P. 1
Public Finance 1

Public Finance 1

|Views: 9|Likes:
Published by Navendu Sharma
Pub Fin
Pub Fin

More info:

Published by: Navendu Sharma on Feb 28, 2013
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

02/28/2013

pdf

text

original

Public Finance in Theory and Practice

Durgesh C Pathak
M W F: 4; G 105; Tutorial: M 8; G 105 CCH: 12-1 pm on Class Days (M W F)

Public Finance is nothing else than a sophisticated discussion of the relationship between the individual and the state. There is no better school of training than public finance. : Vaclav Klaus

Public Finance in Theory & Practice Durgesh C Pathak

2

Organic View of the Government

Individuals form a society

Society is a natural organism

Government is the heart of the natural organism

Community welfare

>>

Individual welfare

Example: “An activity of a citizen is desirable only if it leads to a just society.” : The Republic

The goals of the Society are set by the government

Public Finance in Theory & Practice Durgesh C Pathak

3

Mechanistic View of the Government Government is a contrivance created by individuals to better achieve their individual goals “Government is a trust.” : Henry Clay (1829) Public Finance in Theory & Practice Durgesh C Pathak 4 . and both the trust and the trustees are created for the benefit of the people. and the officers of the government are trustees.

which it can never be the interest of any individual.” : Adam Smith Public Finance in Theory & Practice Durgesh C Pathak 5 .Protection from violence Good of people! So what is good? Protection from physical coercion “Creating and maintaining certain public works and certain public institutions. to erect and maintain. or small number of individuals.

then be trusted with the government of others? Or have we found angels in the form of kings to govern him? Let history answer this question.” Sometimes it is said that man cannot be trusted with the government of himself. E. Can he.. Public Finance in Theory & Practice Durgesh C Pathak 6 .” : Thomas Jefferson Libertarians Mechanistic View of Government Social Democrats Substantial government intervention is required for good of individuals.g.Believe in very limited role of government Extremely skeptical ability of governments to improve social welfare.

political.Modes of Analysis What are the responses of the public/private sector to various fiscal measures? Positive Analysis What are the social. and historical forces that have shaped the present fiscal institutions and which have determined the formulation of contemporary fiscal policy? Modes of Analysis Normative Analysis What criteria should be applied when one is judging the merit of various budget policies? Public Finance in Theory & Practice Durgesh C Pathak 7 .

Tools of Positive analysis The Role of Theory Effect of a tax on wage income on work hours To generate testable hypotheses whose validity can be assessed through empirical work Public Finance in Theory & Practice Durgesh C Pathak 8 .

the cause and the effect) must be correlated o Other possible explanations (say factor Z) for any observed correlation must be eliminated.Causation versus Correlation Conditions necessary for establishing cause and effect: o The Cause (X) must precede the Effect (Y) o X and Y (i. Public Finance in Theory & Practice Durgesh C Pathak 9 . This is called ‘Third Variable Problem’.e..

Treatment Group Experimental Study Control Group Or Counterfactual Observational Study Use of Regression Types of Data Cross-Sectional data Time-Series data Panel data Public Finance in Theory & Practice Durgesh C Pathak 10 .

Tools of Normative Analysis Pure Exchange Economy: o Two People o Two Goods in fixed supplies The Economic Problem: Distribution of the two goods between the two people Tool used: Edgeworth Box Diagram Edgeworth Box Diagram shows allocation of two goods between two people. Public Finance in Theory & Practice Durgesh C Pathak 11 .

Eve has 0’Y of Apples & O’W of Fig Leaves Public Finance in Theory & Practice Durgesh C Pathak Fig Leaves 12 . At point V. Adam has: 0X of Apples & 0U of Fig Leaves.Apples Y R O’ Eve Fig Leaves U V W Adam O X Apples Figure 1: Edgeworth Box diagram of Distribution of Apples and Fig Leaves between Adam & Eve At point V.

Apples R E3 O’ E2 E1 Eve Fig Leaves A1 A2 Adam O Apples Figure 2: Indifference Curves in an Edgeworth Box Public Finance in Theory & Practice Durgesh C Pathak Fig Leaves 13 .

g. Point P in Fig. 3 Public Finance in Theory & Practice Durgesh C Pathak Fig Leaves Pareto Efficient Point 14 . E..Apples R E3 G O’ Eve Fig Leaves P H A1 A2 A3 Adam O Apples Figure 3: Pareto Efficient Allocation of Resources/Goods An allocation point at which the only way to make a person better off is to make another person worse off is called a Pareto Efficient Point.

Example: a movement from point H to point P in Fig.Pareto Improvement: a reallocation of resources/goods that makes one person better off without making anyone worse off. 3 One can find innumerable number of Pareto Efficient Points in an Edgeworth Box Apples R O’ Eve Contract Curve G Fig Leaves P H O Adam Apples Figure 4: The Contract Curve Public Finance in Theory & Practice Durgesh C Pathak Fig Leaves Q 15 .

𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 ………………………eq.Contract Curve: The locus of all Pareto Efficient Points in an Edgeworth Box 𝐴𝑑𝑎𝑚 ∵ 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑖𝑛𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑢𝑟𝑣𝑒 𝑜𝑓 𝐴𝑑𝑎𝑚 = 𝑀𝑅𝑆𝑎𝑓 and. o The Contract curve is the Locus of Points of equal MRS Public Finance in Theory & Practice Durgesh C Pathak 16 . 1 Therefore. 𝐸𝑣𝑒 ∵ 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑖𝑛𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐶𝑢𝑟𝑣𝑒 𝑜𝑓 𝐸𝑣𝑒 = 𝑀𝑅𝑆𝑎𝑓 ∴ 𝑎𝑡 𝑡𝑎𝑛𝑔𝑒𝑛𝑐𝑦 𝑝𝑜𝑖𝑛𝑡 𝑃. o Pareto Efficiency requires that MRS is equal for all consumers and.

c Figure 5 Fig leaves per year w 𝑆𝑙𝑜𝑝𝑒 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑇𝑟𝑎𝑛𝑠𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 y d 0 x z Apples per year Public Finance in Theory & Practice Durgesh C Pathak 17 . If the productive inputs can shift between production of the two goods.The Production Economy Lets relax the assumption of Fixed supplies of the commodities. we face a trade off.

Public Finance in Theory & Practice Durgesh C Pathak 18 . the incremental cost of producing XZ of Apples is WY of Fig leaves ∴ 𝑀𝐶𝑎 = 𝑤𝑦 But 𝑀𝐶𝑎 = 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑃𝑃𝐹 = 𝑀𝑅𝑇𝑎𝑓 … … … … … … … … … … … … … … 𝑒𝑞.𝑴𝑹𝑻𝒂𝒇 is rate at which economy can transform apples into fig leaves Try to think of 𝑀𝑅𝑇𝑎𝑓 in terms of Marginal Costs ∵ In Figure 5. the incremental cost of producing WY of Fig leaves is XZ of Apples ∴ 𝑀𝐶𝑓 = 𝑥𝑧 Similarily. ∵ In Figure 5. 2 𝑓 𝑀𝐶 Thus. 𝑴𝑹𝑻𝒂𝒇 is the marginal cost of producing one more unit of fig leaves or one more unit of apple.

1 We need to extend the Pareto Efficiency Condition in case of Variable supplies of Apples and Fig Leaves.Efficiency Conditions with Variable Production Pareto Efficiency Condition in a Fixed Supply Economy: 𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 … … … … … . Since Supply is variable. Public Finance in Theory & Practice Durgesh C Pathak 19 . 𝑀𝑅𝑇𝑎𝑓 comes into picture. 3 ⇒ The rate at which apples can be transformed into fig leaves 𝑴𝑹𝑻𝒂𝒇 must equal the rate at which the consumers are willing to trade apples for fig leaves 𝑴𝑹𝑺𝒂𝒇 . 𝑓𝑟𝑜𝑚 𝑒𝑞. 𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 𝑀𝑅𝑇𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 … … … … … … … … … … … … 𝑒𝑞.

4 Eq. 𝑀𝐶𝑎 𝑀𝐶𝑓 𝑀𝐶𝑎 𝑀𝐶𝑓 𝑓𝑟𝑜𝑚 𝑒𝑞. 4 is the necessary condition for Pareto Efficiency in an economy with variable Supplies of commodities. Public Finance in Theory & Practice Durgesh C Pathak 20 .Since 𝑀𝑅𝑇𝑎𝑓 = Therefore. 2 𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 = 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 … … … … … … … … … … … … 𝑒𝑞.

a Pareto Efficient allocation of resources emerges. if following Conditions/assumption are met: o All producers and consumers act as perfect competitors o A market exists for every commodity If the above two assumptions are met.The First Fundamental Theorem of Welfare Economics Answers the question “whether a given economy will achieve the Pareto Efficient State Yes. Public Finance in Theory & Practice Durgesh C Pathak 21 .

Since it is a perfect market. . . 5 & eq. 6. for Utility maximization. 5 𝑃𝑓 Similarly for Eve 𝑃𝑎 𝐸𝑣𝑒 𝑀𝑅𝑆𝑎𝑓 = … … … … … … . a necessary condition is that 𝑃𝑎 𝐴𝑑𝑎𝑚 𝑀𝑅𝑆𝑎𝑓 = … … … … … … . 6 𝑃𝑓 From eq. both Adam and Eve should pay same prices for apples and fig leaves Further. 𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 Which is nothing but eq. 𝐸𝑞. 𝐸𝑞. 1 (necessary condition for Pareto Efficiency) Public Finance in Theory & Practice Durgesh C Pathak 22 .

8 𝑃𝑓 Public Finance in Theory & Practice Durgesh C Pathak 23 . 𝑒𝑞. 6. we get 𝐴𝑑𝑎𝑚 𝐸𝑣𝑒 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑆𝑎𝑓 = 𝑀𝑅𝑇𝑎𝑓 Which is the necessary condition for Pareto Efficiency But since 𝑀𝐶𝑎 𝑀𝐶𝑓 𝑃𝑎 … … … … … … … … . . A profit maximizing firm would produce up to a point where MC is equal to Price 𝑀𝐶𝑎 𝑃𝑎 = … … … … … … … . and 8. 7 𝑀𝐶𝑓 𝑃𝑓 is the MRT between apples and fig leaves. 𝑒𝑞. 5. 𝑀𝑅𝑇𝑎𝑓 = From eq.Now consider the production side as well. So.

we get 𝑃𝑎 𝑀𝐶𝑎 = … … … … 𝑒𝑞. 9 𝑃𝑓 𝑀𝐶𝑓 ⇒ For Pareto Efficiency. why not. 4. 5 or 6 into eq. Prices must be in the same ratio as the Marginal Costs. Public Finance in Theory & Practice Durgesh C Pathak 24 .Can we re-write the conditions for Pareto Efficiency in terms of Marginal Cost? Yes. Substituting eq. ⇒ Efficiency requires the additional cost of each commodity is reflected in its price.

Fairness and the Second Fundamental Theorem of Welfare Economics o Why do we need a government? o Is Pareto Efficiency desirable? Apples R O’ Eve Contract Curve G Fig Leaves P Z H O Adam Apples Figure 6: Efficiency Versus Equity Public Finance in Theory & Practice Durgesh C Pathak Fig Leaves Q 25 .

favours more equal distribution of resources Now.. we have to make a value judgment about which of these is a FAIR distribution Public Finance in Theory & Practice Durgesh C Pathak 26 . i.e.What should be the allocation of resources: o Point P? o Point Q? o Point Z? Case for Point P: o Is Pareto Efficient o Favours Eve! Case for Point Q: o Is Pareto Efficient o Favours Adam! Case for Point Z: o Not Pareto Efficient o Favours everyone almost equally.

We can derive a Utility Possibilities Curve from the Contract Curve! Utility Possibility Curve: A graph showing the maximum amount of one person’s utility given each level of utility attained by the other person. U Eve’s Utility  𝑃 𝑍 𝑄 U Adam’s Utility  Figure 7: Utility Possibility Curve Public Finance in Theory & Practice Durgesh C Pathak 27 .

10 Social Welfare (W) is some function (F) of each individuals utility Public Finance in Theory & Practice Durgesh C Pathak 28 .o All points on the Curve UU are Pareto Efficient o These points differ in the allocation of resources they implicitly indicate o Which point is the BEST? The answer lies in the Social Welfare Function A statement of how the society’s well-being relates to the well-being of its members Social Welfare Function Society’s view on relative deservedness of Adam and Eve 𝑊 = 𝐹 𝑈 𝐴𝑑𝑎𝑚 . 𝑈 𝐸𝑣𝑒 … … … … … … 𝑒𝑞.

Try to think in terms of Utility: Social Indifference Curves show how society is willing to trade off one individual’s utility for the other’s U Eve’s Utility  𝑖 𝑖𝑖𝑖 Social Welfare is Increasing as we move to a higher curve 𝑖𝑖 𝑈2 𝑈1 𝑈3 U Adam’s Utility  Figure 8: Maximizing Social Welfare o Point 𝑖: Pareto Efficient but Not fair! o Point 𝑖𝑖: Not Pareto Efficient but fair! o Point 𝑖𝑖𝑖: Pareto Efficient and fair! Public Finance in Theory & Practice Durgesh C Pathak 29 .

it is possible that the free-market allocation of resources may be inefficient and unfair.⇒ Even if an economy generates a Pareto Efficient Allocation of resources. government intervention may be necessary to achieve a “fair” distribution of utility and thus to maximize the social welfare. When the conditions required for the First Welfare Theorem to work are not met in the real world. Public Finance in Theory & Practice Durgesh C Pathak 30 . Government intervention becomes desirable in such circumstances.

You're Reading a Free Preview

Download
scribd
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->