Public Finance

and Public Policy

 Government spending as share of GDP

Different traditions: US smaller government spending.

In African countries the tax capability is lower, hence there
is a lower government spending.

There is a link with the government revenues. Taxes

collected in US lower than those collected in Europe. That’s
why different regions do have smaller or larger government
spendings.

The development of the public sector is quite recent in

an historical prospective.
After the Second World War there is the explosion of
the public sector.
 Main components of the tax revenues:

pensiona
Corporean &
variety Social
*
composition
-

Taxes
of income
consumption taxes
~
-
⑧ ⑧

·
VAT
Very large share. Taxes
L
*
fix competition -

>
Huge issue between countries (Italy IVA 22 %) InErroe
the same
· tex on oil weight paid by people
(employees, civil servants
etc). They go to the State
with the principle of
progressivity (you earn
Lesson 2: more, you pay more)
Public expenditure increased worldwide after Second World War:

So
%

50% GDp produced by Government public expenditure

Recently there was a decline in in public expenditure. China and India also had growth in public
expenditure, however the chart is European-centered. The baricenter of the world is shifting from
the Atlantic and the Pacific: the rise of China will make the country one of the most important along
with US.

Theory:
The 19th century had been the golden age of the market ideology with a huge international trade (Great Britain
was the superpower and the example of the Golden Age (1850)).
This period was the basis of the unification of Italy.
1873= largest crisis, the Great Depression that interested many countries - from now on, there is the decline
of the golden age.
1929= another crisis hit the world, the Second Great Depression. This was the time in which Keynes
developed his theories.
2WW= time of heavy interventionist. Between 1930-1970 debate about which was the best economic system
(capitalism vs communism).Decentralised economy (companies make their own decisions and according
only to the market )vs planned economy. Historically the planned economy did not perform as well are the
capitalist decentralised economy: the Soviet Union did not catch up with the new technologies and
development.
Innovation started to became the center and the technology started to not be so important as before.
Innovation makes the difference.
Japan in 1950s-1960s had an important approach with huge private corporations driven by the government.
then there was the demise of the industrial policy: the government had not to define the goals of innovations
and so on.
Recently, in Europe and US people started to realize that there was the need for stronger State intervention
(imitation, in a smeller extent, of China).
1950s= debate capitalist vs communist. In this environment, Arrow-Debreu came out with a fundamental
result: “competitive markets (decentralised) are efficient” - it was a theoretical proof. This was the First
Fundamental Theorem of welfare economics.

Microeconomics recall:
3 main concept: rationality, equilibrium, efficiency.
Efficiency: definition given by Pareto - “an outcome is efficient if there is no other feasible outcome in which
nobody is better off”. Assumptions given the size of community fixed:
1. individualistic (evaluation of outcomes considered to single individuals, no focus on communities or
groups),.
2. welfaristic (compare outcomes on basis of individual welfare).
3. Consumer sovereignty: the individual knows the best his preferences.

Pareto theory has a very weak requirement and it’s not selective enough (between two Pareto output is difficult
to choose one).
Example: Suppose there is a single good (life) and Pareto is mute
Suppose you have the titanic boat with 3000 people on board and only 1000 places in lifeboats that can save
people from sinking. Who should be saved?
1) youngest (years of life saved);
2)randomly (risk equity) - democratic, distributed equally.
3) socially valuable;
4) intensity of preferences;
5) popularity.

All Pareto Efficient - Pareto is not selective enough.

For the choice — PARETO + ETHICAL CRITERION

So, for Pareto at work you need at least 2 goods. In the case of titanic, the goods were the life, and money -
who pays to be safe etc.

Back to theory:
Simplest market (2 individuals and 2 goods) - general equilibrium.
Example: 2 goods - dogs and cats.
2 individuals - A and B.
slope MRS marginal
= =
rate
of substitution
cat S
Indifference curve of individual A Individual A is a dog lover. 1
↑
It i dog corresponds to 2 cats
2
......
i Do

Indiff. Curve of B CATS This is called edgeworth box

Ip :
↑

20-

i poss
 &
Edgeworth block: contains 2 individuals and 2 groups.
Combine the preferences of both individual A and B (about cats and dogs).
DB

Encompain---
Endowment
·
O
[A ; JA

i
H
↑
*A
P
*

O FB ·
I
indifference
curre
Pure exchange economy: no things produced, the amount of the good A is made up of the
sum of individuals’ endowment.
If the indifference curves shifts above, it means the individual A is better off due to increased
utility. If the indifference curve o individual B shifts below he is better off.
The price set is indicated by P
The indifference curves shift to the price set P.
Assumptions:
1. Voluntary basis;
2. Auctioneer (some external individual that sets the price); (in the financial markets, an
algorithm sets the prices of stocks, e.g. gold).

Efficient allocations:

·
• Set of indifference curves of individuals A and B;
• set of efficient allocation .

D : A only has cats ; B only has sats and dogs >

-
we cannot make both A-B
better
off
Discus bloa
( :
all
dogs and cats to A

& Due to different Pareto points, an equity criterion must be used. How to choose among the very
large set of Pareto efficient points?

Second fundamental theorem of Welfare economics: all efficient allocation can be a market
outcomes if you can redistribute resources.
M1

ministriction
·
market

Bottom
+ Taxes
-
Credestribution)

line :
can
get to any efficient allocation

EQUITY AND EFFICIENCY ARE COMPATIBLE in market economy

 EQUITY CRITERiON - income faces (RAWLS)

·
mmm
· .

↓ pareto efficient outcomes

Consider now tho goods: dogs and money. With the assumption that money have no satiation and
preference for dogs is independent from how much money you have (and preference are quasi-linear
in money st U(D,M)=m+v(D) ).
Use money as a measure of surplus.
TITANIC :

Pareto highest
:Live &
2 goods outcome : Should be saved people who have the willingness to
pyo

DEMAND

Implementation : Action

Is it efficient? remember that efficiency makes sense only if a tax system is implemented. Before
starting auction you redistribute income.

Efficiency has always to be implemented with that system (redistribution).

Example: suppose you have only a valuable item in the economy (a piece of land) and there are
two potential interested: a school and a firm (2 individuals). The school values that piece of land
100, while firm’s value is 120. The efficient outcome is for the good to be allocated to the firm, since
the willingness of the firm to pay is higher.
In an Efficient way: the land should be given to the firm for 120, implement a tax system and
transfer money to the school.

F
v -
S
Take one market: use of statistical econometrics technique to estimate demand and supply.
Supply captures the marginal cost of producing the product. The demand captures the
willingness to pay (marginal benefit)
high. S

P
CS *

Q =

argument that maxim .

WELFARE
I
= DS + C S
Mex
*
La
ge
Efficiency has 3 dimensions:
1. Allocative efficiency: goods one produced are distributed in an efficient way, i.e. the efficient way is
to assign them to the people who value them the most (allocate according to willingness to pay). &
2. Production efficiency: goods produced by firms with the least cost of production.
3. The match between D-S: optimal quantity i.e. how much units should be produced. & Produce those
units for such MB>MC. Marginal costs should be lower than the benefits.
ia

P ~
es
peop Pr Inefficient
Ph---
D
!
PM
Sa

Consider Pm as the price set by a monopoly, with allows to get decent income. However, even if it is price-
maximising, it is inefficient: there are people with high willingness to pay that cannot afford the good and there
are also goods not sold. A part of the population does not take the service. However, it is not profit-maximiser
for the producer.

There could be1an inefficient due to very low prices: rent control

a ma pra

&
err

In the 70s the rent price was decided in a government level to avoid exceeding some amount: this, however,
has some issues. Given the fixed price, the market would only let a smaller quantity of apartment available (Q
upperbar - the apartment left to the market). The CS would become much larger, while PS much lower. But,
this implies that many apartment wouldn’t be in the market anymore: the outcome is inefficient.
There are apartments which could be sold to students who are willing to pay higher for those apartments.
However, some could argue the benefit of a competitive price that could lead to surplus that can be
redistributed through tax system: students in that case can be protected by giving subsidies and not by
interfering the market.
 Different scenarios in which the government use, or not use, the tax system:

Scenario without tax system:

1) international relations across countries;
2) developing countries with weak tax administration;
Let’s consider a price in a market with demand and supply and no tax system.
1

pmonopoly
po - d
What happens if prices go up from 0 to the maximum?
pinopson -

max as

As you increase a little the price, the first scenario is the monopsony price in which there is a maximisation of
the consumer surplus.
Then there is the price in a perfect competition in which both CS and PS are high equally.
Then there is the monopoly price with a maximisation of the PS.
PS 1
efficient
Pres NO AY SYSTEM

·
M
>

the price set by a monopoly (in absence of tax system) is Pareto efficient. All the efficient outcomes (Pareto
efficient) are those between the Price monopoly and the monopsony price.
A price lower than monopsony price is inefficient: it is possible to find another price which is higher where
both parties are better off.

Can i find another price were both parties are better off than a monopoly price? No.

This is because in absence of a tax system, there is no redistribution that could efficiently make better off
both parties. Pareto in this case states to avoid extremes.

Tax system scenario:

is
iM

·p
-
·

PS
-

-
Aparetocient outs

%
"
With redistribution it is possible to find a more efficient point. A monopoly outcome is inefficient in this case
because moving to the optimal point, the CS that increases can be redistributed to the PS that decreases
(the opposite holds as well as in the graph).

In a costly tax system a euro from the CS redistributed to the PS can be lost due to the costly system
(leaky bucket). It means you cannot move along the 45 degree line but highly steeper.
In this case the neighbourhood of the -
Optimal point becomes also efficient efficient
In an extremely costly system Daso
What is the cost of redistribution (tax system)?
Some could argue that costs would be high (super conservative - no redistribution because all of the money
get lost).
Others could argue that is little costly (ultra progressive).

Cost of administration: in Italy 100’000 people are hired for the tax administration;
Compliance costs: bolla di accompagnamento;
Disincentives: incentives when people are subject to taxes.

Market failures= situations in which market is inefficient.

1) Market power (monopoly) known to cause inefficiency (implication studied in competition economics,
industrial organisation);
2). Asymmetric information: developed starting from 1970s onwards (Ackerlof) = some parties have better
information (different from equally ignorant). Most famous example = adverse selection: market for “lemons”,
American slang meaning for defective product. And Market for “Prune” that stands for good products.

Collapse of the market:

1. Marx quote= i would never join a club willing to accept people like me.

• mandatory certification

3)public goods: non-rival in consumption (many people can benefit from the good at the same time).
4)externalities : side effects of economic activities (eg pollution, carbon issue …).
5)missing markets: part of market failure, equilibrium on goods traded but no market (misses). If you have N
market and 4 goods, and each good associate with price (P1, P2, P3) but for the 4th good there is a missing
market hence a missing price (P4 unknown).However, the last price that is missing affect the other markets: all
the other 3 markets are inefficient.

PUBLIC GOODS:
We are considering non-rival public goods, that is that more people can benefit from the same good.
Examples are: the light houses, bridges, public defence.
In this cases the cost of adding another consumer concerning that good is zero (0).
However, there are some intermediate cases of congestionable goods, this is the case of bridges that can be
congested.
n 1
1
rivs/ In
n-

>
n 14
non riva

There are goods that are also non-excludable: people cannot exclude others to use the good.
Let’s focus to non-rivalry goods.
This is the case of the competitive market failure. Services are provided at a cost, but the MC of serving an
additional person is 0 (C’n=0). If i am pricing at a certain cost, i would create a distortion similar to the
monopoly pricing, preventing people with lower willingness to pay to use the good.
Classic solution: public provision. Local administration uses the taxes to pay for the goods (tax payer finances
the goods). Example: the production of knowledge. Consider the university research, the discoveries are
available to everyone and usually the State funds the researches.
Consider a singer. according to the classical solution his music should be paid by the State. Does it
150 % public work? There are many problems:
1. real benefits: how the State know how much people like it. If there is a market the price can be set
Research
in a real value. No real value of the service.
2. Real costs: opportunity costs
~
so % private
J
3. Potential mismatch between those who pay and those who benefit (minor issue). In a market
inefficience D
solution this issue is solved.
Consider drugs:
• non excludable: provided by the public sector (State);
• Excludable: provided by the private sector (pharmaceutical companies can exclude people - consider the
price of vaccines that can be set and esclude people) - introduce property rights.
The choice to make excludable or not is a policy choice. +
Lindhal)
:
SAMUELSON RULES (previously Q
perfect quantity

=
*

Efficient level: cost of producing goo - independent k' 2 bi(q) c(a)

of
= -
=
h. 0

=
- -
w
(a) e
-

benefit
n= size
of community benefit from the public good >
-
not related to financing (who pays for it

This is welfare maximisation - can be applied only if there is a tax system that redistributes.

= MRSi = MR This is the case when no money in the economy

Take an example with fireworks. How many fireworks to launch? First of all, everyone should be able to see -
&

non rival good.

& b' = c' -Samuelson Rule

What happens to Q if n increases? If new people likes the fireworks, Q increases. If you increase n, then the
sum of the marginal benefit increases.
However, dogs owners may have a negative marginal benefit. More people in the city means an increase in
n, but many of this people may be dog owners with b’i<0. Thus Q decreases.

The hard part is to find out b’ and C’. It is possible to use some estimation methods:
1) surveys;
2) indirect methods to measure how much people like a public good. This is the case of transportation costs.
You have to see the distance that people are willing to take on foot instead on transports and considering the
value.
3) another indirect method is edonic pricing. Consider the need to set a price to a park. The method implies
to consider the houses near the park. If the price of the houses near the park increases you get an estimate
of the value of the service.
4) direct ways: referenda. It is a coarse info (grossolano) because its binary: people can only answer yes or
no.