🏙️Public Economics Unit 1 – Introduction to Public Economics

Key Concepts and Definitions

• Public economics studies the role of the public sector in the economy, including government revenues, expenditures, and policies
• Focuses on the allocation of resources, distribution of income, and economic stabilization
• Positive economics describes and explains economic phenomena, while normative economics makes value judgments and prescribes policies
• Market failures occur when the allocation of goods and services by a free market is not efficient, leading to a net loss of economic value
  • Examples include externalities (pollution), public goods (national defense), and asymmetric information (adverse selection in insurance markets)
• Public goods are non-excludable (individuals cannot be prevented from using them) and non-rivalrous (use by one individual does not reduce availability to others)
• Merit goods provide benefits to society beyond those to the individual consumer (education, healthcare), while demerit goods impose costs on society (alcohol, tobacco)
• Pareto efficiency is achieved when no one can be made better off without making someone else worse off

Role of Government in the Economy

• Governments intervene in the economy to address market failures, provide public goods, redistribute income, and stabilize the economy
• Allocative efficiency ensures resources are allocated to their most productive uses, while distributive efficiency promotes a fair distribution of income
• Governments use fiscal policy (taxation and spending) and monetary policy (control of money supply and interest rates) to influence economic activity
• Regulation is used to control externalities (pollution standards), ensure competition (antitrust laws), and protect consumers (product safety standards)
• Government failure occurs when government intervention leads to inefficient outcomes due to problems such as rent-seeking, bureaucracy, and political pressures
• The optimal size and scope of government is a central debate in public economics, balancing the benefits of intervention against the costs of taxation and inefficiency
  • Libertarians argue for a minimal state, while socialists advocate for extensive government control of the economy

Market Failures and Public Goods

• Externalities are costs or benefits that affect third parties not involved in the economic transaction
  • Negative externalities (pollution) lead to overproduction, while positive externalities (vaccination) lead to underproduction
• Public goods (national defense, public parks) are undersupplied by the private sector due to the free-rider problem
• Asymmetric information occurs when one party to a transaction has more information than the other, leading to adverse selection and moral hazard
  • Adverse selection (in insurance markets) occurs when high-risk individuals are more likely to purchase insurance, driving up premiums
  • Moral hazard (in lending markets) occurs when individuals take excessive risks because they are protected from the consequences
• Natural monopolies (utilities) arise when a single firm can supply the market at a lower cost than multiple firms, but may require regulation to prevent abuse of market power
• Governments can address market failures through regulation, taxation, subsidies, and direct provision of goods and services

Taxation Principles and Effects

• Taxation is the primary source of government revenue, used to finance public goods and services, redistribute income, and influence economic behavior
• The ability-to-pay principle suggests that taxes should be based on an individual's capacity to pay, typically measured by income or wealth
• The benefit principle suggests that those who benefit from public goods and services should pay for them in proportion to the benefits received
• Tax incidence refers to who ultimately bears the burden of a tax, which may differ from who legally pays the tax
  • The elasticity of supply and demand determines the extent to which a tax is shifted from producers to consumers
• Efficiency costs of taxation arise when taxes distort economic decisions, leading to deadweight losses (reduced economic activity)
  • Marginal tax rates affect incentives to work, save, and invest
• Equity considerations in taxation include horizontal equity (equal treatment of equals) and vertical equity (higher taxes on those with greater ability to pay)
  • Progressive taxes (income tax) take a larger percentage from high-income earners, while regressive taxes (sales tax) take a larger percentage from low-income earners

Public Expenditure and Social Programs

• Public expenditure includes spending on public goods (defense, infrastructure), merit goods (education, healthcare), and transfer payments (social security, welfare)
• Cost-benefit analysis is used to evaluate public projects by comparing the total costs and benefits to society
  • The discount rate is used to convert future costs and benefits into present values
• Social programs are designed to redistribute income and provide a social safety net
  • Social insurance programs (unemployment insurance, disability insurance) provide benefits to individuals who have paid into the system and meet certain criteria
  • Means-tested programs (Medicaid, food stamps) provide benefits to individuals below a certain income threshold
• The design of social programs involves tradeoffs between targeting (ensuring benefits go to those most in need) and universality (providing benefits to everyone)
• The effectiveness of social programs is often debated, with concerns about poverty traps (reduced incentives to work) and program abuse
• Intergenerational equity is a concern with social programs that transfer resources between generations (social security, public debt)

Economic Analysis of Public Policy

• Public policy analysis uses economic tools to evaluate the costs and benefits of government policies and programs
• Positive analysis describes the effects of policies, while normative analysis makes value judgments about the desirability of policies
• Efficiency is a key criterion in evaluating policies, ensuring that the benefits exceed the costs
• Equity considerations include the distribution of costs and benefits across different groups in society
• Dynamic scoring considers the long-term effects of policies on economic growth and revenue, while static scoring assumes no change in economic behavior
• Behavioral economics incorporates insights from psychology to understand how individuals make decisions and respond to policies
  • Nudges are policies designed to influence behavior without restricting choice (default enrollment in retirement savings plans)
• Political economy considerations include the influence of interest groups, bureaucratic incentives, and voter preferences on the design and implementation of policies

Current Issues in Public Economics

• Income inequality has risen in many countries, with concerns about the concentration of wealth and political influence
  • Policies to address inequality include progressive taxation, minimum wage laws, and investments in education and training
• Intergenerational equity is a concern with long-term fiscal imbalances, such as unfunded pension and healthcare liabilities
  • Policies to address these issues include raising retirement ages, reducing benefits, and increasing taxes
• Globalization has increased economic integration but also raised concerns about tax competition and the distribution of gains from trade
  • Policies to address these issues include international tax coordination and investments in social safety nets and adjustment assistance
• Environmental externalities, such as climate change and pollution, require coordinated policy responses at the national and international levels
  • Policies to address these issues include carbon taxes, cap-and-trade systems, and investments in clean energy and energy efficiency
• The COVID-19 pandemic has highlighted the importance of public health infrastructure and social safety nets
  • Policies to address the pandemic include investments in testing, contact tracing, and vaccine development, as well as support for individuals and businesses affected by the economic downturn

Applications and Case Studies

• The Earned Income Tax Credit (EITC) is a refundable tax credit for low-income working individuals and families in the United States
  • The EITC has been found to increase labor force participation and reduce poverty, but may also create disincentives for some workers to increase their earnings
• The Affordable Care Act (ACA) is a comprehensive healthcare reform law in the United States that expanded health insurance coverage and introduced new regulations on the insurance market
  • The ACA has reduced the uninsured rate and improved access to healthcare, but has also faced challenges with rising premiums and insurer participation
• The pension reform in Chile in the 1980s replaced a pay-as-you-go system with a system of individual retirement accounts
  • The reform increased national savings and capital accumulation, but also exposed workers to financial market risks and created challenges for low-income workers
• The congestion charge in London is a fee charged for driving a vehicle within the city center during weekday business hours
  • The charge has reduced traffic congestion and improved air quality, but has also raised concerns about the impact on low-income drivers and small businesses
• The Bolsa Família program in Brazil is a conditional cash transfer program that provides benefits to low-income families in exchange for meeting requirements such as school attendance and health check-ups
  • The program has reduced poverty and improved health and education outcomes, but has also faced challenges with targeting and program abuse