Four questions of 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 the way they do?
- Competitive market equilibrium = the most efficient outcome for society.
- Market failure: a problem that causes the market economy to deliver an outcome that does
not maximise efficiency.
- Negative externality - one person’s decision imposes costs on others.
- Efficient outcome not necessarily socially desirable.
- Redistribution. Usually, it entails an equity-efficiency trade-off.
- Tax or subsidise private sales or purchases.
- Restrict or mandate private sale or purchase.
-Public provision - government provides the good directly.
- Public financing of private provision - government pay; orivate companies produce.
- Direct and indirect effects.
- Political economy: The theory of how the political process produces decisions that affect
individuals and the economy.
- Twon perspectives in analysing the public sector: positive and normative.
Theoretical Tools used:
- Utility maximisation.
-Whenever a consumer is at a point where the indifference curve and the budget constraint
are not tangent, they can become better off by moving to a point of tangency. Tangency ⇔
Pm/Pc
consumer sets = −𝑀𝑅𝑆
- When prices change - substitution and income effect.
- • Substitution effect: Holding utility constant, a relative rise in the price of a
good will always cause an individual to choose less of that good.

• Income effect: A rise in the price of a good will typically cause an individual to choose less
of all goods because their income can purchase less than before.
- Normal goods: goods which demand increases as income rises.
- Inferior goods: goods which demand falls as income rises.
- Substitution effect holds utility constant but changes the income while reflecting the change
in relative prices.
- Welfare economics: the study of the determinants of well-being, or welfare in society. We
discuss it by social efficiency and then how to integrate redistribution into this analysis.
- Social efficiency: the net gains to society from all trades that are made in a market. Sum of
consumer and producer surplus.
-Consumer utility maximsation - demand curve. Firm profit maximisation - supply curve.
Social efficiency is maximised at the competitive equilibrium.
- Consumer surplus is the area under the deamnd curve and above equilibrium price.
- Producer surplus is the area above the supply curve and below equilibirum price.
- Social surplus = A+B+C+D+E
- First fundamental theorem of welfare economics: the competitive equilibrium, where supply
equals demand, maximises social efficiency.
- Deadweight loss: the reduction in social efficiency from preventing trades for which
benefits exceed costs.
- Secon fundamental theorem of welfare economics: society can attain any efficient outcome
by suitably redistributiong resources among individuals and then allowing them to freely
trade.
- Equity-efficiency trade-off: the choice society must make between the total size of the
economic pie and its distribution among individuals.
- Social welfare function: a function that combines the utility functions of all individuals into
an overall social utility function. Utilitarian social welfare function maximizes the sum of
U
individual utility: 𝑆𝑊𝐹 = 𝑈 + 𝑈 + … + 𝑈 Rawlsian social welfare function maximizes
1 2 N
R
the utility of the worst-off member of society: 𝑆𝑊𝐹 =min(𝑈 ,𝑈 ,…,𝑈 )
1 2 N
- While reducing cash aid benefits may increase social efficiency, it need not increase social
welfare. Overall conclusion depends on social welfare function.