Public Economics

Unit 1: Introduction

Dr. Ravikiran Naik

Introduction to Public Economics
Tuesday 5th September, 2023

Unit 1: Introduction· 1/62

» What is Public Economics? » Motivation 1: Practical Relevance

∗ Public economics focuses on answering two types of questions ∗ Interest in improving economic welfare → interest in public economics
1. How do government policies affect the economy? ∗ Almost every economic intervention occurs through government policy (i.e. involves
2. How should policies be designed to maximize welfare?
public economics) via two channels:

∗ Three motivations for studying these questions:

- Price intervention: taxes, welfare, social insurance, public goods
1. Practical Relevance - Regulation: minimum wages, FDA regulations (25% of products consumed), zoning, labor
2. Academic Interest laws, minimum education laws, environment
3. Methodology

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» Motivation 1: Practical Relevance » Motivation 2: Academic Interest

∗ Public economics is typically the end point for many other subfields
∗ Stakes are extremely large because of broad scope of policies
∗ Macro, development, labor, and corporate finance questions often ultimately motivated by
- Ex. Tax reforms immediately affect millions
a public economics question
- Ex 1: Macro studies on costs of business cycles and intertemporal models of household
∗ Contentious debate on the appropriate role of government in society
behavior
- Ex 2: Labor studies on employment effects of the minimum wage
∗ Only one of these views can be correct
- Injecting science into these debates has great practical value
∗ Natural to combine public finance with another field
∗ Understanding public finance can help ensure that you work on relevant topics

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» Motivation 3: Methodology » Theme 1: Connecting Theory to Data

∗ Modern public economics tightly integrates theory with empirical evidence to derive
∗ Public economics is at the frontier of a methodological transformation in applied quantitative predictions about policy
microeconomics - What is the optimal income tax rate?
- What is the optimal unemployment benefit level?
∗ Data-driven approach to answering important policy questions
∗ Traditional approach: theoretical models and numerical simulations
- Combines a broad set of skills: applied theory, applied econometrics, simulation methods
- Theory often makes weak predictions: optimal tax rate between 0 and 100
- Useful skill set for many applied fields in economics
- Numerical simulations rely on strong assumptions

∗ Topics in the course reflect a broad set of methodological themes

∗ Recent work derives robust formulas that can be implemented using well-identified
empirical estimates

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 Anscombe (1973): Dataset 1
» Theme 2: Quasi-Experimental Empirical Methods

15
∗ Research in public economics exploits a variety of quasi-experimental research designs to
β=0.5 (0.12)
identify parameters of interest
- Event studies, regression discontinuity, synthetic control

Earnings ($1000)
10
∗ Good way to learn practical lessons in applied econometrics

- What is ”identification by functional form” and why is it undesirable?

5
- Is the LATE or ATE of greater interest in your problem?
- When is propensity score reweighting credible?
- When do weak instrument problems arise and how can they be fixed?

0
∗ Emphasis on non-parametric graphical techniques rather than parametric regression 0 5 10 15 20
Years of Schooling
models
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Anscombe (1973): Dataset 2 Anscombe (1973): Dataset 3

15

15
β=0.5 (0.12) β=0.5 (0.12)
Earnings ($1000)

Earnings ($1000)
10

5 10
5

0
0

0 5 10 15 20 0 5 10 15 20
Years of Schooling Years of Schooling

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Anscombe (1973): Dataset 4

» Theme 3: ’Big Data’
15

β=0.5 (0.12)

∗ Compelling implementation of quasi-experimental methods requires a lot of data

Earnings ($1000)
10

∗ Recent availability of very large datasets has transformed research in applied

microeconomics
- Scanner data on consumer purchases
5

- Tax and social security records

- School district databases
0

0 5 10 15 20
Years of Schooling

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» Use of Pre-Existing Survey Data in Publications in Leading Journals, 1980-201

Use of Pre-Existing Survey Data in Publications in Leading Journals, 1980-2010
» Use of AdministrativeUse
DataofinAdministrative
Publications inData
Leading Journals, 1980-2010
in Publications in Leading Journals, 1980-2010
Micro-data Based Articles using Admin. Data (%)
Micro-data Based Articles using Survey Data (%)

100 100

80 80

60 60

40 40

20 20

0 0

1980 1990 2000 2010 1980 1990 2000 2010

Year Year
AER JPE QJE ECMA AER JPE QJE ECMA
Note: “Pre-existing survey”datasets refer to micro surveys such as the CPS or SIPP and do not Note: “Administrative”datasets refer to any dataset that was collected without directly surveying
include surveys designed by researchers for their study. Sample excludes studies whose primary individuals (e.g., scanner data, stock prices, school district records, social security records).
data source is from developing countries. Sample excludes studies whose primary data source is from developing countries.
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» What are the Benefits of Administrative Data? » Theme 4: Behavioral Models

∗ Recent work in public economics draws on insights from psychology and economics
1. Higher quality information: virtually no missing data or attrition literature
- Current Population Survey non-response rate now 31% for income
- Strong evidence that individuals fail to optimize

2. Longitudinal tracking over long periods ∗ Raises new policy questions

- Match rates of 95% over 20+ years in studies of long-term impacts of early childhood
education [Chetty et al. 2011, Chetty, Friedman, Rockoff 2012] ∗ Suggests new policy instruments

- E.g. information, social incentives

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» FOCUS QUESTIONS » Economics role of the Government

∗ Questions
- Why does government engage in certain economic activities?
∗ Central questions on public sector economics? - Reasons for changes in government’s scope over the years?
- Does the government do too much? Does it perform well?
∗ Differing views on the government’s economic role? Changes and reasons?
- Can government be more efficient in its economic role?
∗ How do economists study the public sector economics?
∗ Disagreements among economists on government policies? ∗ To address these questions, we will consider:
- The economic role of government in modern economies
- How ideas about the role of government have emerged
- The changing role of government in the twenty-first century

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» Public Policy: Case of India » India: Mixed Economy: (Capitalism with Government intervention)

∗ India’s experience since the First Five Year Plan

∗ Equal importance to private and public sector. However, major factors of production and
∗ Economic role of government changed
distribution are owned and managed by the state.
∗ Privatization: govt. firms to private
∗ Success or Failure?…Debatable issue
∗ New Economic Policy: 1990’s privatization in India
∗ Ex: India, France and Holland
∗ PSUs perform poorly vs. private firms
∗ India: Mixed Economy, govt. and private activities

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» Contrasting Economic Roles of Governments » Mixed Economy in the United States

∗ Former Soviet Union:

- Most economic activities were undertaken by the central government.
∗ North Korea and Cuba:
- Government has a significant role and primacy in economic activities.
∗ Western European economies: governments have had a larger role in economic activity
than US
∗ Privatization trend since the 1980s: government to private firms.
∗ Government role is still larger than in the United States after privatization.
∗ Origin
- US Constitution addressed the economic role of government: federal govt. specific roles
- Intellectual property rights established to encourage innovation.
- Federal govt.’s regulatory activities are justified under the interstate commerce clause.
∗ Evolution of the Economic Role of Government
- US government’s economic role has changed over time.
- Shift from private to public ownership of highways and railroads.
- Study of public sector economics in mixed economies is crucial.

∗ Some European privatizations fell short of expectations.

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» Influence of Adam Smith and the Laissez-Faire Doctrine
Views on the government’s economic role have evolved over time.
∗ Mercantilists advocated active government promotion of trade and industry.
∗ Adam Smith’s ”The Wealth of Nations” (1776)
- limited government; emphasis on competition and the public interest.
- The invisible hand concept promotes efficient outcomes in the economy.
∗ Adam Smith’s ideas influenced governments and economists.
∗ 19th-century economists like Mill and Senior supported laissez-faire ⇒ benefit society
∗ Laissez-faire proponents opposed government regulation of private enterprise.
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» Contrasting Principles and Changing Economic Roles
∗ Private ownership vs. government control: 21st century’s key political and economic
forces.
∗ Former Soviet Union and Eastern bloc transitioning to market systems, changing
government’s role.
∗ US government’s economic role evolving in response to century-long events.
∗ Broad consensus on the significance of markets and private enterprises, with government’s
complementary role.
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» Government Intervention in the Economy
∗ “When is government intervention necessary in a market economy?”
- Market first, government second approach
- Why? Private market outcome is efficient under a broad set of conditions (1st Welfare
Theorem)
∗ Two approaches :
1. How can government improve efficiency when the private market is inefficient?
2. What can the government do if the private market outcome is undesirable due to
redistributional concerns?
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» Government Response in the US and Post-War Challenges
∗ Federal government played a key role in stabilizing the economy during the Great
Depression.
∗ New Deal programs provided unemployment insurance, Social Security, and agricultural
support.
∗ Post-World War II prosperity was not evenly distributed.
∗ Some faced poverty, limited education, and job opportunities due to their circumstances.
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» Alternative Perspectives on the Role of Government
∗ Dissent among 19th-century social thinkers regarding Adam Smith.
∗ Concerns over inequality, living conditions, and unemployment spawned alternative
theories.
∗ Dickens depicted working-class struggles in novels.
∗ Marx, Sismondi, and Owen questioned private capital ownership.
∗ Marx advocated state control of production, and Owen promoted cooperation.
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» Contending Views on the Role of Government
∗ Government’s role sparks ongoing debate and disagreement.
∗ Role varies across countries, and evolves based on societal expectations and funding.
∗ Northern European countries prioritize government-provided services (higher taxes).
∗ Public health care systems achieved better outcomes at lower costs in some countries.
∗ 2008 economic crisis : the need for government intervention in market activities.
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» Changing Attitudes toward Government
∗ The Great Depression fundamentally changed attitudes toward government intervention.
∗ Market failure during the Depression led to pressures for government action.
∗ Keynes argued for government intervention during economic slumps.
∗ The belief in the government’s role in stabilizing the economy was embedded in
legislation.
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» Government Programs in the 1960s
∗ Inequities in society led to government programs enacted in the 1960s.
∗ President Lyndon B. Johnson initiated the ”War on Poverty.”
∗ Some programs aimed to provide a safety net, such as food and medical care.
∗ Other programs focused on improving economic opportunities, like job retraining and
Head Start.
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» Government Actions and Program Success
∗ Government actions aimed to alleviate societal problems and inequities.
∗ Success of programs measured based on their ability to address key issues.
∗ Program outcomes didn’t always meet the expectations of supporters but still had value.
∗ Example: Medicaid
∗ Social Security provided economic security, but future sustainability is questioned.
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» Government Programs and Criticisms
∗ Critics exaggerate government program failures, say supporters of continued efforts.
∗ Careful program design is crucial, acknowledging limitations and avoiding
“government failures”.
∗ Government should address social and economic problems despite limitations and market
failures.
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» Government and Market Limitations
∗ Markets can fail; governments aim to correct market failures.
∗ Economists acknowledge limitations of both government and markets.
∗ Consensus: markets fall short; efficiency assumptions have limits.
∗ Government tackles major market failures with proven impact.
∗ Dominant view: limited intervention, private enterprise at the core.
∗ Emphasis on synergy between government and markets, reinforcing each other.
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» Contemporary Rethinking of Government’s Role
∗ Views on government’s economic role are closer than a century ago.
∗ Contemporary rethinking: deregulation and privatization.
∗ Deregulation reduced government’s regulatory role under President Carter.
∗ Reforms in banking, telecommunications, and electricity for improved outcomes.
∗ Global reforms driven by market failures and technological advancements.
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» Challenges and Unintended Consequences
∗ Poverty persists despite government efforts, but programs have reduced its impact.
∗ Challenges remain in overcoming poverty and addressing unintended negative
consequences.
∗ Some programs intended to improve inner cities have led to affordable housing.
∗ Farm programs have disproportionately benefited large farms, impacting small farms.
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» Market Failures and Government Role
∗ Recent focus on market failures: excessive volatility and growing inequality.
∗ US faces high inequality and limited economic opportunity
∗ Concerns include predatory lending, abusive credit card practices, and exploitation of
market power.
∗ Role for government in addressing market failures, but concerns about government
contribution to problems.
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» Controversy over Government’s Role
∗ Controversy remains regarding government’s role in addressing market failures.
∗ Economists’ perspectives differ on market failures and government effectiveness. .
∗ Disagreements arise from views on market failures and inequality.
∗ Political factors shape opinions on government’s ability to address market failures.
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» THE EMERGING CONSENSUS: Deregulation and Privatization
∗ Deregulation enthusiasm, like in the US, led to crises and emphasized financial market
regulation.
∗ Privatization more common in Europe than the US, transferring government activities to
the private sector.
∗ Conflicts of interest with privatized firms complicated nuclear disarmament discussions.
∗ Privatization challenges the balance between private and public sectors in a mixed
economy.
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 Equity-E¢ ciency Tradeo¤
» Why Limit Government Intervention? » Equity-Efficiency Tradeof
Amy’
s
∗ One solution to these issues would be for the government to oversee all production and Consumption
allocation in the economy (socialism).

∗ Serious problems with this solution

1. Information: how does the government aggregate preferences and technology to choose
optimal production and allocation?

2. Government policies distort incentives (behavioral responses in the private sector)

∗ In practice, there are sharp tradeoffs between the costs and benefits of government
intervention
Bob’
s Consumption

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» When is Government Intervention Necessary? » When is Government Intervention Necessary?...

∗ Externalities and transaction costs require intervention

∗ Asymmetric information ⇒ market failures: health insurance is an example
∗ Government provides public goods (e.g., bridges, education)
∗ Government intervention may be necessary (e.g., mandate insurance coverage, Forced
∗ Relevant Questions: saving through social security)
- How much to provide? ∗ Markets not entirely competitive, need regulation (e.g., electricity)
- What to provide?
∗ Paternalistic approach (e.g., banning smoking in public places)
- How to incentivize socially beneficial behavior?
- How to finance public goods (tax types)?

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» First Welfare Theorem

∗ Private market alone can’t handle all functions in the economy: market failure! ∗ Private market ⇒ Pareto efficient outcome under three conditions
∗ Markets deliver private goods efficiently but not social goods.
1. No externalities
∗ Consumers won’t pay for social goods voluntarily: Free riding problem exists.
∗ Private markets ̸= supply public goods (no exclusion). 2. Perfect information

∗ Public intervention improves economic outcomes. 3. Perfect competition

∗ Theorem tells us when the government should intervene

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» Failure 1: Externalities » Failure 2: Asymmetric Information and Incomplete Markets

∗ When some agents have more information than others, markets fail

∗ Markets may be incomplete due to lack of prices (e.g. pollution) ∗ Ex. 1: Adverse selection in health insurance
∗ Achieving efficient Coasian solution requires an organization to coordinate individuals – - Healthy people drop out of private market → unraveling

that is, a government - Mandated coverage could make everyone better off

∗ This is why government funds public goods (highways, education, defense)

∗ Ex. 2: Capital markets (credit constraints) and subsidies for education
∗ Questions: What public goods to provide and how to correct externalities?
∗ Ex. 3: Markets for intergenerational goods

- Future generations’ interests may not be fully reflected in market outcomes

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 » Failure 3: Imperfect Competition » Individual Failures

∗ If agents do not optimize, government intervention (e.g. by forcing saving via social
∗ When markets are not competitive, there is a role for government regulation security) may be desirable
- Ex: natural monopolies such as electricity and telephones
∗ This is an ”individual” failure rather than a market failure
∗ This topic is traditionally left to courses on industrial organization ∗ Conceptual challenge: how to avoid paternalism critique
∗ But taking the methodological approach of public economics to problems traditionally - Why does government know better what’s desirable for you (e.g. wearing a seatbelt, not
analyzed in IO is a very promising area smoking, saving more)

∗ Difficult but central issues for optimal policy design

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» Re-distributional Concerns » Central Public Economic Questions

∗ Even when the private market outcome is efficient ̸= good distributional properties ∗ What is to be produced? Allocation of resources between public and private goods.
∗ Efficient markets generally seem to deliver very large rewards to a small set of people ∗ How should it be produced? Decisions on production methods and technologies.
∗ Government can redistribute income through the tax and transfer system ∗ For whom is it to be produced? Distribution of income and public goods.
∗ Distributional considerations are vital in public policy. ∗ How are production decisions made?

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CHAPTER 1 DEFINING PUBLIC SECTOR RESPONSIBILITIES

» Production Possibilities Schedule » Collective Decision Making

IGURE 1.1 Private
goods
ODUC TION
SCHEDULE N
aximum level G ∗ Choices made in the public sector are collective decisions. Challenging Part!
s that society
evel of public E ∗ Disagreements in collective decision-making ⇐ differing preferences.
shes to enjoy
s, it must give ∗ Decision-making in large corporations is more complex than simplistic models.
rivate goods.
Production ∗ Differences in views and values affect decision-making within corporations.
I possibilities
schedule ∗ Public sector economics studies collective choices in democratic societies.

Public
goods

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2. How should it be produced? Under this question are subsumed such deci-
sions as whether to produce privately or publicly, to use more capital
and less labor or vice versa, or to employ energy-efficient technologies.
Other issues are also subsumed under this second question. Gov-
ernment policy affects how firms produce the goods they produce:
environmental protection legislation restricts pollution by firms; pay-
» Four stages ofroll taxesanalysis:
economic that firms must pay on the workers they employ may make » Economics Models
labor more expensive and thus discourage firms from using production
techniques that require much labor.
∗ Understanding Policy Consequence
describe, analyze, evaluate,
3. For whom and
is it to beinterpret
producedgovernment
(the questionactions
of distribution)? Government
- Consequences of policies are central to public sector economics analysis.
decisions about taxation or welfare programs affect how much income
- Disagreements among economists require empirical testing of predicted outcomes.
1. Knowingdiff erent
what individuals
activities have sector
the public to spend. Similarly,
engages in andthehowgovernment must
these are organized
decide what public goods to produce. Some groups will benefit from the - Historical evidence often falls short in resolving disagreements about economic behavior.
2. Understanding and, insofar as possible, anticipating the
production of one public good, others from another.
full consequences of these
governmental activities. ∗ Analyzing Policy Consequences
4. How are choices made? In the public sector, choices are made collec-
3. Evaluating Alternative Policies - Economic models analyze policy impacts, simplifying essential features.
tively. Collective choices are the choices that a society must make
- Models focus on relevant details for specific questions in the complex economy.
4. Interpreting the Political
together—for Processchoices concerning its legal structure, the size
instance,
of its military establishment, its expenditures on other public goods, - Simplifying assumptions in models are advantageous, not detrimental.
and so on. Texts in other fields of economics focus on how individuals
make their decisions concerning consumption, how firms make their
decisions concerning production, and how the price system works to
ensure that the goods demanded by consumers are produced by fiUnit rms.
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» Three Types of Questions in Public Economics
1. Positive analysis: What are the observed effects of government programs and
interventions?
2. Normative analysis: What should the government do if we can choose optimal policy?
3. Public choice/Political economy
- Develops theories to explain why the government behaves the way it does and identify
optimal policy given political economy concerns
- Criticism of normative analysis: fails to take political constraints into account
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» Consequences and Normative Evaluation of Beer Tax
Consequences of Beer Tax (Positive Economics):
∗ Estimating the effect of the tax on the quantity of beer consumed.
∗ Investigating the relationship between beer consumption and road accidents.
∗ Attempting to estimate the impact of the tax on the number of accidents.
Normative Evaluation:
∗ Balancing tax revenue benefits and consumption distortions.
∗ Addressing inequities from tax burden on lower-income individuals.
∗ Evaluating potential lives saved from reduced road accidents.
∗ Comparing beer tax with other revenue-raising methods.
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» Disagreements in Policy Analysis
∗ Disagreements in Consequences (Positive Analysis)
- Varying opinions on the consequences of policies such as affirmative action
- Differences in views on the progressiveness of the income tax.
- Divergent perspectives on the effectiveness and allocation of resources in providing education.
∗ Disagreements in Values (Normative Analysis)
- Diverse opinions on the desirability of affirmative action
- Varying stances on the progressiveness of the income tax.
- Conflicting views on the allocation of resources for education.
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» Positive (Outcomes) and Normative Economics (Desirability Distinction)
∗ Positive economics describes the economy’s functioning.
∗ Normative economics evaluates policy desirability. Relies on positive economics.
∗ Good normative economics= explicit about values=policy recommendations aligned with
objectives.
The normative logic . . . though it yields by itself no final answers, does provide guidance as
to the lines along which answers may fruitfully be sought.—William Vickrey
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» Analysis of Political Processes
∗ Positive Analysis
- Describing the consequences of the majority voting system.
- Examining the impact of political processes on social choices.
- Analyzing the consequences of different rules and reforms in political campaigns.
∗ Normative Analysis
- Consequences of a two-thirds majority for public expenditures.
- Effects of increased politicians’ pay and restricted contributions.
- Implications of public support for political campaigns.
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» Disagreements how economy behaves
∗ Predicting Consequences of Policies
- Analyze the full consequences of policies by predicting household and firm reactions.
- Example: England’s window tax in 1696 as a substitute for an income tax.
∗ Debate on the value individuals place on the light in their houses and their WtP the tax.
∗ Lack of statistical studies at that time ⇒ uncertainties in predicting the revenue and outcomes.
∗ Government raised less revenue than expected, resulting in darker homes for many.
∗ Economists disagree on the best economic model
- differ on response type and magnitude.
- Some use perfect info & competition model; Others argue for imperfect info & competition.
- Studies, data, and techniques yield diverse conclusions.
- Advancements in data analysis may resolve disagreements.
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