Failures

• Externalities: Spillover effects of actions (e.g. vaccinations = positive externality; pollution = negative externality).
• Public Goods: Non-rival and non-excludable (e.g. defense, caring for the homeless).
• Asymmetric Information: One party knows more than the other (e.g. insurance markets).
• Imperfect Competition: Market power held by buyers or sellers (e.g. monopoly, monopsony).

Methods of Government Intervention

1. Price Mechanisms
   • Taxing bads: E.g., carbon tax to reduce CO2 emissions.
   • Subsidizing goods: E.g., vaccination subsidy.
2. Regulation
   • Restricting sales/purchases: E.g., drug prohibition.
   • Mandating purchases: E.g., mandatory car insurance.
3. Provision of Goods and Services
   • Direct provision: E.g., public safety services.
   • Public financing: E.g., air force carriers.
   • Facilitation: E.g., loan guarantees by Fannie Mae and Freddie Mac.

Effects of Government Intervention

Direct Effects

• Effects if no one changes their behavior in response to policy change.

Indirect Effects

• Changes in behavior due to policy change.
• E.g., a policy transferring money for wearing stripes could lead to more people wearing stripes.

Examples of Questions Addressed in Public Finance

• Does taxing interest earnings reduce savings?
• Does corporate income tax affect job creation?
• Does unemployment insurance extend unemployment spells?
• Does welfare discourage work?

Case Study: TANF (Temporary Assistance for Needy Families)

• Provides monthly checks to low-income families.
• Maximum benefit varies by state.
• Great Recession renewed debate on TANF due to increased demand and reduced state revenues.
• Discusses redistribution of benefits and work incentives.

Welfare Economics

• Study of determinants of well-being (welfare) in society.
• Consumer Surplus: Difference between willingness to pay and price paid.
• Producer Surplus: Difference between price received and cost of production.
• Social Efficiency: Sum of consumer and producer surplus.
• Deadweight Loss: Loss when competitive equilibrium is not achieved.

Social Welfare Functions

1. Utilitarian: Equating marginal utilities across individuals.
2. Rawlsian: Maximizing the welfare of the worst-off person.

Empirical Tools in Public Finance

• Time Series Regression: Analyzing co-movement of variables over time.
• Cross-Sectional Regression: Analyzing variables across individuals within the same time period.
• Challenges include addressing confounding factors, unobserved variables, and ensuring representativeness.

Case Study on Welfare Reform

• Examines the effects of reducing TANF benefits on incentives to work.
• Utilizes theoretical tools like constrained utility maximization, income, and substitution effects.

Conclusion

• Theoretical analysis and empirical evidence are crucial to understanding public finance.
• Public finance involves studying both the direct and indirect effects of government intervention and utilizing welfare economics to assess social preferences.