ECO 354 Public Economics

(Undergraduate)

Kriti Manocha

Shiv Nadar Institute of Eminence

Spring 2025

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Public Economics

Public Economics is the study of the role of the government in the economy.

Government is instrumental in most aspects of economic life.

Education, retirement benefits, health care rely heavily on government/employers

support.

Almost every economic intervention occurs through government policy via two
channels:
• Price intervention: taxes, welfare, social insurance, public goods
• Regulation: min wages, FDA regulations, zoning laws, labor laws, min
education laws, environment, legal code

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Role for Economists

Economists have a narrow minded view of individual behavior: purely selfish and
economically rational agents interacting through markets.

The core of the economy: profit-maximizing firms interacting with households in

competitive markets under certain conditions generates a desirable (efficient)
outcome.

If these conditions were satisfied, the role of the government would be very limited.

Over the past decades, many evidences highlighted that the market does not work
so perfectly. Precisely:
– periods of massive unemployment
– pollution
– Economic crisis 2008

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Role for Economists

To understand the role of the public sector we have to understand:

1. When markets work well

2. When, and in what ways, they do not

Economic theory can help in understanding when markets are useful and how
individualistic forces can undermine institutions.

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Questions in Public Economics

1) When should the government intervene in the economy?

2) How might the government intervene?

3) What is the effect of those interventions on economic outcomes?

4) Why do governments choose to intervene in the way that they do?

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Market Efficiency

Which notion of efficiency can we use to evaluate the alternatives?

Resource allocations so that no one can be made better off without someone
being made worse off are said to be Pareto efficient, or Pareto optimal

...the government is contemplating building a bridge. Those who wish to use the
bridge are willing to pay more than enough in tolls to cover the costs of
construction and maintenance the construction is likely to be a Pareto
improvement...

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First Welfare Theorem

Private market provides a Pareto efficient outcome under three conditions

• No Externalities
• Perfect information
• Perfect competition

Theorem tells us when the government should intervene.

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When should the government intervene in the economy?

1) Market Failures: Market economy sometimes fails to deliver an outcome that

is efficient.

Main market failures:

• Externalities: (example: greenhouse carbon emissions) ⇒ require govt

interventions (such as corrective taxation)
• Imperfect competition: (example: monopoly) ⇒ requires regulation
(typically studied in Industrial Organization)
• Imperfect or Asymmetric Information: (example: health insurance markets
are subject to death spirals)
• Individual failures: People do not behave as “fully rational individuals”.
This is analyzed in behavioral economics a field in huge expansion (example:
myopic people may not save enough for retirement)

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Failure 1: Externalities

Markets may be incomplete due to lack of prices (e.g. pollution)

Achieving efficient Coasian solution requires an organization to coordinate

individuals that is, a government

This is why govt. funds public goods (highways, education, defense)

Questions: What public goods to provide and how to correct externalities?

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Failure 2: Asymmetric Information and Incomplete Markets

When some agents have more information than others, markets fail

Ex. 1: Adverse selection in health insurance. Healthy people drop out of private
market.

Ex. 2: Capital markets (credit constraints) and subsidies for education

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Failure 3: Imperfect Competition

When markets are not competitive, there is role for govt. regulation

Ex: natural monopolies such as electricity and telephones

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Failure 4: Individual Failures

Recent addition to the list of potential failures that motivate government

intervention: people are not fully rational

Government intervention (e.g. by forcing saving via social security) may be

desirable

This is an individual failure rather than a traditional market failure

Conceptual challenge: how to avoid paternalism critique

Why does govt. know better what’s desirable for you (e.g. wearing a seatbelt, not
smoking, saving more)

Difficult but central issues to policy design

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When should the government intervene in the economy?

2) Redistribution: Even when the private market outcome is efficient, may not
have good distributional properties. It might generate very high economic
disparity across individuals

Governments use taxes and transfers to redistribute from rich to poor and reduce
inequality

Redistribution through taxes and transfers might reduce incentives to work

(efficiency costs)

⇒ Redistribution creates an equity-efficiency trade-off

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Efficient Private Market Allocation of Goods

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Role for Government: Improve Efficiency

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Role for Government: Improve Distribution

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Types of Intervention

1. Regulation

Relevant to efficient or equitable operation of markets under imperfect information

Regulation of quality mainly affects supply: hygiene laws, consumer protection

laws

Regulation of quantity mainly affects demand: requirement to attend school, take

out car insurance

Regulation of price: minimum wage, rent control

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Types of Intervention

2. Finance

Subsidies/taxes

Income transfers: tied to specific types of expenditure (education vouchers,

housing benefits) OR untied (social security benefits)

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Types of Intervention

3. Production

Regulation and Finance modify markets but the state can produce goods and
services itself

State owns capital inputs and employs labour to produce education and health
care services.

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What Are the Effects of Alternative Interventions?

1) Direct Effects: The effects of government interventions that would be

predicted if individuals did not change their behavior in response to the
interventions.

2) Indirect Effects: The effects of government interventions that arise only

because individuals change their behavior in response to the interventions
(sometimes called unintended effects)

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Why Do Governments Do What They Do?

Political economy: The theory of how the political process produces decisions
that affect individuals and the economy

Explains why the government behaves the way it does and identify optimal policy
given political economy concerns.

Example: Understanding how the level of taxes and spending is set through
voting and voters’ preferences in a democracy

Public choice is a sub-field of political economy from a Libertarian perspective

that focuses on government failures

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Normative vs Positive Public Economics

Normative Public Economics: What should the government do if we can choose

optimal policy? (e.g., should the government intervene in health insurance
market? how high should taxes be?, etc.)

Positive Public Economics: What are the observed effects of government

programs and interventions? (e.g., Does govt provided health care crowd out
private health care insurance? Do higher taxes reduce labor supply?)

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Outline of the course

• Fundamentals revisited
• Public Goods and Externalities
• Tax Incidence and Efficiency
• Income Taxation and Labor Supply

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References

• Economics of the Public Sector [4th edition] by J E Stiglitz and J K

Rosengard, published by WW Norton & Co, 2015.
• Public Finance and Public Policy [6th edition] by Jonathan Gruber,
Macmillan, 2019.

Any other editions of these texts would also do.

We will loosely refer to these references.
It is not an exhaustive list.
Lecture slides will be forwarded after the lecture.
Detailed lecture notes will NOT be provided (presence in class is implied).

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Assessment

• Problem sets (30%)

• Midterm examination (20%)
• Final examination (50%)

Midterm examination will cover everything covered before that. Likewise for final
examination.

Problem sets will be take-home group assignments/quizzes during tutorials.

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More..

Office hours: Monday 4 pm to 6 pm

Please email before dropping by the office.

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