Test 1 Notes

This set of notes for the midterm is meant as a supplement to your other study materials:
class notes, problem set and quiz solutions, and notes from the test review.
What We Have Done
The book gives four central questions to the study of public finance:
1. When should the government intervene in an economy?
2. How might the government intervene?
3. What is the effect of government interventions on economic outcomes?
4. Why do governments choose to intervene in the way that they do?
To answer any of the above questions we first need a framework. A framework is a toolkit that
allows us to reduce very complicated questions into something that we can digest in order
to bring credible answers forward. Our toolkit is microeconomics and the use of marginal
analysis to understand social problems.

Efficiency and Market Failure

In a market for a privately produced final good, the efficiency conditions are
1. MC=MB for the final trade (where supply and demand intersect, generating P ∗ and
Q∗
2. Gains from trade are maximized if equilibrium price P ∗ and quantity Q∗ prevail. This
is the no deadweight loss condition.
The outcome from a supply and demand model is the pareto efficient outcome for that
single market. Understand this is a theoretical idea and not likely to represent most markets
we face in reality. We start our analysis with the efficient outcome as a baseline then compare
how consumer surplus and producer surplus changes when P ∗ and Q∗ do not prevail. In this
case of market failure gains from trade are not maximized and either consumers, producers,
or both are made worse off.

Elasticities
To understand changes to consumer, producer, and total surplus under market failure we
must understand elasticities of supply and demand. You should know the range of values
for the supply and demand curves deemed either to be elastic or inelastic. Recall that in
the very short run the supply curve is perfectly inelastic. You should also be able to draw
supply and demand curves under different elasticity assumptions and tie those concepts to
market failure and surplus changes.

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Utility Maximization
If I give you a utility function, and a budget constraint, you should be able to draw an indif-
ference curve, the budget constraint, and show the optimal choices of two goods described
(X1 and X2 for instance). You should also be able to identify the why the slope of the budget
constraint and the intercepts of the budget constraint change when a tax is applied to the
price of one or both goods.

Social Welfare Functions

We covered four social welfare functions:

1. Utilitarian or additive SWF

2. Distributional Weights SWF (Weighted Sum)

3. Rawlsian SWF

4. Pure Efficiency SWF

The most important thing here is to understand that SWFs are used as an alternative to
surplus/welfare analysis. To study welfare changes using SWFs, it requires the economist
to specify a utility function and/or define how to weight each member of society when
aggregating gains from trade. Both the form of the utility function and the weights applied
play a large role in what a SWF will reveal about winners and losers of policy. Important
consideration in the use of social welfare functions include:

• The income distribution of the economy studied

• How a policy affects different people along the income distribution

• How each social welfare function aggregates the gains and losses for different people
along the income distribution

• Regressive and progressive policy

Public Goods
The government has a role in providing certain public goods for society. Consider a good G,
which fits the definition of a pure public good :

• non-rivalrous

• non-excludable

The production of G requires the same capital and labor resources that would otherwise
be used for private production of other goods that people enjoy. The question immediately
becomes what is the efficient level of G?

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The Samuelson condition gives us a way to solve for G∗ and evaluate how the efficient public
good level changes when other aspects of society change. There are no prices, no taxes, and
the results are driven purely by opportunity cost of using up capital and labor for G. The
Samuelson question will come directly from the problem set. Our baseline setup of public
goods includes

• Specifying the utility of households living in a community

• Requiring allocative efficiency over private consumption goods and public goods (ie all
input resources are used up)

• Assuming that the goal is pareto efficiency (ie no one household’s utility should de-
crease)

Mathematically we use these assumptions to show that efficient public good provision occurs
where MB = MC, where MB is the sum of the MRS across all household’s in society, and
MC is the marginal cost of the public good in terms of less production of private goods.There
will be at least one question on the test that requires you to solve the Samuelson condition
and answer questions about the parameters involved. The Samuelson question will come
directly from the problem set.

Externalities
An example of market failure are externalities. They occur when social benefits do not
equate with private benefits, or social costs do not equate with private costs. There are four
types of externalities we have modeled in class

1. Positive consumption externality

2. Negative consumption externality

3. Positive production externality

4. Negative production externality

For any of these you should be able to draw a supply and demand diagram to illustrate the
market failure and deadweight loss. Conceptually, you should be able to describe who bears
the cost or benefits if the externality is left unmitigated, and identify the deadweight loss.
The Coase Theorem gives us a good idea of what is required for the free market to fully
internalize the additional costs and benefits of externalities. The Coase Theorem is a step
towards private sector regulation or compensation for spillovers from externalities.

Taxes, subsidies and quotas are the public sector approach for regulating externalities.
A few things to consider in the public sector cases:

• Efficiency of taxes vs quotas

• What happens to deadweight loss under taxation and quotas

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• How elasticities play a role in the winners and losers of taxes and quotas

• How a tax or quota on one market can have spillover effects on complement or substitute
good markets (and input markets)

• How a subsidy in one market can have spillover effects on complement or substitute
good markets (and input markets)