Chapters 1 to 4

1. Chapters 1 to 4 • Outline • The Four Questions of Public Finance • Utility maximization • Labor supply example • Efficiency • Social welfare functions • Correlation versus causation • Discounting

2. Question 1: When Should the Government Intervene in the Economy? • Normally, competitive private markets provide efficient outcomes for the economy. • In many circumstances, it is hard to justify government intervention in markets. Two common justifications are: • Market failures • What is a market failure? • Redistribution • Shifting resources from some groups to others.

3. When Should Government Intervene? An example of market failure • In 2003, there were 45 million people without health insurance in the United States, or 15.6% of the population. • Lack of insurance could cause negative externalities from contagious disease–the uninsured may not take account of their impact on others. • Measles epidemic from 1989-1991, caused by low immunization rates for disadvantaged youth, was a problem. • Government subsidized vaccines for low-income families as a result.

4. When Should the Government Intervene? Redistribution • Of the uninsured, for example, roughly three-quarters are in families with incomes below the median income level in the United States. • Society may feel that it is appropriate to redistribute from those with insurance (who tend to have higher incomes) to those without insurance (who tend to have lower incomes). • Redistribution often involves efficiency losses. • The act of redistribution can change a person’s behavior. Taxing the rich to distribute money to the poor could cause both groups to work less hard.

5. Question 2: How Might the Government Intervene? • If the government wants to intervene in a market, there are a number of options: • Using the price mechanism with taxes or subsidies. • Tax credits that lower the “effective price” of health insurance. • Mandate that either individuals or firms provide the good. • “Pay-or-play” mandates that require employers to provide health insurance, such as California’s Health Insurance Act. • Public Provision • The Medicare program for U.S. senior citizens. • Public Financing of Private Provision • Medicare prescription drug cards, where private companies administer the drug insurance.

6. Question 3: What Are the Effectsof Alternative Interventions? • Much of the focus of empirical public finance is assessing the “direct” and “indirect” effects of government actions. • Direct effects of government actions assume “no behavioral responses” and examine the intended consequences of those actions. • Indirect effects arise because some people change their behavior in response to an intervention. This is sometimes called the “law of unintended consequences.”

7. Question 4: Why Do Governments Do What They Do? • Positive (as opposed to normative) question. • Governments do not simply behave as benign actors who intervene only because of market failure and redistribution. • Tools of political economy helps us understand how governments make public policy decisions. • Just as market failures can lead to market inefficiency, there are a host of government failures that lead to inappropriate government intervention.

8. Chapter 2:Review (Quickly) Economics 301 • Constrained Utility Maximization is based on • Preferences (indifference curves), and • Budget sets. • Start with a discussion of preferences. • A utility function is a mathematical representation U = f(X1, X2, X3, …) • Where X1, X2, X3 and so on are the goods consumed by the individual, • And f(•) is some mathematical function.

9. Utility From Different Bundles Figure 2 QCD (quantity of CDs) Bundle “C” gives higher utility than either “A” or “B” Bundle “C” gives 4 “utils” and is on a higher indifference curve Higher utility as move toward northeast in the quadrant. “A” and “B” both give 2 “utils” and lie on the same indifference curve A C 2 B IC2 1 IC1 0 1 2 QM(quantity of movies)

10. Constrained Utility Maximization: Marginal utility • With the utility function, U = QMQC, the marginal utility is: • Take the partial derivative of the utility function with respect to QM to get the marginal utility of movies. • Normally, preferences exhibit diminishing marginal utility, as would be the case if U = (QMQC)1/2 , since

11. Constrained Utility Maximization:Marginal rate of substitution • Marginal rate of substitution—slope of the indifference curve is called the MRS, and is the rate at which consumer is willing to trade off the two goods. • Direct relationship between MRS and marginal utility. • MRS shows how the relative marginal utilities evolve over the indifference curve.

12. Constrained Utility Maximization:Budget constraints • The budget constraint is a mathematical representation of the combination of goods the consumer can afford, given income. • Assume there is no saving or borrowing. • In the example, denote: • Y = Income level • PM= Price of one movie • PC= Price of one CD

13. Utility Maximization Figure 8 QCD (quantity of CDs) This bundle of goods gives the highest utility, subject to the budget constraint. This indifference curve gives much higher utility, but is not attainable. 3 This indifference curve is not utility-maximizing, because there are bundles that give higher utility. 2 1 0 1 2 3 QM (quantity of movies)

14. Constrained Utility Maximization:Putting it together: Constrained choice • Thus, the marginal rate of substitution equals the ratio of prices: • At the optimum, the ratio of the marginal utilities equals the ratio of prices. But this is not the only condition for utility maximization. • The second condition is that all of the consumer’s money is spent

15. The Effects of Price Changes:Substitution and income effects • A change in price consists of two effects: • Substitution effect–change in consumption due to change in relative prices, holding utility constant. • Income effect–change in consumption due to feeling “poorer” after price increase. • Figure 11 illustrates this.

16. Income and Substitution Effects (price of rooms rises) Meals SE: Find a hypothetical budget line with the new price ratio just tangent to the original IC. Income effect Substitution effect Rooms

17. Derive Demand Curves: First, Increase in the Price of Movies Figure 18 QCD (quantity of CDs) Raising PM even more gives another (PM,QM) combination with even less movies demanded. Initial utility-maximizing point gives one (PM,QM) combination. Raising PM gives another (PM,QM) combination with fewer movies demanded. QM,3 QM,2 QM,1 QM (quantity of movies)

18. Deriving the Demand Curve for Movies: Second, plot the optimal price-quantity pairs Figure 19 PM Various combinations of points like these create the demand curve. At a high price for movies, demanded QM,3 At a somewhat lower price for movies, demanded QM,2 PM,3 At an even lower price for movies, demanded QM,1 PM,2 PM,1 Demand curve for movies QM,3 QM,2 QM,1 QM

19. EQUILIBRIUM AND SOCIAL WELFARE Elasticity of demand • A key feature of demand analysis is the elasticity of demand. It is defined as: • That is, the percent change in quantity demanded divided by the percent change in price. • Demand elasticities are: • Typically negative number. • Not constant along the demand curve (for a linear demand curve). • It is easy to define other elasticities (income, cross-price, etc.)

20. EQUILIBRIUM AND SOCIAL WELFARE: Supply curves • We do a similar drill on the supply side of the market. Firms have a production technology (we might write it as) • We can construct isoquants, which represent the ability to trade off inputs, fixing the level of output. • Firms also have an isocost function, which represent the cost of various input combinations. • Firms maximize profit (minimize cost) when the marginal rate of technical substitution equals the input price ratio. • Also MR=MC at the profit-maximizing level of output.

21. EQUILIBRIUM AND SOCIAL WELFARE Equilibrium • In equilibrium, we horizontally sum individual demand curves to get aggregate demand. • We also horizontally sum individual supply curves to get aggregate supply. • A firm’s supply curve is the MC curve above minimum average variable cost. • Competitive equilibrium represents the point at which both consumers and suppliers are satisfied with the price/quantity combination. • Figure 21 illustrates this.

22. Equilibrium with Supply and Demand Figure 21 PM Supply curve of movies Intersection of supply and demand is equilibrium. PM,3 PM,2 PM,1 Demand curve for movies QM,3 QM,2 QM,1 QM

23. EQUILIBRIUM AND SOCIAL WELFARESocial efficiency • Measuring social efficiency is computing the potential size of the economic pie. It represents the net gain from trade to consumers and producers. • Consumer surplus is the benefit that consumers derive from a good, beyond what they paid for it. • Each point on the demand curve represents a “willingness-to-pay” for that quantity.

24. EQUILIBRIUM AND SOCIAL WELFARESocial efficiency • Producer surplus is the benefit derived by producers from the sale of a unit above and beyond their cost of producing it. • Each point on the supply curve represents the marginal cost of producing it.

25. EQUILIBRIUM AND SOCIAL WELFARESocial efficiency • The total social surplus, also known as “social efficiency,” is the sum of the consumer’s and producer’s surplus. • Figure 25 illustrates this.

26. Social Surplus Figure 25 PM Providing the first unit gives a great deal of surplus to “society.” The surplus from the next unit is the difference between the demand and supply curves. Supply curve of movies Social efficiency is maximized at Q*, and is the sum of the consumer and producer surplus. The area between the supply and demand curves from zero to Q* represents the surplus. P* This area represents the social surplus from producing the first unit. Demand curve for movies 0 1 Q* QM

27. EQUILIBRIUM AND SOCIAL WELFARE Competitive equilibrium maximizes social efficiency • The First Fundamental Theorem of Welfare Economics states that the competitive equilibrium, where supply equals demand, maximizes social efficiency. • Any quantity other than Q*reduces social efficiency, or the size of the “economic pie.” • Consider restricting the price of the good to P´<P*. • Figure 26 illustrates this.

28. Deadweight Loss from a Price Floor Figure 26 PM Supply curve of movies This triangle represents lost surplus to society, known as “deadweight loss.” The social surplus from Q’ is this area, consisting of a larger consumer and smaller producer surplus. With such a price restriction, the quantity falls to Q´, and there is excess demand. P* P´ Demand curve for movies Q´ Q* QM

29. EQUILIBRIUM AND SOCIAL WELFAREThe role of equity • Societies usually care not only about how much surplus there is, but also about how it is distributed among the population. • Social welfare is determined by both criteria. • The Second Fundamental Theorem of Welfare Economics states that society can attain any efficient outcome by a suitable redistribution of resources and free trade. • In reality, society often faces an equity-efficiency tradeoff.

30. Chapter 3: Empirical Approaches to Policy Analysis • Empirical public finance is the use of data and statistical methodologies to measure the impact of government policy on individuals and markets. • Key issue in empirical public finance is separating causation from correlation. • Correlated means that two economic variables move together. • Casual means that one of the variables is causing the movement in the other.

31. THE IMPORTANT DISTINCTION BETWEEN CORRELATION AND CAUSATION • One interesting, tragic example given in the book describes some Russian peasants. • There was a cholera epidemic. Government sent doctors to the worst-affected areas to help. • Peasants observed that in areas with lots of doctors, there was lots of cholera. • Peasants concluded doctors were making things worse. • Based on this insight, they murdered the doctors.

32. The Problem • In the Russian peasant example, the possibilities might be: • Doctors cause peasants to die from cholera through incompetent treatment. • Higher incidence of illness caused more physicians to be present. • Peasants thought the first possibility was correct.

33. MEASURING CAUSATION WITH DATA WE’D LIKE TO HAVE: RANDOMIZED TRIALS • Randomized trials are one often effective way of assessing causality. • Trials typically proceed by taking a group of volunteers and randomly assigning them to either a “treatment” group that gets the intervention, or a “control” group that is denied the intervention. • With random assignment, the assignment of the intervention is not determined by anything about the subjects. • As a result, with large enough sample sizes, the treatment group is identical to the control group in every facet but one: the treatment group gets the intervention.

34. The Problem of Bias • Bias represents differences between treatment and control groups that is correlated with the treatment, but not due to the treatment. • An example of bias: in 1988 the SAT scores of Harvard applicants who took test preparation courses were lower than those of students who did not. This would bias straightforward effort to study the effects of SAT classes on test scores. • By definition, such differences do not exist in a randomized trial, since the groups, if large enough, are not different in any consistent fashion.

35. Why We Need to Go Beyond Randomized Trials • Randomized trials present some problems: • They can be expensive. • They can take a long time to complete. • They may raise ethical issues (especially in the context of medical treatments). • The inferences from them may not generalize to the population as a whole. • Subjects may drop out of the experiment for non-random reasons, a problem known as attrition.

36. Time Series Analysis • Time series analysis documents the correlation between the variables of interest over time. • It is difficult to identify causal effects when there are slow moving trends and other factors are changing. • Sharp changes in a policy variable over time, may create opportunities for valid inference.

37. Figure 2

38. Cross-Sectional Regression Analysis • Cross-sectional regression analysis is a statistical method for assessing the relationship between two variables while holding other factors constant. • “Cross-sectional” means comparing many individuals at one point in time. • An example: • Where the control variables account for race, education, age, and location

39. Quasi-Experiments • Economists typically cannot set up randomized trials for many public policy discussions. Yet, the time-series and cross-sectional approaches are often unsatisfactory. • Quasi-experiments are changes in the economic environment that create roughly identical treatment and control groups for studying the effect of that environmental change. • This allows researchers to take advantage of randomization created by external forces.

40. An Example of a Quasi-Experiment • New Jersey raises their state minimum wage. Pennsylvania does not. • We are interested in the effect of the minimum wage on employment. • We could look at the employment of low-skilled workers in NJ before and after the minimum wage increase. • But other things in the economy might be occurring. • So, we can see how employment changed in PN over the same interval. • The difference in employment in NJ, before and after, compared to the difference in employment in PN, before and after, may reveal the causal effect of minimum wages changes, if NJ and PN are identical (similar?) in other respects.

41. Structural Modeling • Both randomized trials and quasi-experiments suffer from two drawbacks: • First, they only provide an estimate of the causal impact of a particular treatment. It is difficult to extrapolate beyond the changes in policy. • Second, the approaches often do not tell us why the outcomes change. For example, the approaches do not separate out income and substitution effects in the TANF example used in the book. • Structural estimation attempt to estimate the underlying parameters of the utility function.

42. Chapter 4: A Couple Tools and Definitions • Government debt is the amount that a government owes to others who have loaned it money. • It is a stock variable; the debt is an amount owed at any point in time. • Government deficit is the amount by which spending exceeds revenues in a given year. • It is a flow variable; the deficit flow is added to the previous year’s debt stock to produce a new stock of debt owed.

43. Real vs. Nominal • The debt and deficit are often expressed in nominal values–that is, in today’s dollars. • Inflation changes the real value of the debt or deficit, however, because prices change. • The consumer price index (CPI) measures the cost of purchasing a typical bundle of goods. It increased 91% between 1982 and 2003. • Inflation reduces the burden of the debt, as long as that debt is a nominal obligation to borrowers. • Rising prices leads to what is known as the “inflation tax” on the holders of the debt–the payments are worth less because of rising prices. • In 2003, the national debt was $3.91 trillion and inflation was 1.9%. The inflation tax was therefore $74 billion, which would reduce the conventionally measured deficit from $375 billion to $301 billion.

44. Background: Present Discounted Value • To understand budgeting, you must understand the concept of present discounted value (PDV). • Receiving a dollar in the future is worth less than receiving it today, because you have foregone the opportunity to earn interest. • PDV takes future payments and expresses them in today’s dollars. • It does so by discounting payments in some future period by the interest rate.

45. Background: Present Discounted Value • A stream of payments would be discounted as: • Where B0 through Bt represent a stream of benefit obligations, r is the interest rate, and t is the number of periods. • For example, $1,000 received 7 years from now is only worth $513 with a 10% interest rate: • A constant payment received indefinitely has the PDV=P/r