Reference Documents

1. PGS, TS.Phạm Văn Vận, ThS. Vũ Cương, Kinh tế công cộng, Nxb Thống kê, 2006
2. Joseph Stiglitz, Economics of the public sector, Third Edition, 2000
3. Jean-Jacques Laffont, Fundamentals of Public Economics, MIT Press, 1998
4. Donijo Robbins, Handbook of Public Sector Economics, Marcel Dekker/CRC Press 2004
5. David Schultz, Encyclopedia of Public Administration and Public Policy, Facts On File Inc.; 2004

SECTION 1: INTRODUCTION

CHAPTER 1: INTRODUCTION TO PUBLIC ECONOMICS

I. Object and Methods to Study

1. Object to Study
What is Public Economics?
● The economic science deals with the government intervention in the market economy to
enhance economic efficiency and economic equity => Economics of the Government (kinh tế
học về chính phủ)
● P.E ⇒ Gov ⇒ Social welfare: Max and Fair Distribution
● It studies how Government’s decisions are made.
● It analyses what decisions should be made.

2. Methods to Study
a. The Method of Positive Analysis
The positive analysis is about explaining why there is a public sector, how government policies
are chosen, and how these policies affect the economy.
● Analyzing the effect of the corporate tax on inward investment is an example of positive
analysis.

b. The Method of Subjective/Normative Analysis

The normative analysis investigates what the best policies are, and aims to provide a guide to
good government.
● Example: should the level of pensions be indexed to average wages?
 ● Example: When we consider the construction of a bridge, with the method of subjective
analysis, we will find whether there are other better solutions: ex buy barges, ships instead of
bridges…

Q&A: True or False?

(1) Normative statements describe how the world is, while positive statements prescribe how the
world should be. F
(2) Positive statements are descriptive (miêu tả) while normative statements are prescriptive (lí
thuyết). T
(3) Positive statements can be evaluated using data alone, but normative statements cannot. T
(4) "Society would be better off if the welfare system were abolished" is a normative statement, not a
positive statement. T
(5) "Other things equal, an increase in supply causes a price decrease" is a normative statement, not a
positive statement. F

II. The Four Questions of Public Economics

1. When Should the Government Intervene in the Economy?
● Normally, competitive private markets provide “efficient” outcomes for the economy.
● Generally hard to justify government intervention in markets. But two main justifications are:
○ Market failures: Problems that cause a market economy to deliver an outcome that does not
maximize efficiency.
○ Redistribution: The shifting of resources from some groups in society to others.

a. Market Failure: Efficiency Unachievable

● Market failure arises when efficiency is not achieved.
● Sources of market failure:
○ monopoly
○ public goods
○ externalities
○ asymmetric information
● Market failure may justify additional government intervention
○ it must be tested whether intervention is beneficial
○ government cannot always improve upon the unregulated economy
 b. When There is No Equity: Redistribution
● Government intervention is also motivated by
○ inequality of income
○ inequality of opportunity
○ inequality of wealth.
● Redistribution of resources
○ alleviates these inequalities
○ may raise welfare
● Two conflicting aims
○ efficiency
○ equity
● Optimal policy
○ the correct trade-off between equity and efficiency

2. How Might the Government Intervene?

If the government wants to intervene in a market, there are several options:
● Using the price mechanism with taxes or subsidies.
○ The government can directly restrict the private sale or purchase of goods that are
overproduced.
● Mandate that either individuals or firms provide the good.
○ The government can mandate the private purchase of goods that are underproduced and force
individuals to buy that good.
● Public Provision
○ The government can provide the good directly, in order to potentially attain the level of
consumption that maximizes social welfare. Ex: the Medicare program for elderly citizens.
● Public Financing of Private Provision
○ Governments may want to influence the level of consumption but may not want to directly
involve themselves in the provision of a good.
○ Medicare prescription drug cards, where private companies administer the drug insurance.

3. What Are the Effects of Alternative Interventions?

Much of the focus of empirical public economics is assessing the “direct” and “indirect” effects of
government actions.
 ● Direct effects of government actions assume “no behavioral responses” and examine the intended
consequences of those actions.
● Indirect effects arise because some people change their behavior in response to an intervention.
This is sometimes called the “law of unintended consequences.”

4. Why Do Governmenlo9i,ts Do What They Do?

● Governments do not simply behave as benign actors who intervene only because of market
failure and redistribution.
● Political economy: the theory of how the political process produces decisions that affect
individuals and the economy
● Tools of political economy help us understand how governments make public policy decisions.
○ Just as market failures can lead to market inefficiency, there are a host of government failures
that lead to inappropriate government intervention.
● For example, substantial variation across developed countries in health care delivery suggests
efficiency and redistribution are not the only considerations.
○ U.S.: Private health insurance
○ Canada: National public health insurance
○ Germany: Mandates private health coverage
○ U.K.: Free national health care
○ Thailand?

III. Generality about the Government

1. The Government and Major Roles in the Market Economy
a. Definition of Government
● Is an organization that is the governing authority of a political unit.
● Elected by the society, the government regulates individual behavior in this society (=
regulator), and its activities are for a better society.

b. Functions of the Government

● Maintaining the legal and social framework
● Providing public goods and services
● Maintaining competition
● Redistribution income
● Correcting for externalities
 ● Stabilizing the economy

2. Government Failure When Intervention in the Market Economy

● Government failure refers to situations where allocative efficiency may have been reduced
following government intervention in markets designed to correct market failure.
● Government failure if Asymmetric information
Imperfect information:
○ Lack of knowledge of:
■ Prices ■ Long term effects
■ Value ■ Behavioral changes
■ Costs ■ External costs and benefits
■ Benefits ■ Value of producer and consumer surplus
○ – all mean less than efficient allocation may result from government intervention.
● Government failure if there is own interest
Public Choice Theory:
○ Politicians, bureaucrats, and others acting on behalf of the ‘public’ may act in their own self-
interest as ‘utility maximizers’.
○ The ‘invisible hand’ may not work in the provision of public goods.
○ ‘Rent seeking’ or ‘Log rolling’ - two important concepts.

3. The Generality of Government Role in the History of Economic Theories

● Since XVth to XVIIth century
● Since XVIIth to XXth century
● Since the late 30s to 70s of the XXth century J.M.Keynes
● The years of 1980 of the XXth century: the neoliberalism
● Since the decade 1990: the mixed economy
SECTION 2: GOVERNMENT AND ECONOMIC EFFICIENCY
(market failures)

CHAPTER 1: IMPERFECT COMPETITION: THE CASE OF

MONOPOLY

★ INTRODUCTION

● Market failure occurs when freely functioning markets, operating without government
intervention, fail to deliver an efficient or optimal allocation of resources.
● Therefore economic and social welfare may not be maximized.
● This leads to a loss of economic efficiency.
 ■ 2 agents involving buyers and sellers
P
⇒ initial situation

S ■ 3rd person: non-market participants

■ SW R =Σ(CS+ PS) ~ Benefit to market
C participants
S
both sellers and buyers are → At Q , Σ(CS+ PS) is at the maximum level.
¿
P
happy ~ efficient equity
*
P ★ SW R =max → implication: no need for GI?
S ⇒ FALSE because the government always intervenes
O D to distribute SW fairly even if SW is at its
maximum level
Q Q Q Q
1 2 ⇒ We always need GI.
*

Normally, there are 2 agents in the market, but in some specific cases (market failure such as imperfect competition,
etc.) ⇒ need a 3rd person.

★ MONOPOLY
1. DEFINITION OF MONOPOLY
● While a competitive firm is a price taker, a monopoly firm is a price maker.
● A firm is considered a monopolist if . . .
○ It is the sole seller of its product.
○ its product does not have close substitutes.
● Monopoly power occurs when the seller of a product can influence prices
○ A single seller is a monopolist
○ There is an oligopoly if there are several sellers
● Monopsony power occurs when the buyer of a product can influence the price
○ A single buyer is a monopsonist
● Other cases: Oligopoly and Oligopsony

2. WHY MONOPOLY?
The fundamental cause of monopoly is barriers to entry.

● The reason a monopoly exists is that other firms find it unprofitable or impossible to enter the
market.
● Barriers to entry are the source of all monopoly power; there are two general types of barriers
to entry:
 ○ technical barriers
○ legal barriers

a) Technical Barriers to Entry

● The production of goods may exhibit decreasing marginal and average costs over a wide
range of output levels.
In this situation, relatively large-scale firms are low-cost producers.
○ firms may find it profitable to drive others out of the industry by cutting prices.
○ This situation is known as the natural monopoly.
○ Once the monopoly is established, the entry of new firms will be difficult.
● Another technical basis of monopoly is special knowledge of a low-cost productive
technique.
○ it may be difficult to keep this knowledge out of the hands of other firms.
● Ownership of unique resources may also be a lasting basis for maintaining a monopoly.

b) Legal Barriers to Entry

● Many pure monopolies are created as a matter of law:
○ With a patent, the basic technology for a product is assigned to one firm.
○ The government may also award a firm an exclusive franchise to serve a market.

c) Creation of Barriers to Entry

● Some barriers to entry result from actions taken by the firm
○ research and development of new products or technologies
○ purchase of unique resources
○ lobbying efforts to gain monopoly power
● The attempt by a monopolist to erect barriers to entry may involve real resource costs.
 d) Economies of Scale as a Cause of Monopoly

3. RECAP ABOUT MONOPOLY

★ MONOPOLY vs. COMPETITION

MONOPOLY PERFECT COMPETITION

No. of market Sole seller, with many buyers Many sellers, with many buyers
participants

Product Unique Identical

Market power Yes → price maker No → price taker

Slope of DC Downward sloping Horizontal line (P*)

→ reduces the price to increase sales → sells as much or as little at the
same price

Barrier to entry Yes (technical, legal) No

→ economies of scale
<at a high enough level of Q, unit
costs/average costs/marginal costs are
reduced>

● For a competitive firm, price equals marginal cost: P=MR=MC

● For a monopoly firm, price exceeds marginal cost: P> MR=MC

★ MONOPOLY’S REVENUE
 ● Total revenue: TR=P . Q
TR
● Average revenue: AR=P=
Q
ΔTR
● Marginal revenue: MR=
ΔQ
⇒ A monopolist’s marginal revenue is always less than the price of its goods.
○ The demand curve is downward sloping.
○ When a monopoly drops the price to sell one more unit, the revenue received from
previously sold units also decreases.

★ PROFIT-MAXIMIZATION FOR A MONOPOLY

■ A → intersection of the MR and

P MC curve determining the profit-
monopoly’s
profit MC maximizing quantity.
■ The price consistent with this
B quantity is shown by the demand
P
m curve (at B)
monopoly’s ATC ⇒ Because monopolists are price
price A makers, to satisfy the downward
⇒ determined by
demand represents the price curve ~ sloping DC, they should lower their
D the willingness to pay of the
buyer prices, resulting in the rev. received
upon the sale of an additional unit
O Qm Q is lower than ATC.
ax revenue received when
M an additional unit is ⇒ This explains why MR is lower
R sold
than DC.

★ MONOPOLY’S PROFIT

Profit ¿ TR−TC= ( TRQ − TCQ ) .Q=( P−ATC ). Q

The monopolist will receive economic profits as long as the price is greater than ATC.
If P= ATC ⇒ π=0
When the monopoly firm maximizes its profit, what happens to SW?
If SW < maximum, how would the government intervene? ⇒ what would be the effects?

4. DEADWEIGHT WELFARE LOSS UNDER MONOPOLY

↳ monopoly = failure
 ■ P1 ⇒ monopoly price
P
CS ■ P2 = MSB = MSC ⇒ competitive price
transferred to MC =
MSC ⇒ a monopoly produces less than the social optimum
monopoly
firm
C ● MC = S under perfect competition
P
1 S ○ Σ(CS+ PS)=SW ⇒ when Q is higher or
P lower than Q2, (CS+ PS) is not at its
2 P
MC maximum.
S
D ○ Qreal =Q1⇒ a part of CS is transferred to the
W AR = MSB
PS.
M L =D
R ⇒ SW under monopoly is lower than that under
O Q1 Q2 Q
monopoly output ↵ perfect competition
⤷ perf. comp. output
⇒ DEADWEIGHT WELFARE LOSS

5. PUBLIC POLICY TOWARDS MONOPOLIES

★ Public policy towards monopolies (in general)
Government responds to the problem of monopoly in 1 of 4 ways:
■ Making monopolized industries more competitive (FDI)
■ Regulating the behavior of monopolists.
⤷ price regulation
■ Turning some private monopolies into public enterprises
⇒ QUỐC HỮU HÓA [Keynesian period policy]
For example, (1) railway
(2) MS Office directly sold to buyers
⇒ The US government forced MS to share the installation/disk (?) with other
competitors.
■ Doing nothing at all

★ Regulation of Monopoly
■ The natural policy is to encourage competition.
■ This can be done directly by enforcing the division of monopolists…
For example, US antitrust legislation applied to Standard Oil (1911) and Bell System (1984) ⇒
division into separate competing firms.
■ … or by reducing barriers to entry:
○ Technology barriers can be reduced by an insistence on knowledge sharing.
For example, the US insists Microsoft provides information.
○ Legal barriers can be removed by changing the law.
But why were they imposed in the first place?
○ Patents are also a barrier to entry
● Optimum length trades reward for innovation against stifling competition.
 ○ Advertising and excess capacity can be part of an entry deterrence strategy.
● Advertising expenditure can be limited (e.g. tobacco).
● Providing excess capacity is held to deter entry is difficult.

★ Regulation of a Natural Monopoly ⇒ large scale of production/economies of scale

■ Natural monopolies such as the utility, communications, and transportation industries are
highly regulated in many countries.
■ Many economists believe that it is important for the prices of regulated monopolies to reflect
marginal costs of production accurately.
■ An enforced policy of marginal cost pricing will cause a natural monopoly to operate at a
loss.
Natural monopolies exhibit declining average costs over a wide range of output.

Because natural monopolies exhibit decreasing costs,

P M D MC falls below AC.
R
An unregulated monopoly will maximize its profit at Q1
and P1.
P If regulators force the monopoly to charge a price of P2,
1
the firm will suffer from a loss because P2 < C2.
C A
1 C ● Q1 = Qm → MC = MR
C
P2 M ● Q2 = QPC → P = AR = MR = MC
2 C <Q without monopoly>
O Q1 Q2 Q

○ Marginal-Cost Pricing for a Natural Monopoly

P
D

AT AT ⇒ P = MC
C C
Regulate M
d Price Loss C

O Q0 Q

○ Pricing for a Natural Monopoly as AC

 ★ Interpretation:
P
CS before ○ Without GI: monopolist produces at Q1 =
D GI
Qm
○ With GI: P = AC

P1 = ⇒ Q ↑ from Q1 to Q2; P ↓ from P1 to ATC

Pm D → π=0
WL
A A
TC T
P M ⇒ Buyer: CS ↑
C
0 C
M Society: SW ↑, DWL ↓ (DWL always > 0)
O R
Q1 = Q Q0 = QPC Q
Qm 2 = Q*

Usually, the government asks monopolists to produce at a specific price around the AC so they could
maintain the production while DWL is kept as low as possible.
In theory, P = AC is called the 2nd best price.

■ P = MC is the first best price.

○ For the Seller: ● P ↓ from Pm to P0 = MC

● Without GI, the firm produces at Qm, but with GI, it produces at Q0 ⇒
Q↑
● P = MC < P = AC
⇒ Firm suffers from a loss since π <0

→ In the long run, normally, firms will not be able to continue to produce → Gov has to intervene.
⇒ When P is set at MC, firms may close the production soon → Gov should subsidize the firms with the
tax/subvention to monopolists.
○ For the Buyer: CS ↑
○ For the society: SW is maximized at Q0

⇒ The government prefers P = AC (the 2nd best price) as they do not need to further intervene.

○ Price discrimination

■ Different prices for the same product depending on the situation.

→ 3 level / 3-tier price discrimination
 ● Type of contract: wholesale (higher P) & retail (lower P)
● Time of contract: end-season sale, opening ceremony sale, birthday sale
● Type of customers: rich (higher P) & poor (lower P)

■ Two important effects of price discrimination:

● It can increase the monopolist’s profits.
● It can reduce deadweight loss.

■ But in order to discriminate price, the firm must:

● Be able to separate the customers from the basis of willingness to pay.
● Prevent the customers from reselling the product.

○ In case of no GI, monopolists wish to maximize their revenue & clear the store. Normally, the firm
will actively apply the two first types of price discrimination.
○ The firm has no incentive to apply the 3rd price discrimination because π is lower (as for the poor, P
< Pm) → loss of profit ⇒ Gov will intervene.
○ But there is an indirect effect:
Poor people consume with lower P but no real necessities (?)
→ they sell the product to the rich
→ both benefit while the firm suffers from a loss.

■ Two-part price
○ Without GI, P = Pm
○ P: ● Fixed part price ~ fixed value
● Variable part price ~ MC ~ suffer loss
 Suppose that the regulatory commission allows the
P monopoly to charge a price P1 to some users while
offering the lower price of P2 to other users.
D
The profits on the sales to high-price customers are
enough to cover the losses on the sales to low-price
customers.

P1 Another approach followed in many regulatory

situations is to allow the monopoly to charge a price
C1 above marginal cost that is sufficient to earn a “fair”
AT rate of return on investment.
C2
C
M If this rate of return is greater than that occurring in
P2 a competitive market, there is an incentive to use
C
relatively more capital than would truly minimize
costs.
O Q Q Q
1 2

Exercise 1: A Monopolist has a total cost function C(q) = 1000 + 5Q and a demand function
P = 200 - 5Q, where P is price and Q is output. Use this information to calculate
a. The profit-maximizing price and the quantity
b. Maximized profit of the monopolist
c. If with GI, the monopolist must set the price at MC ⇒ profit of firm and welfare of the society
d. DWL and loss in CS under monopoly relative to the case of best welfare outcome.

a. Demand curve: AR=P=200−5 Q ⇒ TR=AR . Q=200 Q−5 Q 2 ⇒ MR=200−10Q

A monopolist maximizes its profit at a point where MR = MC
⇒ 200−10Q m=5 ⇒ Q m =19.5⇒ Pm =102.5

b. π=Rev−Cost =(102.5× 19.5)−(1000−5× 19.5)=901.25

c. P1=MC=5 ⇒ Q 1=39

π 1=Rev−Cost =(5 × 39)−(1000−5× 39)=−1000

1
SW= (200−5)39=3802.5
2
1
d. ΔCS= (19.5+ 39)(102.5−5)=2851.875
2
1
ΔSW = (39−19.5)(102.5−5)=950.625
2
MULTIPLE CHOICE
What is the main reason for a firm to be a monopoly?
(1) The Government’s policy
(2) The barrier to entry

When the regulated price equals MC,

(1) The monopoly will have the maximum profit
(2) The monopoly will produce at Qmonopoly
(3) The monopoly will suffer a loss
(4) The monopoly will have a zero profit

A patent could be considered a technical barrier to entry.

(1) False -> a legal barrier
(2) True

A Natural Monopoly is most likely to exist when

(1) There is government regulation of the industry
(2) There are long-term patents
(3) There are large economies of scale
(4) There are large barriers to entry

A Monopsonist is
(1) A single seller with many buyers
(2) A single buyer with many sellers
(3) Several buyers with many sellers
(4) Several sellers with many buyers

Comparing a monopoly and a competitive firm, the monopolist will:

(1) Produce more at a lower price
(2) Produce less at a lower price
(3) Produce more at a higher price
(4) Produce less at a higher price
A competitive market will always be more efficient in the allocation of resources than a market
dominated by a few big suppliers/firms:
(1) False
(2) True

Monopolies
(1) Will set a higher price and a higher level of output than would be set under competition
(2) Will set a higher price and a lower level of output than would be set under perfect
competition
(3) Will set a lower price and a lower level of output than would be set under perfect competition
(4) Will set a lower price and a higher level of output than would be set under perfect competition

Why are monopolistic markets thought to lead to an inefficient allocation of resources?

(1) Because they redistribute income from producers to consumers
(2) Because they will always have higher costs than competitive firms
(3) Because they restrict output and charge a higher price creating a deadweight loss of
economic welfare
(4) Because they are much less likely to use new technologies

The Monopoly would like to produce an optimal quantity at

(1) P = MC
(2) MR = MC
(3) AR = TC
(4) None of the above

When there is price discrimination, the monopoly will get the maximum profit
(1) False
(2) True
CHAPTER 2: EXTERNALITIES
Ngoại ứng

★ INTRODUCTION
Externalities arise whenever the actions of one party make another party worse or better off, yet the
first party neither bears the costs nor receives the benefits of doing so.
⤷ represents a market failure for which government action could be appropriate and improve
welfare.
⇒ How many types? 4
● In production: negative / positive
● In consumption: negative / positive

★ EXTERNALITY THEORY
a. NEGATIVE PRODUCTION EXTERNALITIES

● To understand the case of negative production externalities, consider the following example:
○ A profit-maximizing steel firm, as a by-product of its production, dumps sludge into a river.
○ The fishermen downstream are harmed by this activity, as the fish die and their profits fall.
● This is a negative production externality because:
○ Fishermen downstream are adversely affected.
○ And they are compensated for this harm.
⤷ Why? Because the river is a common resource, and fishermen cannot ask for
compensation. ⇒ TRAGEDY OF THE COMMONS

● The figure below illustrates each party’s incentives in this situation.

 ○ + = sum of CS & PS at Q1.
P SMC =
SW max PMC + → However, it does not represent the SW as
DW MD there is a 3rd person and its effect has not
L been taken into account yet.
S=
P2 PMC
○ The marginal damage curve (MD)
P1 represents the fishery’s harm per unit. / ~
marginal externality curve.
MD
(MEC) ⤷ Normally, MD is upward sloping, but in this
D= case, MD is supposed to be a horizontal line,
Q2 Q1 PMB representing the loss per unit paid by the 3rd
= SMB person. From society’s point of view, SMC
= MD * Q2 ⇒ total damage paid by the Q
3rd person at Q = Q2 must be equal to MC of the firm + MD paid
by the 3rd person.

○ The SMC is the sum of PMC and MD, representing the cost to society.
○ The socially optimal level of production is at Q2, the intersection of SMC and SMB.
○ The (created by the gap between the SMC and SMB) is the maximum SW.
○ The triangle is the DWL from the private production level (at Q1).

■ Why, in this situation, is PMB = SMB?

B refers to the utility, benefit, or anything that consumers could receive when consuming the products.
→ Answer: It is supposed that there is no externality in consumption, meaning that when consumers
get the benefit from the product they consume and that such consumption of steel by the
consumers does not bring about any benefit nor cost to the 3rd person. ⇒ Therefore,
PMB = SMB.
Normally, SMB = PMB + MB of the 3rd person (which, in this situation, equals 0)
If externalities arise in consumption, SMB shall be different from the PMB.

■ GOVERNMENT INTERVENTION on a market activity that generates negative externality?

⇒ Common direction: minimize DWL
⇒ Policy: Pigovian/Pigouvian (Pigou) taxation → producers must pay the tax to the gov.
 → the graph explaining the mechanism a
Psteel SMC = PMC
market fails due to the negative
SW max + MD
externalities in production.
SW
loss S= ■ Before GI, the river was a common resource.
P2 PMC → the fishermen have to pay the MD.
■ At Q2 (optimal quantity), SMB = SMC, SW is
P1 CS + maximized.
PS
MD ⇒ For any Q < Q2: SW is not maximized.
(MEC) ⇒ For any Q > Q2: the society suffers from
D= welfare loss.
PMB
= SMB
Q2 Q1 Qstee
l

[2nd question - HOW?] The common direction is to lower DWL. (using Pigou tax to reduce Q and raise
P).
⇒ The tax will be imposed by the government on the producer, with the unit tax = MD. The new PMC
shall then move towards the SMC. (as SMC = PMC + MD = PMC + tax)
⇒ Q2 - optimal quantity will then be achieved by Pigouvian tax.

[3rd question - WHAT EFFECT?]

→ the tax generates direct effect:
○ To the producer: higher P and lower Q
○ To the society: no more DWL.

★ When the government intervenes to achieve the optimal Q, does

P the damage to the fishermen equal to 0?
→ NO. The loss to the 3rd person is always > 0.
★ If the 3rd person always suffers loss from production, why does
the government not close the production of the company so that
MD
(MEC) the damage to the 3rd person is 0?
○ Damage = 0 ~ no production
Q2 Q1 Q ○ As the government represents everyone in the economy, they
do not act solely in the favor of the 3rd person but also of the
= MD * Q2 ⇒ total damage paid by
the 3rd person at when optimal Q is whole society.
achieved ○ Even when the government intervenes, the 3rd person still
suffers from losses; however, these losses are compensated by
(SMB - SMC) = SW > 0.

★ General Situation of Negative Externalities in Production

 SMC = PMC +
Psteel MD

DWL S = PMC

P2
P1 △SW = △(CS + PS)

MD (MEC)

D = PMB
Q2 Q1 = SMB

△damage Qsteel

b. POSITIVE PRODUCTION EXTERNALITIES

○ In the case of positive externalities in production,

P S= SMC is lower than PMC.
PMC
→ the market quantity (Q1) is lower than the optimal
SMC = PMC - quantity (Q2).
P2 DW MEC ○ Always: DWL is created by the gap between
L SMC and SMB (from Q1 → Q2).
P1
→ the government should intervene to minimize the
DWL.
D = PMB =
SMB ⇒ Policy: subsidy → Pigouvian subsidy to the
producers = MEB of the 3rd person.
⇒ PMC shifts downward, to the right, to the
Q2 Q1 Q position of SMC ⇒ optimal quantity Q2
achieved.
⇒ P is lowered, Q is raised.

c. NEGATIVE CONSUMPTION EXTERNALITIES

 (Without GI, there is no way that smokers will pay for
Pcigarettes the compensation.)
+ = (PS + CS) ○ PMC = SMC because in this case, production
max activities are not analyzed → suppose that there are
S=
PMC no externalities in production, only the consumers’
DW behavior is taken into account. <imagining
L cigarettes are imported>
P1
P2 ○ PMC ∩ PMB=Q1 → market / real quantity
M ⇒ At Q1, the benefit of market participants (sellers
D and buyers) is maximized.
D=
SMB = PMB - PMB ○ MD represents the impact to the 3rd person (non-
MD
SW (at Q2 Q1 Qcigarette smokers). In reality, MD is supposed to be upward
Q2) s sloping, but in this situation, MD is deemed to be
constant.

○ From the society’s viewpoint (SMB), every benefit from the consumption of cigarettes is deducted by the
value of MD (the damage of the 3rd person).
⇒ SMB is, therefore, on the left side of PMB.
⇒ In the case of positive consumption externalities, SMB is higher and on the right of PMB.
○ MC ∩ SMB=Q 2 → social/optimal quantity
⇒ At Q2, the SW is maximized.
○ When Q > Q2 ⇔ SMC > SMB, resulting in the DWL of the society.

[?] Why is SW lower than the market participants’ benefit/surplus?

⇒ because in this situation, the loss to the 3rd person must be taken into account.

[2nd question - HOW?] ⇒ The POLICY that should be applied is tax (unit tax = MD).
→ this tax must be paid by the CONSUMERS.
⇒ resulting in consumers having a lower willingness to pay ⇒ demand curve moving to the left (towards
SMB)
⇒ Q2 is achieved.

○ In the case of negative externalities in consumption, Gov must intervene and change the behavior of
consumers (not producers) by applying a tax on the consumers.
○ In the case of positive externalities in consumption, there is MEB and SMB = PMB + MEB. The market
quantity is then lower than the optimum quantity.
→ the government should apply subvention to the consumer so that the demand curve moves to SMB and
that Q optimum is achieved.
 … in on
production producers
NEGATI
TAX
VE
… in on
SUMMARY of consumption consumers
EXTERNALI
TIES … in on
production producers
POSITIV SUBVENTI
E ON
… in on
consumption consumers

★ SOLUTIONS FOR THE PRIVATE SECTOR - THE COASE THEOREM

Hypothesis ■ The Coase Theorem: when there are well-defined property rights and costless
bargaining, then negotiations between the parties will bring about the socially
efficient level.
⇒ The author of this theorem is an economist conducting research on negative externalities
in production → found out all major reasons leading to the problem of Tragedy of the
Commons / common resources.

Conclusion ■ Thus, the role of government intervention may be very limited - that of simply
enforcing property rights.

■ Consider the Coase Theorem in the context of the negative production externality
example from before.
⇒ The fishermen are given property rights over the amount of steel produced.
○ According to the hypothesis:
(1) The river is no longer the common resource but is now a private asset (either the company or the
fishermen could own)
(2) Costless bargaining: The negotiation between who causes the externality and who suffers from
the damage will not result in any considerable cost.
⇒ bring about a socially efficient level ⇒ optimum quantity achieved.

⇒ Government intervention is restricted.

○ When the fishermen become the owner of the river, the favorable Q to be produced is 0 so that no
more sludge is emitted. ⇒ no production since initial Q = 0.

★ Negative Externalities in Production and Bargaining

 Suppose that Q is accepted to be 1:
Psteel SMC = PMC
B + MD → is the effect to the fishermen (damage)
C ⇒ the firm must pay at least this amount of
E S= compensation to the fishermen
P2 PMC
is the benefit to the society (SW at Q1)
P1 ABCD is the benefit to the company at Q1
MD The firm would prefer to produce at Q = 2 where there
F (MEC) would be an additional benefit to the firm represented by
A D D=
PMB the area CDEF, additional SW represented by the area.
= SMB However, at Q = 2, there would also be additional damage
O 1 2 Q2 Q1 Qstee to the fishermen represented by the area.
l

The negotiation shall end at Q = Q2.

⇒ If the negotiation continues to set a quantity of Q > Q2, the damage to the 3rd person keeps rising while the
benefit to the firm declines.
→ The firm cannot afford compensation that is higher than the marginal profit received from an additional unit
sold and the 3rd person cannot accept compensation that is lower than the damage.

(*) The negotiation shall also end at Q = Q2 even if the river is owned by the firm.
[?] If the river is owned by the firm, what could be the initial quantity decided to be produced?
→ Q1. At Q1, the PS is maximized but the damage (Q1*MD) is high enough so that the fishermen have the
incentives to ask for a reduction in production (a lower Q).

○ If after negotiation, the Q is at Q3:

Psteel SMC = PMC
+ MD → the damage is lowered by the amount of , but the
firm suffers from a profit loss of .
DWL
reduced S= → This profit loss is also the minimum compensation
P2 PMC that the fishermen should pay to the producer.

P1 Firm’s profit ⇒ The negotiation should end at Q2 because at any Q

loss < Q2 (equivalent to one additional cut-back unit),
MD the loss of firm would be higher than the benefit to
(MEC) the fishermen gained from one unit cut back. Also,
D = PMB =
the firm would not accept any compensation that is
Q2 Q3 Q1 SMB
lower than its loss in marginal profit.
O Damage Qstee
lowered l

■ Through a process of bargaining, the steel firm will bribe <~give sb money to persuade them> the fishery to
arrive at Q2, the socially optimal level.
■ After that point, the MD exceeds (PMB - PMC), so the steel firm cannot come up with a large enough
 compensation to further expand production.
■ Another implication of the Coase Theorem is that the efficient solution does not depend on which
party is assigned with the property rights, as long as someone is assigned.
■ The direction in which the bribes go does depend on the assignment, however.

PROBLEMS WITH COARSIAN SOLUTIONS

1. THE ASSIGNMENT PROBLEM relates to two issues:

○ It can be difficult to truly assign blame.
⤷ if the owners of the river are fishermen, but there are many steel producers → who will be paying the
compensation?

○ It is hard to value the marginal damage in reality.

2. THE HOLDOUT PROBLEM arises when the property rights in question are held by more than 1 party.
○ The shared property rights give each party power over all others,
→ this could lead to a breakdown in negotiations.
3. THE FREE RIDER PROBLEM is that when the investment has a personal cost but a common benefit,
individuals will underinvest.
⤷ For example, if the steel firm were assigned property rights and you are the last (of many) fishermen to
pay, the bribe is larger than the marginal damage to you personally. ⇒ This means that someone refused
to pay the compensation but is still benefiting from the resources.
4. TRANSACTION COSTS & NEGOTIATION PROBLEMS
⤷ It is hard to negotiate when there are a large number of individuals on one or both sides.

⇒ IN SUMMARY: The Coase Theorem is provocative, but perhaps not terribly relevant to many of the most
pressing environmental problems.
⇒ not applicable in reality.

★ SOLUTIONS FOR THE PUBLIC SECTOR

⤷ Coasian solutions are insufficient to deal with large-scale externalities. Public policy makes use
of these three types of remedies to address negative externalities:
○ Corrective taxation = MEC (or MD)
○ Subsidies = MEB
○ Regulation (on quantity for the case of negative production externalities)

Exercise 1: Suppose that there is a market of steel with Q S = 10P - 270, QD = -2P + 150 (Q: tons; P:
million VND/ton)
The production of steel creates an external cost to the citizens, which is represented by MD curve: P = 3
a. Calculate the efficient quantity for the market and the efficient quantity for the society.
 b. Calculate the DWL when there is no government intervention?
c. When the efficient social quantity is achieved, count the loss in CS and the loss in PS?
d. If the government decides to tax the production of steel, how much money could the government
receive?
Reply to the same questions with MD = 0.1Q

With MD = 3

1
Psteel ○ S = PMC: P= Q +27
SMC = PMC + 10 S
75
SW max MD
−1
○ D: P= Q +75
SW S= 2 D
loss PMC
1
P2 = 37.5 ○ SMC: P= Q +30
P1 = 35 10 S
a. The efficient quantity for the market is
30 D= the quantity at which PMC = PMB.
PMB 1 −1
27 Q 1 +27= Q +75 ⇒ Q 1=80
= SMB ⇒
3 MD 10 2 1
(MEC) The efficient quantity for the society is
Q2 = Q1 = 80 Qsteel the quantity at which SMC = SMB.
75
1 −1
⇒ Q 2 +30= Q +75 ⇒ Q2=75
10 2 2
c. CS at market’s efficient quantity Q 1=80 is:
b. When there is no government
1 intervention, the produced quantity is
CSQ = (75−35) 80=1600
2
1
Q 1=80 ; deadweight loss is the area of
the triangle generated by SMC and SMB,
from Q2 to Q1:
1
DWL= (Q 1 −Q 2) MD=7.5
2
1
CS at socially efficient quantity Q 2=75 is: CS Q2 = (75−37.5)75=1406.25
2
⇒ Loss in CS: ΔCS=−193.75
1
PS at market’s efficient quantity Q 1=80 is: PSQ = (35−27)80=320
2 1

1
PS at socially efficient quantity Q 2=75 is: PSQ = (37.5−30) 75=281.25
2
2
⇒ Loss in PS: Δ PS=−38.75
d. If the government decides to tax the production of steel, the unit tax shall be: t=MDQ❑
Exercise 2: There is some information concerning a market of tobacco (suppose that it is a case of a
negative externality in consumption):
PS = 160 + 4Q; PD = 230 - 3Q; MD = 1.5Q
a. Count the social optimal quantity and the private optimal quantity.
b. Calculate the DWL when producing at the private quantity
c. If the government uses tax to regulate this negative externality, how much tax could be collected?
d. Show your results in a graph of illustration.
CHAPTER 3: PUBLIC GOOD

★ WHAT ARE PUBLIC GOODS?

● Pure public goods have 2 traits:

○ They are non-rival in consumption. The marginal cost of another person consuming the good
is zero and does not affect your opportunity to consume the good.
⇒ the product/good is always available for consumption without needing to produce more units
or paying extra costs for any additional unit
For example, fireworks <non-rival> vs. ice cream <rival>
⤷ GI towards consumer behaviors, not on the production activities.
○ They are non-excludable. There is no way to reject someone from the opportunity to
consume the good.

Example Defining pure and impure public goods.

Is the good rival in consumption?

Yes No

Ice cream Cable TV

Yes
Is the good ⤷ private goods ⤷ impure public goods
excludable? Crowded city side-walk National defense
No
⤷ impure public goods ⤷ pure public good

(*) Impure public goods only have 1 out of the 2 characteristics.

○ Other public goods: fireworks, clean air, radio, and television broadcast signals.

★ DEMAND FOR A PRIVATE GOOD

 ○ Tom has an individual downward-sloping DC for ice
P There is a market
supply curve cream.
associated with
producing ice cream
○ At a price of $3, neither Tom nor Jerry demands much
ice cream.
S=
SMC ⇒ Adding up Tom’s and Jerry’s individual demands at $3
$ gives the society’s demand at $3.
3
○ At a price of $2, both demand more ice cream.
$
⇒ At the competitive equilibrium of $2, Tom and Jerry
2
consume different quantities.

○ Suppose there are 2 consumers in the market.

DJerr DTo Dtotal = When P rises from $2 to $3, both consume less.
y m
SMB When P declines from $3 to $2, both consume more.
O QJ QT Qtota Q
l ○ SMC ∩ SMB=Q total: CS & PS are maximized.
○ At equilibrium: Q of individuals are different; Q of
the market = sum of individual Q with the same price.

★ OPTIMAL PROVISION OF PRIVATE GOODS

■ In the figure above, as price adjusted, each person changed his quantity consumed.
■ For a private good, consumers demand different quantities at the same market price.

★ DEMAND FOR A PUBLIC GOOD

○ SMC ∩ SMB={Q¿ =5 ; P=3 }

Pfireworks Adding up Tom’s and Jerry’s
willingness to pay gives the → social optimum Q → SW is maximized
society’s demand for 1
fireworks.
(*) When should the government intervene?
$6 (it is not like when comparing the market with and without
SWmax monopoly, or with and without externalities)
S=
→ Private sector decision of consumption provision (
SMC
$4 SW Q ) ≠ Optimum provision (social viewpoint) (
R

SW Q )¿

$3
Dtotal = SMB Q R is determined by the customer’s decision.
$2 Analyzing individual’s consumption behavior:
<graph below>
DJerry
$1
● DTom ∩ SMC=QTom
DTom
→ The trapezoid made up of SMB and SMC (from 0 to
O
1 5 Qfireworks QT ) is the social welfare at Q T .
 → The triangle made up of SMB and SMC (from QT
Pfireworks
onward) is the deadweight loss at Q T .
SWQTom
● DJerry ∩SMC =QJerry
→ The trapezoid made up of SMB and SMC (from 0 to
Q J ) is the social welfare at Q J .
S=
DWLQT SMC QJ
om
→ The triangle made up of SMB and SMC (from
onward) is the deadweight loss at Q J .

Dtotal = (*) How should the government intervene?

SMB ■ Common direction: encourage consumption
DJerr ■ Specific policy:
y
(1) Subsidize the consumer:
DTo
m ⤷ subsidize Jerry until Q* is achieved (why?
O
Q Q Q*= Qfirewor because it is less costly subsidizing Jerry)
T J
5 ks
⇒ D Jerry moves rightward: D ' Jerry =D Jerry + s
(s = per unit subsidy)

(2) Tax price <~ giá thuế>

○ The government prefers to subsidize the individual with a higher demand curve because the marginal
subsidy is lower.
→ CRITICISM: unrealistic because in fact, there are millions of consumers but limited capacity of provision by
the private sector.
○ Tax price: the amount of money that the consumers pay to the government to satisfy their needs.
⇒ Between subsidy and tax price, the government should apply tax price.
⤷ The effect of the tax price mechanism is that everyone is happy (always receiving surplus).
→ unit tax price = PMB at Q*
○ Provided by the government means the government organizes the consumption (by the public sectors)
→ The government determines the supply and the aggregate demand (Q*)

As per the graph above, Σtax price per unit=1+ 2=3 ⇒ Σtax price=3.Q =15
¿

⇒ Ban đầu, G cũng phải trả chi phí cung cấp hàng hóa nhưng được bù đắp bởi tax paid by consumers.

★ OPTIMAL PROVISION OF PRIVATE GOODS

■ Unlike the case of private goods, where AD is found by summing the individual demands
horizontally, with public goods, AD is found by vertically summing the individual demands.
■ That is, holding the quantity fixed, each customer has a different willingness to pay.
■ In general, the private sector underprovided public goods because of the free-rider problem.
★ THE FREE RIDER PROBLEM
The fundamental problem of all public goods is that I’d rather someone else paid for the public goods
I consume.
⤷ This is called the free-rider problem. → Game theories

★ PRISONERS’ DILEMMA IN ACTION

○ Imagine that it costs £4 to provide a clean street outside my house.
○ Either I or my neighbor can afford it. We value clean streets at £3.

He pays He doesn’t pay

I pay A (-1; -1) B (-1; 3) → the neighbor is free-rider

I don’t pay C (3; -1) D (0; 0) → dominant scenario

⤷ I am the free-rider
★ When is private provision likely to overcome the Free Rider Problem?
○ While the free-rider problem clearly exists, there are also examples where the private market
is able to overcome this problem to some extent, but the private market may still fall short of
the socially optimal amount.
○ Examples of private provision of public goods.
● Privately financed fireworks displays
● Privately owned British lighthouse until 1842.
○ Under what circumstances are private market forces likely to solve the free-rider problem?
● Intense preferences <some individuals care more than others>
● Altruism <many caring about the needs or outcomes of others & willing to help them>
● Utility from one’s own contribution to the public goods.
¿
⇒ the Q R ≪¿ Q under private provision → always needs GI.

★ PUBLIC SECTOR’S PROVISION OF PUBLIC GOODS

■ In principle, the government could solve the optimal public goods provision problem and then
either provide the goods directly or mandate individuals to provide the amt.
■ In practice, three problems emerge:
● Crowd-out <the private sector provide less>
● Measuring costs and benefits (CBA)
● Determining the public preferences <addressed in the field of political economics>
1. THE PROBLEM OF CROWD-OUT

■ In some cases, the private market may already be providing a socially inefficient level of the
private good.
→ Public provision may crowd-out some of the private provision - as the government provides
more of the public goods, the private sector provides less.
■ For example, in the fireworks example with Tom and Jerry, if one assumes:
○ Tom and Jerry care only about the total number of fireworks provided.
○ Government provision will be financed by charging equal amounts to each of them.
○ And the government provides no more fireworks than were being provided privately
beforehand.
→ Each dollar of the public provision will crowd out private provision one-for-one.
■ The full crowd-out in the fireworks example is rare, though partial crowd-out is much more
common and can occur when:
○ People who don’t contribute to the public good are taxed to finance its provision.
○ Or when individuals derive utility from their individual contribution as well as the
total amount of the public good provided.
■ If noncontributors are forced to pay for the good (but it is still below the social optimum),
then the contributors’ effective income levels are higher than before.
■ As a result of this income effect, contributors buy more if the public good is a normal good,
offsetting the crowd-out to some extent.
■ Alternatively, as discussed previously, there may not be a full crowd-out if an individual
cares about his own contribution (the warm glow model).
■ In this case, an increase in government contributions will not fully crowd out giving.

2. MEASURING COSTS & BENEFITS OF PUBLIC GOODS

■ Another problem for government provision is the measuring of costs and benefits of public
goods.
■ For example, improving a highway involves valuations of commuting time saved as well as
reduced traffic facilities.

3. DETERMINING PUBLIC GOOD’S PREFERENCES

■ Finally, our model of optimal public good provision assumes that the government knows each
person’s preferences over public & private goods.
Tax ⇒ State’s budget spending ~ which is considered by politicians (representants)
⤷ Public good/services (education, national defense, medical, transportation)
■ In reality, this runs into problems with preference revelation, preference knowledge, and
 preference aggregation.
⤷ There is no model in reality; politicians consider building plans on spending budget <~dự thảo
ngân sách> annually. (one for each ministry)
⇒ The National Assembly approves these plans at meetings where ministers would present and
convince others to vote.

⤷ In fact, there are millions of people and problems (such as the free-rider problem or the problem
arising when somebody hides their preferences to avoid the tax price).
⇒ hard to aggregate social preferences
⇒ hard to build an exact model.

EXERCIS Suppose there are 2 individuals in the market of a pure public good with 2 private DCs:
E P1 = 10 - 0.1 Q P2 = 20 - o.1 Q

a. If SMC1 = 15, calculate the socially efficient quantity and maximum SW.
b. If SMC2 = 30, calculate the socially efficient quantity and maximum SW.
c. Suppose the good is provided by the private sector (by either the 1st or the 2nd person), calculate
the real quantities (supposing that SMC = 15).
d. In your opinion, how should the government intervene in this situation? → tax price = ?
e. In your opinion, should the individuals show honestly their real willingness to pay? Explain your
answer.

a. From 0 to Q1max (= 100): Dt =D1+ D2=30−0.2Q

From Q1max to Q2max (= 200): D t =D 2=20−0.1Q
⇒ If SMC = 15, socially efficient quantity is: 30−0.2Q t =15 ⇔Q t =75

1
Social welfare: SW = 15.75=562.5
2
b. If SMC = 30, both socially efficient quantity and social welfare equal 0.
c. SMC = 15 ⇒ real quantity: 20−0.1Q 2 =15 ⇔ Q R =Q 2=50
d. The first way of intervention is subsidizing the individual with a higher demand curve in order to lessen the
cost of subvention.
 ⇒ The subsidy will result in the demand curve of the
P second person shifting upward and to the right until
30 Dt = SMB 1st and 2nd person’s the intersection of D2 and SMC generates a quantity
willingness to pay at Qt of Q2 = Qt.
⇒ The unit subsidy is the gap between D2 and D2’:
22.5 D’2 SW s=22.5−20=2.5
20 The second way of intervention is imposing tax
D2 prices. At Qt = 75, the 1st person’s willingness to
S=
15 SMC1
pay is 2.5, while that of the 2nd person is 12.5.
12.5 Summing up these two individuals' willingness to
D1 pay, we have the unit tax price being 15.
10
e. From society’s viewpoint, they should be honest in
revealing their preferences in order to maximize the
SW. However, in reality, people will try to avoid
2.5
doing that so that they can evade taxes.
O Q2 Qt Q1max Q2max Q

→ The government cannot control the behavior of every single one in the economy.

APPENDIX
★ PUBLIC PROVISION & OVERCONSUMPTION

P P

D Welfare loss from

Welfare loss
excessive consumption
from excessive
(benefit < cost) D
consumption

M M
C C

DWL DWL

O Q O Q
Qe Qm Qe Qm

No price ⇒ Q = Qm ; Qe → Qm ⇒ MB < MC ⇒ more elastic products

⇒ For some goods, such as water, supplying the ⇒ For other goods, such as certain medical services,
goods freely rather than at MC results in relatively supplying the goods freely rather than at MC
little additional consumption. results in excessive consumption.
(not considering the cost when providing the goods
freely)

→ DISTORTIONS ASSOCIATED WITH FREE SUPPLY OF GOODS:

 ● The more-elastic product causes higher DWL
● The less-elastic product causes lower DWL

★ COST OF EXCLUSION / TRANSACTION COST <chi phí loại trừ>

Example: Service: bridge
P
D MC ∩ MB(¿ D)=Q 0 ⇒ optimum quantity
● If the government intervenes by public provision ⇒
overconsumption.
P* Maximum quantity (Qm) consumed ⇒ traffic jams.
transaction ● If the government intervenes by the cost of
cost D
exclusion → no more overconsumption.
W
MC = c
L
c
(production [P* > MC, transaction costs DO NOT directly relate to
cost) production costs]
O Q0 Qe Qm Q

● For many goods, the issue is not so much the feasibility (= possibility) of rationing, but the
cost. The costs associated with the exclusion for private goods as well as for public goods are
called transaction costs.
● When transaction costs are sufficiently high, it may be more efficient to supply the goods
publicly than to have the goods supplied by the private market.
⇒ Cost of exclusion is used to exclude those who do not want to pay the cost ⇒ restricting the number of
consumers: Qm (without) < Q0 (with exclusive cost)

★ UNIFORM PROVISION (before Renovation)

P
DISTORTIONS ASSOCIATED WITH THE
UNIFORM PROVISION:
→ When publicly provided private goods are
c D supplied in equal amounts to all individuals,
MC of
W some get more than their sufficient level and
L productio
some get less.
n

⇒ For high-demander: Q* < Q1 → loss of benefit

DC of high-
For low-demander: Q* > Q2
demander
DC of low-
O Q Q Q1 demander Q
2
*
CHAPTER 4: ASYMMETRIC INFORMATION

★ INTRODUCTION

● Information in Competitive Markets:

In purely competitive markets all agents are fully informed about traded commodities and
other aspects of the market.

● Asymmetric Information in Markets

○ Markets with one side or the other imperfectly informed are markets with imperfect
information.
○ Imperfectly informed markets with one side better informed than the other are markets
with asymmetric information.
e.g:
■ A doctor knows more about medical services than does the buyer.
■ An insurance buyer knows more about his riskiness than does the seller.
■ A used car’s owner knows more about it than a potential buyer.

● Asymmetric Information
○ Asymmetric information exists when either the buyer or the seller in a market exchange
has some information that the other does not have.
○ Information can cause the buyer or seller to lower the demand or supply of the good in
question.

★ ASYMMETRIC INFORMATION IN A PRODUCT MARKET AND IN A FACTOR

MARKET
a. ASYMMETRIC INFORMATION IN A PRODUCT MARKET
 S1 =
MPC
Price and

E
E 1
Cost

2
D1 = MPB1
(asymmetric
information)
D2 = MPB2
(symmetric
O
information)
Q Q Quan
Output 2 1 Output tity
with with
symmet asymm
ric etric
informa informa
tion tion

b. ASYMMETRIC INFORMATION IN A FACTOR MARKET

Wage S2 = MPC2
Rate (symmetric
Wage information)
with S1 = MPC1
symme E (asymmetric
tric W 2 information)
inform 2
ation W E
1 1
Wage
with D1 =
asymm MPB
etric O
inform Q Q Quantity of
ation Quantity of 2 1 Quantity ofLabor
labor with labor with
symmetric asymmetric
information information

[?] Is There Market Failure?

● Asymmetric information seemingly resulted in “too much” or “too many” of something – either
too much of a good being consumed or too many workers working for a particular firm.
● The point is whether or not the asymmetric information fundamentally changes the outcome from
 what it would be if there were symmetric information.
● The presence of asymmetric information does not guarantee that the market fails. What
matters is whether the asymmetric information brings about a different outcome than the outcome
that would exist if there were symmetric information. If this occurs, the case for market failure
can be made.

★ ASYMMETRIC INFORMATION IN MARKETS: APPLICATIONS

a. ADVERSE SELECTION
● Some economists argue that under certain conditions, information problems can eliminate
markets or change the composition of markets.
● Adverse selection exists when the parties on one side of the market, who have information
not known to others, self–select in a way that adversely affects the parties on the other side
of the market.
● Asymmetric Information leads to adverse selection.

Example of Adverse Selection:

● Consider a used car market. Two types of cars; “lemons” and “peaches”.
● Each lemon seller will accept $1,000; a buyer will pay at most $1,200.
● Each peach seller will accept $2,000; a buyer will pay at most $2,400.
● If every buyer can tell a peach from a lemon, then lemons sell for between $1,000 and $1,200,
and peaches sell for between $2,000 and $2,400.
● Gains-to-trade are generated when buyers are well informed.
● Suppose no buyer can tell a peach from a lemon before buying.

[?] What is the most a buyer will pay for any car?
Ans:
Let: q be the fraction of peaches,
1 - q be the fraction of lemons.
The expected value to a buyer of any car is at most:
EV = $1200(1 - q) + $2400q
● Suppose EV ≥$2000:
○ Every seller can negotiate a price between $2000 and $EV (no matter if the car is a lemon
or a peach).
○ All sellers gain from being in the market.
● Suppose EV < $2000:
○ A peach seller cannot negotiate a price above $2000 and will exit the market.
○ So all buyers know that the remaining sellers own lemons only.
○ Buyers will pay at most $1200 and only lemons are sold.

➔ Hence “too many” lemons “crowd out” the peaches from the market.
Gains-to-trade are reduced since no peaches are traded.
The presence of the lemons inflicts an external cost on buyers and peach owners.

[?] How many lemons can be in the market without crowding out the peaches?
Ans:
Buyers will pay $2000 for a car only if:
EV = $1200(1 - q) + $2400q ≥$2000
2
➔ q≥
3
So if over one-third of all cars are lemons, then only lemons are traded.

● A market equilibrium in which both types of cars are traded and cannot be distinguished by the
buyers is a pooling equilibrium.
● A market equilibrium in which only one of the two types of cars is traded, or both are traded but
can be distinguished by the buyers, is a separating equilibrium.

[?] What if there are more than two types of cars? Suppose that:
● car quality is uniformly distributed between $1000 and $2000
● any car that a seller values at $x is valued by a buyer at $(x+300).
Which cars will be traded?
Ans:
● The expected value of any car to a buyer is $1500 + $300 = $1800.

Seller values 1000 15000

2000
So sellers who value their cars at more than $1800 exit the market.
● The distribution of values of cars remaining on offer

Seller values 1000 1800

● The expected value of any remaining car to a buyer is $1400 + $300 = $1700.

Seller values 1000 1400 1800

So now sellers who value their cars between $1700 and $1800 exit the market.

[?] Where does this unraveling of the market end?

Ans:
● Let v H be the highest seller value of any car remaining in the market.
1 1
● ×1000+ × v H .
The expected seller value of a car is
2 2
1 1
● So a buyer will pay at most ×1000+ × v H +300 .
2 2
● This must be the price that the seller of the highest value car remaining in the market will just
1 1
accept; i.e. ×1000+ × v H +300=v H .
2 2
➔ v H =$ 1600
 Adverse selection drives out all cars valued by sellers at more than $1600.

Example of Adverse Selection with Quality Choice:

● Now each seller can choose the quality, or value, of her product.
● Two umbrellas; high-quality and low-quality.
● Buyers value a high-quality umbrella at $14 and a low-quality umbrella at $8.
● Before buying, no buyer can tell the quality.
● The marginal production cost of a high-quality umbrella is $11.
The marginal production cost of a low-quality umbrella is $10.
[?] Which will be manufactured and sold?
Ans:
● Suppose every seller makes only high-quality umbrellas.
○ Every buyer pays $14 and sellers’ profit per umbrella is $14 - $11 = $3.
○ But then a seller can make low-quality umbrellas for which buyers still pay $14, so
increasing profit to $14 - $10 = $4.
○ There is no market equilibrium in which only high-quality umbrellas are traded.
● Suppose all sellers make only low-quality umbrellas.
○ Buyers pay at most $8 for an umbrella, while the marginal production cost is $10.
○ There is no market equilibrium in which only low-quality umbrellas are traded.
● Suppose both types of the umbrella are manufactured.
○ A fraction q of sellers make high-quality umbrellas; 0 < q < 1.
○ Buyers’ expected value of an umbrella is
EV = 14q + 8(1 - q) = 8 + 6q.
○ High-quality manufacturers must recover the manufacturing cost,
1
EV =8+ 6 q ≥ 11⇒ q ≥ .
2
○So at least half of the sellers must make high-quality umbrellas for there to be a pooling
market equilibrium.
○ But then a high-quality seller can switch to making low-quality and increase profit by $1
on each umbrella sold.
○ Since all sellers reason this way, the fraction of high-quality sellers will shrink towards
zero but then buyers will pay only $8.
○ So there is no equilibrium in which both umbrella types are traded.
➔ The market has no equilibrium in all situations.
Adverse selection has destroyed the entire market!

b. SIGNALING
● Adverse selection is an outcome of an informational deficiency.
● What if information can be improved by high-quality sellers signaling credibly that they are high-
quality?
● E.g. warranties, professional credentials, references from previous clients, etc.

Example of Signaling:
● A labor market has two types of workers; high-ability and low-ability.
 ● A high-ability worker’s marginal product is a H .
A low-ability worker’s marginal product is a L.
a L< a H
● h is the fraction of high-ability workers.
1 - h is the fraction of low-ability workers.
● Each worker is paid his expected marginal product.
● If firms knew each worker’s type they would
○ pay each high-ability worker w H =a H
○ pay each low-ability worker w L =a L
● .If firms cannot tell workers’ types then every worker is paid the (pooling) wage rate; i.e. the
expected marginal product w P =(1−h)a L + h a H .
● w P =(1−h)a L + h a H < aH : the wage rate paid when the firm knows a worker really is high-
ability.
● So high-ability workers have an incentive to find a credible signal.
● Workers can acquire “education”.
● Education costs a high-ability worker c H per unit
costs a low-ability worker c L per unit
c L >c H
● Suppose that education has no effect on workers’ productivity; i.e., the cost of education is a
deadweight loss.
● High-ability workers will acquire education units if
w H −w L =a H −a L > c H e H (i)
and w H −w L =a H −a L < c L e H (ii)
○ (i) says acquiring e H units of education benefits high-ability workers.
○ (ii) says acquiring e H units of education hurts low-ability workers.
● a H −aL >c H e H and a H −aL <c L e H together require
a H −a L a −a
<e H < H L
cL cH
● Acquiring such an education level credibly signals high-ability, allowing high-ability workers to
separate themselves from low-ability workers.

[?] Given that high-ability workers acquire e H units of education, how much education should low-ability
workers acquire?
Ans:
Zero. Low-ability workers will be paid w L =a Lso long as they do not have e H units of education
and they are still worse off if they do.

➔ Signaling can improve information in the market. But, total output did not change and education
was costly so signaling worsened the market’s efficiency.
➔ So improved information need not improve gains-to-trade.
 c. MORAL HAZARD
● Asymmetric information can also exist after a transaction has been made. If it does, it can cause
a moral hazard problem.
● Moral Hazard occurs when one party to a transaction changes his behavior in a way that is hidden
from and costly to the other party.
e.g: If you have full car insurance are you more likely to leave your car unlocked?
● Moral hazard is a reaction to incentives to increase the risk of a loss and is a consequence of
asymmetric information.
● If an insurer knows the exact risk from insuring an individual, then a contract specific to that
person can be written.
● If all people look alike to the insurer, then one contract will be offered to all insurees; high-risk
and low-risk types are then pooled, causing low-risks to subsidize high-risks.
● Examples of efforts to avoid a moral hazard by using signals are:
○ higher life and medical insurance premiums for smokers or heavy drinkers of alcohol
○ lower car insurance premiums for contracts with higher deductibles or for drivers with
histories of safe driving.

d. INCENTIVES CONTRACTING
● A worker is hired by a principal to do a task. Only the worker knows the effort she exerts
(asymmetric information).
➔ The effort exerted affects the principal’s payoff.
● The principal’s problem: design an incentives contract that induces the worker to exert the
amount of effort that maximizes the principal’s payoff.

★ SOLUTION FOR ASYMMETRIC INFORMATION

● Private sector:
○ Signaling; incentives contracts
○ R&D
○ Participate in international exhibitions
● Public sector
○ Regulation of advertising activities
○ Give more information to the market
○ Create and develop quality control centers
 SECTION 3: GOVERNMENT AND THE PROBLEM OF
EQUITY
Poverty, Inequality and Redistribution policy

● Horizontal equity implies that we give the same treatment to people in an identical situation.
● Vertical equity implies that people with higher incomes should pay more tax. Vertical equity is
important for redistributing income within society.

CHAPTER 1: INEQUALITY

I. INCOME DISTRIBUTION
● There’s no simple relation between poverty/inequality and per capita income.
○ Inequality (high or low) seems to be very persistent, but it typically changes (up or
down) when output per capita changes.
○ There might be a complicated relation, involving the interaction of many factors.
● Inequality is probably determined by
○ history
○ social cleavages,
○ politics and government policies
● Careful statistical/econometric analysis is necessary to identify the effect of each factor.

II. INEQUALITY
1. Measuring Inequality
● size distributions
○ How much income does household X earn?
○ Sort people according to income and put them in major groups.
○ Ignore differences in the source of income (heritage or capabilities, for example)
○ A quartile is a fourth (25%) of the population;
a decile is a tenth (10%);
a quintile is a fifth (20%).
○ The Kuznets ratio: the ratio of the share of income of the highest x% divided by the
share of income of the lowest y%.
● Lorenz curves
○ Arrange the population according to the share of income they receive, from lowest to
highest (and put them in major groups).
○ Calculate cumulative percentages.
○ Plot the cumulative percentage of households against the cumulative percentage of the
income they earn.
○ The greater the Curvature of the Lorenz Line, the greater the Relative Degree of
Inequality
 ○ Four Possible Lorenz Curves

● Gini Coefficients (an aggregate measure of inequality)

○ It’s a quantitative measure of how far a society is
from being perfectly equal.
○ Calculate the area between the perfect-equality
curve and the actual curve.
○ Divide that area by the total area under the perfect-
equality curve.
○ The Gini coefficient is interesting because
■ It’s anonymous: it doesn’t treat some people as
better than others, it just reports their income.
■ It’s money unit-independent:
measuring income in dollars or
in rupees doesn’t change it.
 ■ Its scale is population-independent: changing the number of people but keeping
income distribution constant doesn’t change it.
■ It follows the transfer principle: transferring income from a richer to a poorer
person (without changing their order) improves it.

2. Causes of Inequality
a. Human Capital
● Demand for High-skilled and Low-skilled
Wage rate
labor
(dollars/hour)
○ High-skilled labor has a higher VMP
(value of the marginal product) than low-
skilled labor and greater demand.
VMP of ○ The demand curve for high-skilled labor,
skill D H , lies above the demand curve for
low-skilled labor, D L, by the VMP of
D skill.
H

D
0 L
Labor (thousands of
hours/day) and low-
Demand for high-skilled
skilled labor

● Supply of High-Skilled and Low-Skilled

Wage rate
Labor
(dollars/hour)
Compensation S ○ Skills are costly to acquire, and a worker
for costs of H pays the cost of acquiring a skill before
acquiring skill benefiting from a higher wage.
S ○ High-skilled labor bears the cost of
acquiring skill.
L
○ The supply curve of high-skilled labor,
S H , lies above the supply curve of low-
skilled labor, S L, by the compensation
for the cost of acquiring skill.
0
Labor (thousands of
hours/day) and low-
Supply for high-skilled
skilled labor
 ● Wage rates of High-Skilled and Low-Skilled
Wage rate
Labor
(dollars/hour) S ○ The combined effects of skill on the
H demand for and supply of labor generate
a higher wage for high-skilled labor than
for low-skilled labor.
S
L

D
H
D
0 L
Labor (thousands of
hours/day) and low-
Markets for high-skilled
skilled labor

b. Discrimination
● Human capital differences explain much of the income inequality that exists.
● Economists are not sure whether (and disagree about) discrimination adds to income inequality.
● One line of argument is that competition prevents discrimination. But race and sex income
differences do persist.

c. Unequal Ownership of Capital

● Inequality arises from saving and bequests.
● Two features of bequests make intergenerational transfers of wealth a source of increased
inequality:
○ Debts Cannot Be Bequeathed
■ Debts cannot be forced onto other household members.
■ Because a zero inheritance is the smallest inheritance that anyone can receive,
bequests can only add to future generations’ wealth and income potential.
○ Assortative Mating
■ The tendency for people to marry within their own socioeconomic class.
■ Wealth becomes more concentrated.
CHAPTER 2: POVERTY

● Poverty is
○ Lack of income;
○ Lack of drinking water;
○ Lack of access to health care;
○ Lack of protection against adverse shocks.

★ MEASURING ABSOLUTE POVERTY

● The Absolute Poverty Headcount H simply adds the number of people whose income is below
an agreed-upon poverty line.
● The Headcount index H/N divides this number by the population.
● The international poverty line is $1 a day, but the adjustment to local conditions can lead to a
different number.

● The “poverty gap” is different but H or H/N would be the same.

● Total Poverty Gap
H
TPG=∑ ❑(Y p−Y i )
i=1

○ Y p is the absolute poverty line

○ Y i is the income of person i
● Average Poverty Gap
TPG
APG=
H
○ H is the number of persons under the poverty line
○ TPG is the total poverty gap
● The Normalized Poverty Gap is the Total Poverty Gap divided by the product of the poverty
line and the population = APG/Yp, always gives a value between 0 and 1 so this is useful to
compare countries.
 H

∑ ❑(Y p−Y i )
NPG= i=1
NY p
● Foster-Greer-Thorbecke Measure
○ Is a very general form of poverty measure that satisfies
■ anonymity (no person is worth more than another),
■ population independence (a larger population doesn’t change it, ceteris paribus),
■ monotonicity (making a person richer won’t decrease the index) and
■ distributional sensitivity (taking income away from a poor person makes the
poverty index worse).
H α
1 Y −Y i
Pα = ∑ ❑ p
N i=1 Yp( )
○ If α=2, you get a measure that is extremely sensitive to the depth and severity of
poverty.
● Is “$1 a day” too low?
● Is “$2 a day” too low?
○ Lots of people live between “$1 a day” and “$2 a day”, and although there are fewer
people below “$1 a day”, the proportion of people living under “$2 a day” hasn’t fallen
much.
● How about “$15 a day” as the standard to say that someone is poor?
○ If “$15 a day” makes you poor in the US, why should you be non-poor if you make “$10
a day” in Zambia?
● How about using income rather than consumption, and national accounts rather than surveys?
○ The number of poor people seems to be much fewer.

★ POVERTY, INEQUALITY, AND SOCIAL WELFARE

● Extreme income inequality leads to inefficiency.
○ Lack of access to credit leads to underfinancing of good productive opportunities.
○ skewed income distribution (the rich have most money) leads to more aggregate savings
and less aggregate consumption; growth comes from capital appreciation; bubbles
develop.
○ even income distribution (poorer people having more money) leads to more consumption
and lower savings; growth comes from profitability; trade is sustainable.
● Extreme income inequality leads to inefficient allocation of assets.
○ Overemphasis on higher education to the detriment of basic education.
● Extreme income inequality leads to political and social instability.
○ The poor try revolution while the rich try corruption and rent-seeking to retain power.
● Most people think it’s unfair.
○ Rawls’s “veil of ignorance.”
■ A sense of unfairness lowers welfare.

★ THE RANGE OF POLICY OPTIONS: SOME BASIC CONSIDERATIONS

● Areas of intervention
 ○ Change the functional distribution
■ Give more income to labor and less to capital.
○ Change asset and skill inequality: the sources of income inequality.
■ Land reform; microcredit; basic education
○ Make taxes more progressive.
○ Poverty reduction programs: direct transfers or subsidies for food, education, health, etc.
● Policy options
○ Changing relative factor prices
■ Traditional-sector workers have very low incomes and minimum-wage laws are
seldom enforced.
■ Artificially high modern-sector wages (due to unions or laws) reduce the growth
of the modern sector, condemning more people to poverty and exclusion.
■ Market-determined wages (which would be lower) in the modern sector would
increase employment and incomes for the poor.
■ Market-determined cost of capital (which would be higher) would encourage
firms to hire workers rather than buy capital.
○ Transfer payments and public provision of goods and services
■ Make sure it’s targeted to the poor.
■ Prevent the poor from becoming dependent on it … but encourage appropriate
risk-taking.
■ Discourage switching from work to program.
■ Avoid resentment by nearly-poor-but-not-enough people who are working.
● The need for a ‘package’ of policies
○ Eliminate price distortions: more efficiency, more employment, and less poverty
○ Structural change in asset ownership
○ Progressive taxes and transfers; safety net
CHAPTER 3: INCOME REDISTRIBUTION

I. SOME THEORIES OF REDISTRIBUTION

1. Theory of Utilitarianism
a. Hypothesis
● All the people have the same MU function and MU depend only on the level of revenue
● These MU functions follow the law of diminishing MU
● The total revenue is fix and still stable when there is the redistribution policy
➔ The function of social welfare W = U1 + U2 + Ui +….+ Un

b. Description
● Lost of A: abcd
M M ● Gain of B: abef
U e U ● Gain of Social welfare: cdef
B ● g: max of social welfare, revenue i = h
A f ● Conclusion: at which point there is perfect
g equality?

d
c
O O
h b a ’
Reve Reve
nue A nue B

c. Some problems
● The 1st hypothesis: if people have different MU functions?
● The 2nd hypothesis: the law of diminishing MU is true with the goods, but how about the revenue?
● The 3rd hypothesis: all programs of redistribution need at least the administrative cost ⇒ loss of
total revenue

2. Theory of Egalitarianism
● The function of social welfare W = U1 = U2 = Ui =…= Un
● Some problems
○ Perfect equality
○ But what happens if people have different MU functions?
○ Not easy to implement in the real-life
 3. Rawls Theory
● Social welfare depends only on the benefit
B of the poorest.
( ⇒ max social welfare = max
U utility of the poorest.
W
B) E ● The function of Social welfare W =
*
U min{U1, U2,…, Un}

2
W
O 1
U A
Redistribution (
1
according to Rawls’U
theory ) A

II. THE PROBLEMS OF REDISTRIBUTING INCOME

● Society may decide to redistribute income from the rich to the poor to meet its ideal of fairness.
● Redistribution programs can have substantial side effects which can subvert the intention of the
program.
○ The labor to leisure incentive effect.
○ The tax avoidance or evasion incentive effect.
○ The incentive to look needier than you really are
● Politics, Income Redistribution, and Fairness
○ Often politics, not value judgments, play a central role in determining what taxes an
individual will pay.
○ Although the poor outnumber the rich, there is limited political support for income
redistribution programs:
■ Many poor do not bother to vote.
■ Politicians do not see the poor as a solid voting block.
■ Poor people who vote often cast their votes with other issues in mind.

III. INCOME REDISTRIBUTION POLICIES

The government redistributes income through direct and indirect methods.

1. The direct methods

● Taxation - policies that tax the rich more than the poor.
○ Taxes can be:
■ Progressive : the average tax rate increases with income.
■ Proportional : the average tax rate is constant regardless of income.
■ Regressive : the average tax rate decreases with income.
○ The federal government gets most of its taxes from the personal income tax, the corporate
income tax, and the Social Security tax.
○ State and local governments get most of their taxes from:
 ■ Income taxes which are somewhat progressive;
■ Sales taxes which tend to be proportional but are slightly regressive;
■ Property taxes which are roughly proportional
○ Taxation has not proven to be an effective means of redistributing income.
● Expenditures - programs that help the poor more than the rich.
○ Expenditure programs have been more successful than taxation for redistributing income.

2. The indirect method

The indirect method involves the establishment and protection of property rights.
● Social Security – a social insurance program that provides financial benefits to the elderly and
disabled and to their eligible dependents and/or survivors.
● Medicare – a multibillion-dollar medical insurance program.
● Public assistance programs – means tested social programs targeted to the poor and providing
financial, nutritional, medical, and housing assistance. The main types of public assistance
programs are:
○ Temporary Assistance for Needy Families (TANF).
○ Food stamps.
○ Medicaid.
○ General assistance.
● Supplemental Security Income (SSI) – a federal program that pays benefits, based on need, to
the elderly, blind, and disabled.
● Unemployment compensation – short-term financial assistance, regardless of need, to eligible
individuals who are temporarily out of work.
● Housing programs – federal and state governments have many different programs to improve
housing or to provide affordable housing.

➔ The Success of Income Redistribution Programs

● After-transfer income is significantly closer to being equally distributed.
● The increasing equality comes at the cost of a reduction in the total amount of income earned by
society.
● The most important redistribution decisions the government makes involve the establishment and
protection of property rights.
SECTION IV: PUBLIC CHOICE AND POLITICAL ECONOMY

INTRODUCTION
● In the real world, it is not always easy for the government to maximize welfare.
● Politicians have considerations other than getting to the socially efficient level or conducting
cost-benefit analyses in order to approve a project. Instead, such economic decisions are made in
the context of a political system.
● This lesson focuses on the fourth question of public finance: Why do governments do what they
do?
● We start by discussing the “best-case scenario” in which the government appropriately measures
and aggregates the preferences of its citizens in deciding what projects to undertake.
● Then we examine both direct democracy and representative democracy.
● Finally, we examine government failure, the inability (or unwillingness) of government to
appropriately address market failures.

MECHANISMS FOR AGGREGATING INDIVIDUAL PREFERENCES

● This section discusses how voting can serve to aggregate individual preferences into a social
decision.
● For now, we focus on direct democracy, whereby voters directly cast ballots in favor of or in
opposition to particular public projects.

CHAPTER 1: DIRECT DEMOCRACY

★ UNANIMOUS CONSENT ON PUBLIC GOODS LEVELS: LINDAHL PRICING

● Ideally, the government could provide public goods through the unanimous consent of its
citizens.

a. LINDAHL PRICING
● Lindahl pricing is a system where individuals report their willingness to pay for each quantity of
the public good, and the government aggregates preferences to form a measure of the social
benefit.
● To illustrate Lindahl’s procedure, imagine that the public good in question is fireworks for two
people (Ava and Jack).
● First, the government announces tax prices for the public good, that is, the share of the cost that
each individual must bear.
● When a tax price is arrived at where both individuals want the same amount of the public good,
the government has reached Lindahl equilibrium.
● The government produces the public good at that level and finances it by charging each person
their tax price.
● Each person announces how much of the public good he or she wants at those tax prices.
 ● If the individual announcements differ, the government raises the tax price for the person who
wants more of the good and lowers it for the person who wants less.

● Jack’s demand curve for fireworks is fairly

Willingne steep.
ss SMB
pay =
$ to ● Ava’s demand curve for fireworks is fairly
4 DJACK + flat.
D AVA ● Adding up their individual demands curves
$
JA vertically gives the aggregate demand.
3
C ● With this marginal cost, it is socially
K
$ beneficial to produce goods.
2 ● The socially efficient level is 75 units.
D S=
$ ● This generates a tax price of $0.75 for Jack
$ A1 SM
and a price of $0.25 for Ava in Lindahl
$0.V C
0 equilibrium.
7A
0. 2 5 7 1 Fire ● The area of the triangle a is Jack’s surplus.
25 5 0 5 0 wor
● The area of the triangle a is Ava’s surplus.
5 0 ks

● Fireworks production of 75 units is in equilibrium for two reasons.

● First, both Ava and Jack are happy to pay those tax prices to get that quantity.
● Second, the government has covered the marginal cost of producing the fireworks by charging
each person their marginal willingness to pay.
● Lindahl pricing corresponds to the concept of benefit taxation, which occurs when individuals
are being taxed for a public good according to their valuation of the benefit they receive.
● With Lindahl pricing, the government does not need to know the utility functions of individual
voters: it gets the voters to reveal their preferences by stating their willingness to pay for
different levels of the public good.

b. PROBLEMS WITH LINDAHL PRICING

Lindahl pricing is unlikely to work in practice, however.
● Preference revelation problem: Individuals may behave strategically, and pretend their
willingness to pay is low in order to get others to bear a larger cost of the public good.
● Preference knowledge problem: It is hard for people to properly value goods they do not shop
for on a regular basis.
● Preference aggregation problem: Aggregating millions of voters’ preferences is difficult in
reality.

c. APPLICATION: DIRECT DEMOCRACY IN THE UNITED STATES

 ● Direct democracy was very prominent in the news in 2003 when the citizens of California voted
to replace their governor, Gray Davis, with Arnold Schwarzenegger in a recall election.
○ A recall election is a special election initiated by citizens with the goal of replacing a
sitting official.
● Only one sitting governor had been removed before. 18 states allow the recall of state officials,
and 36 allow recall of local officials.
○ About 5,000 recall elections have been held in the U.S., with nearly half resulting in the
removal of an elected official.
● Two other ways in which voters participate in direct democracy are through referendum and voter
initiative.
○ A referendum is a measure placed on the ballot by the government allowing citizens to
vote on state laws or constitutional amendments that have already been passed by the
state legislature.
○ A voter initiative is the placement of legislation on the ballot by citizens.
● For example, on October 5, 2003 (two days before he was recalled), Gray Davis signed a health
insurance mandate on employers. In a referendum on the November 2004 ballot–Proposition 72–
California voters narrowly overturned this law by a 51% to 49% margin.

★ MAJORITY VOTING
a. WHEN IT WORKS
● The Lindahl pricing scheme had a very high standard for coming to a consensus: only when
citizens were unanimously in agreement did the government achieve Lindahl equilibrium.
● A common mechanism used to aggregate individual votes into a social decision is majority
voting, in which individual policy options are put to a vote, and the option that receives the
majority of votes is chosen.
● Majority voting does not always provide a consistent means of aggregating preferences.
● To be consistent, an aggregation mechanism must satisfy three goals:
○ Dominance: If one choice is preferred by all voters, then the aggregation mechanism
must be such that this choice is made by society.
○ Transitivity: Choices must satisfy this mathematical property.
○ Independence of Irrelevant Alternatives: The introduction of a third choice does not
change the ranking of the first two choices.
● It turns out that with these three conditions, majority voting can only produce a consistent
aggregation of individual preferences if preferences are restricted to take a certain form.

Table 1: Majority voting delivers a consistent outcome

Type of voters

Parents Elders Young Couples

Preference First High Low Medium
rankings
Second Medium Medium Low

Third Low High High

● A town is deciding on education taxes (and spending). There are 3 possibilities: high, medium,
and low spending. There are also 3 groups, represented in equal proportions.
● Consider pairwise voting:
○ High vs Low: Parents vote for H, Elderly and Young Couples vote for L.
⇒ L wins,
○ High vs Medium: Parents vote for H, Elderly and Young Couple vote for M.
⇒ M wins.
○ Medium vs Low: Parents and Young Couples vote for M, Elderly vote for L.
⇒ M wins.
➔ Since M has beaten both H and L, M is the overall winner in this case.

b. WHEN IT DOES NOT WORK

Table 2: Majority voting does not deliver a consistent outcome

Type of voters

Parents Private Parents Young Couples

Preference First High Low Medium

rankings
Second Medium High Low

Third Low Medium High

● Consider pairwise voting:

○ High vs Low: L wins,
○ High vs Medium: H wins.
○ Medium vs Low: M wins.
➔ No clear result.
● This set of outcomes is problematic because there is no clear winner. These results violate the
principle of transitivity resulting in cycling–when majority voting does not deliver a consistent
aggregation of individual preferences.
● Note that the failure to get a consistent winner from majority voting does not reflect a failure on
the part of individuals–each group has a sensible set of preferences.
 ● The problem is aggregation–we are unable to use voting to aggregate these individual
preferences into a consistent social outcome.
● This creates the problem of the agenda setter, the person who decides the sequencing of the
votes.
● In the second situation, he can affect the outcome.
○ For low spending to win, for example, first set up a vote between H and M. H wins.
Then a vote between L and H means L will win.
○ Any outcome can win with appropriate ordering.

★ ARROW’S IMPOSSIBILITY THEOREM

● In fact, there is no voting system that will produce a consistent outcome here.
● Arrow’s Impossibility Theorem states that there is no social decision (voting) rule that converts
individual preferences into a consistent aggregate function without either restricting preferences
or imposing a dictatorship.

★ Restricting Preferences to Solve the Impossibility Theorem

● One way to solve this problem is to restrict preferences to “single-peaked” preferences.
○ A “peak” in preferences is a point that is preferred to all its immediate neighbors. Utility falls
in any direction away from this point.
○ Multi-peaked preferences mean that utility may first rise, then fall, then rise again.
● If preferences are single-peaked, majority voting will yield a consistent outcome.
● We can visualize our earlier examples:
 Util Util
ity Young ity Private Young Public
Elders marrieds Parents parents marrieds parents

School
School 0
0 L M H
L M H
spendi
spendi
The utility of private parents ng
Elders are Young Parents ng goes in either direction from
single- marrieds are are single- M.
peaked at single-peaked peaked at
“L”. at “M”. “H”.

● The failure of these preferences for the “private parents” in this second case is what leads to the
inability of majority voting to consistently aggregate preferences.
● Fortunately, single-peakedness is a reasonable assumption in most cases

Exercise 1: Suppose that there are 5 voters with preference rankings for 4 projects (A, B, C, D) as
follows:
1 2 3 4 5

First B A C A D

Second C D B C B

Third D C D B C

Fourth A B A D A

a. Draw the preference rankings graph of voters

b. Find the voters with single-peaked preferences
c. With majority voting, direct elimination pairwise voting, which project will win? Which project
will win with simultaneous pairwise voting?
 b. The voters with single-peaked preferences are voters
Util number 1 and 3.
ity 2 4 1 3 5 c. Simultaneous pairwise voting:
(A-B) ⇒ B wins (A-D) ⇒ D wins
(A-C) ⇒ C wins (B-C) ⇒ C wins
(B-D) ⇒ B wins (C-D) ⇒ C wins
⇒ C wins.

Direct elimination pairwise voting:

(1) (A-B) ⇒ B wins (2) (A-C) ⇒ C wins

(B-C) ⇒ C wins (C-B) ⇒ C wins
(C-D) ⇒ C wins (C-D) ⇒ C wins
Projec
0 A B C D
⇒ C wins. ⇒ C wins.
ts

★ LOGROLLING
● Logrolling or voting trader: a mechanism by which voters can buy, sell or exchange the bill
saying “yes” from other voters.
● Objectives: To be the winner in majority voting.

a. INCREASE SW

Voters Total Net Benefit

Projects
X Y Z (SW)

Hospital 200 -50 -55 95

School -40 150 -30 80

Library -120 -60 400 220

● Find the winner project and social welfare without logrolling

⇒ without logrolling, no project shall win.
● If there is logrolling by exchanging bills between voters, which project(s) could be passed? And
the SW=?

X wants hospital: ○ Y (school): 200 - 40 = 160 ⇒ X chooses Y

○ Z (library): 200 - 120 = 80

Y wants school: ○ X (hospital): 150 - 50 = 100 ⇒ Y chooses X

○ Z (library): 150 - 60 = 90

Z wants library: ○ X (hospital): 400 - 55 = 345 ⇒ Z chooses Y

○ Y (school): 400 - 30 = 370
 ⇒ X will cooperate with Y ⇒ SW = 95 + 80 = 175 (logrolling increases SW)

(*) X can buy votes from Y with the minimum price of 50 and the maximum price of 55 <~vì
nếu trên 55 thì X sẽ mua của Z>.

b. DECREASE SW

Projects Voters Total Net Benefit

X Y Z

Hospital 200 -110 -105 -15

School -40 150 -120 -10

Library -270 -140 400 -10

● Find the winner project and social welfare without logrolling

⇒ without logrolling, no project shall win.
● If there is logrolling by exchanging bills between voters, which project(s) could be passed? And
the SW=?

X wants hospital: ○ Y (school): 200 - 40 = 160 ⇒ X chooses Y

○ Z (library): 200 - 270 = -70

Y wants school: ○ X (hospital): 150 - 110 = 40 ⇒ Y chooses X

○ Z (library): 150 - 140 = 10

Z wants library: ○ X (hospital): 400 - 105 = 295 ⇒ Z chooses Y

○ Y (school): 400 - 120 = 280

⇒ X will cooperate with Y ⇒ SW = - 15 - 10 = - 25 (logrolling decreases SW)

★ MEDIAN VOTER THEORY

● When preferences are single-peaked, then majority voting will deliver a consistent aggregation of
preferences of the individual voters.
● Even stronger, the median voter theorem states that majority voting will yield the outcome
preferred by the median voter if preferences are single-peaked.
○ The median voter is the voter whose tastes are in the middle of the set of voters, so an
equal number of other voters prefer more and prefer less of the public good.

★ Potential Inefficiency of the Median Voter Outcome

● Thus, the voting would suggest that the government only needs to find the preferences of the
median voter, and implement that level of public goods.
● This does not account for the intensity of preferences, however, so it does not follow that the
social marginal benefits equal the social marginal cost.
○ For example, if small numbers of individuals derive enormous benefits from the public
good, this should be accounted for in the total social marginal benefits.
● For example, imagine that there are 1,001 voters in a town, who are considering building a
monument that costs $40,040 ($40/person).
○ Assume all 1,001 voters have single-peaked preferences, so the median voter will
determine the outcome.
● If 500 citizens value the monument at $100 each, and the other 501 value it at $0, then the social
marginal benefit is $50,000, far greater than the cost. However, the monument wasn't built.
CHAPTER 2: REPRESENTATIVE DEMOCRACY AND POLITICAL
ECONOMY

★ REPRESENTATIVE DEMOCRACY: Vote-Maximizing Politicians

● In reality, voters elect representatives, who are supposed to aggregate their preferences and take
them into account when they vote on the appropriate level of public goods.
● If politicians care about maximizing the number of votes they get, they choose the outcome
preferred by the median voter.
● The public good in question is defense; the key question is what fraction of the budget (0% to
50%) should be spent on defense? Voters are uniformly distributed on this continuum.
● Two politicians, John and George, are running for office and vying to maximize their votes.

Voters for John Voters for George

(a) Defense
spending
0 J1 25 G 50
% Voters for John % Voters for George 1 %

(b Defense
) J2 25 G 50 spending
0
% Voters for John % Voters for George 1 %

(c) Defense
J2 25 G 50 spending
0
% Voters for John % 2Voters for George %

(d Defense
) spending
0 J3 = G3 = 50
% 25% %

● John is trying to appeal to those who don’t want much defense, so he places himself at J 1 while
George chooses a much higher level of defense G 1. In this case (a), the candidates split the vote
equally.
● But now imagine that John changes his position to J2. By doing so he gets the majority of the
votes (case (b)).
● In response, George lowers his position to G2. By doing so, George now gets a majority of the
votes (case (c)).
● This process will continue until the median voter’s preferences are arrived at (case (d)).
● The median voter model is a powerful tool but relies on a number of assumptions worth
mentioning:
○ Single-dimensional voting: Voters only care about one issue.
○ Only two candidates: With a 3rd candidate, there is no stable equilibrium.
○ No ideology or influence: Assumes politicians only care about votes, not ideological
positions.
○ No selective voting: All citizens actually vote.
○ No money as a tool of influence
 ○ Perfect information along three dimensions: voter knowledge of the issues, politician
knowledge of the issues, and politician knowledge of voter preferences.

★ Lobbying
● The issues of money and information make it likely that elected officials will be lobbied by
highly interested and informed subgroups.
● Lobbying is the expansion of resources by certain individuals or groups in an attempt to influence
a politician.
● Lobbyists can:
○ Inform politicians
○ Reward politicians
● The problem with lobbying arises when an issue benefits a small group and imposes small costs
on a larger (perhaps even a majority) group.
○ In this case, politicians might support socially inefficient positions.
● The key point to remember is that large groups of people with a small individual interest in an
issue suffer from a free-rider problem in trying to organize politically.
● Small groups with large interests overcome the free-rider problem.

★ Application: Farm policy in the United States

● Even though only 2.5% of workers are employed on farms, this sector receives $25 billion in
direct support from the federal government.
● This comes in direct subsidy payments to farmers, and price supports (guaranteed minimum
prices for crops).
● These subsidies cost each American household about $360 per year on average, and the average
recipient of a subsidy receives $18,000 per year.
● The 2002 farm bill was estimated to cost $190 billion over the following decade. Although it is
motivated by preserving “family farms,” this motivation is completely at odds with the facts.
○ Only 8 of 400 crops are eligible for the subsidy.
○ Subsidy increases with production, so large farms benefit more than small farms.
○ Two-thirds of all subsidies accrue to 10% of recipients, most of who earn over $250,000
per year.
● How do such expensive, and poorly targeted subsidies end up surviving?
● The total cost per American family is modest ($360), and dwarfed by the enormous gain to the
typical farm ($18,000).
● The small group of farms is able to effectively organize and lobby, while the much larger group
of taxpayers hurt by the programs are not able to do so.

★ Empirical Evidence on the Median Voter Model

● While the median voter model is a potentially powerful tool, does it have predictive power?
○ The empirical evidence is mixed. It certainly does not completely explain legislator
behavior. There is strong evidence that legislators consider their own ideology, and that
of their core constituency when they vote on policies.
● Stratmann (2000) found that redistricting, which changes the nature of the district’s median voter
for largely exogenous reasons, affected the voting preferences of legislators.
● He asked: When districts become more conservative through redistricting (as measured by the
vote for the Republican presidential candidate in 1988 and 1992), but were represented by the
same politician, did the politician start to vote more conservatively?
○ The answer: Yes.
● There is also evidence that “core constituencies” matter as well.
● Levitt (1996) compared two senators from the same state but different political parties. Median
voter theory suggests they should take the same position on legislation, yet he found that the
senators vote very differently.
○ The senators vote very similarly to senators from other states who are in their party.
○ He found that legislators care roughly equally about the median voter, voters in their own
core constituencies, and the “party line.” Yet most of the voting pattern is explained by
individual ideological differences.

★ Cycling in Representative Democracies

● An issue that arises in direct democracy, cycling, can also arise in a representative democracy if
legislator preferences are not single-peaked.
● There is some evidence that such cycling has occurred in Congress from time to time.

★ The Political Business Cycle

● Another issue that arises in a representative democracy is the “political business cycle.”
Pocketbook issues matter.
○ Bill Clinton’s mantra – “It’s the economy, stupid!”
● Ray Fair has developed models relating the fraction of the vote for the incumbent to the
economy’s growth rate and inflation rate.

● On average, the
predicted share of
the vote for the
incumbent party
is within 2.6
percentage points
of the actual vote
received.
● It has done a
pretty good job at
predicting
winners in
presidential
elections.
● The fact that voters respond to economic conditions close to the Presidential election has led
some to posit the existence of a political business cycle, where politicians attempt to manipulate
economic conditions.
● Although the actual business cycle may or may not exist, it is clear that incumbents do use
government powers of taxation and spending to try to win voter favor.

★ PUBLIC CHOICE THEORY: THE FOUNDATIONS OF GOVERNMENT FAILURE

● The analysis in most of this course assumes a benign government intent on maximizing social
welfare.
● Public choice theory questions this assumption by noting that governments often do not behave in
an ideal manner, so the traditional assumption of a benevolent social-welfare maximizing
government may be inappropriate.
● Government failure is the inability or unwillingness of the government to act primarily in the
interest of its citizens. Reasons include:
○ Size maximizing bureaucracy
○ Leviathan theory
○ Corruption

★ Size-Maximizing Bureaucracy
● Niskanen (1971) developed a model of the budget maximizing bureaucrat. In this model, the
bureaucrat runs an agency that has a monopoly on the government provision of some good or
service.
● Bureaucrat’s salary is typically unrelated to efficiency. His compensation consists of salary, but
also perks like the size of his office and support staff.
● The larger government tries to rein in the bureaucrats.
● A key question is then whether goods and services are more efficiently provided by the public or
private sector.
○ For most goods and services, it is abundantly clear that private provision is more
efficient.
○ In a review of the literature, Mueller (2003) finds that only 5 of 71 studies found state-
owned companies outperformed their private counterparts.
● For some goods, such as social services, public provision may be superior, especially when there
is a market failure.
○ Hart, Shliefer, and Vishny (1997) compared public and private prisons. Private prisons
were 10% cheaper, through lower wages to guards. The low pay led to more violence,
however.

★ Leviathan Theory
● Leviathan theory sees individual bureaucrats and the larger government as one monopolist that
simply tries to maximize the size of the public sector.
● This view would help explain rules that explicitly tie the government’s hands in terms of taxes
and spending.

★ Corruption
● Finally, corruption is where government officials abuse their power in order to maximize their
own personal wealth or that of their associates.
● Application: Government Corruption
○ Former Illinois governor George Ryan was indicted in December 2003 for selling state
contracts to his friends in exchange for cash, gifts, loans, and trips for his family. The
case is still pending.
○ This was uncovered as part of “Operation Safe Road,” which investigated bribes that
many truck drivers had given to officials at then Secretary of State Ryan’s office to
obtain a driver’s license. At least 20 people had died in accidents involving drivers who
had bribed officials for their licenses.
○ The investigation resulted in 70 indictments and over 60 convictions of many people who
were close friends and allies of the former governor.

★ The Implications of Government Failure

● There is clear evidence that governments fail in some instances to benevolently serve the interests
of their citizens.
● Can citizens “undo” these harms through actions like direct democracy?
● Some empirical evidence suggests that government failures can have long-lasting negative
impacts on economic growth.
● Acemoglu, Johnson, and Robinson (2001) examined two sets of nations that were similar when
they were colonized by European powers, yet colonization took very different forms.
○ Treatment group: Nations in the Caribbean, Central America, and Africa.
■ The colonizers were focused solely on extracting natural resources, and not
interested in setting up institutions to foster economic success.
○ Control group: Nations in North and South America, Australia, and New Zealand.
■ The colonizers moved to these nations in large numbers and set up institutions to
foster economic success.
● Why the lack of “hands-on” governing in the treatment group?
○ The odds of colonists dying from the locally infectious disease were much higher. This
exogenously affected settlement patterns of colonizers.
● Despite their pre-colonization similarity, the treatment nations have grown much more slowly
post-colonization than the control nations.
● The treatment nations continue to suffer from the long-run detrimental effects of inefficient
government.