Introduction: Principles of Public Finance

1. PA 546 Constantine Hadjilambrinos Introduction: Principles of Public Finance Lecture 1 August 30, 2005

2. PA 546 Constantine Hadjilambrinos Government—What is it good for? • Set common rules of behavior • Protect citizens from external threats • Pool resources for the common good • Address and correct market failures

3. PA 546 Constantine Hadjilambrinos The Elements of Nonappropriability

4. PA 546 Constantine Hadjilambrinos Non-rival use: Once a good is provided for one consumer, the cost of supplying it to another consumer is zero. (Marginal cost = 0) Non-exclusion: Once a good is provided for one consumer all other consumers can use it—cost allocation is impossible. Free rider: A consumer who uses a benefit intended to promote certain behavior but who would have engaged in this behavior anyway.

5. PA 546 Constantine Hadjilambrinos Externality: Effect of market transaction imposed on a “third party” (neither producer nor consumer of the transaction good). Positive: Third party receives benefits from transaction (vaccinations)—Hidden benefits: undersupply of good. Negative: Third party incurs costs from transaction (factory pollution emissions)—Hidden costs: oversupply of good.

6. PA 546 Constantine Hadjilambrinos Criteria for undertaking government action • Cost-benefit: Do benefits to society exceed costs? (No distribution considerations) Kaldor: Those benefiting could compensate losers. • Pareto (optimal): Do at least some members of society benefit without any losing out? • Majority rule (democracy): Do more members of society benefit than lose? • Oligarchic (elite rule): Do those who control society benefit? • Social justice (re-distributive): Do worse off members of society benefit?

7. PA 546 Constantine Hadjilambrinos Total benefit exceeds total cost (Benefit = $36,000 Cost = $20,000) Individual cost (evenly distributed) is $4,000 ( $20,000/5 ) All individuals benefit from the project Benefit is not equal for each individual, ranging from $1,000 for C and E to $5,000 for D

8. PA 546 Constantine Hadjilambrinos Total cost exceeds total benefit (Benefit = $19,000 Cost = $20,000) Individual cost (evenly distributed) is $4,000 ( $20,000/5 ) Three individuals benefit from the project. Two lose. If decision based on majority rule, and if everyone voted strictly on self interest, project would go forward, even though costs exceed benefits.

9. PA 546 Constantine Hadjilambrinos Total benefit exceeds total cost (Benefit = $20,000 Cost = $12,500) Four individuals benefit from the project. One loses. Costs can be re-distributed, so they are proportional to benefits (i.e., if one receives 15% of benefit, he/she should pay 15% of the cost). In this way, everyone benefits.

10. PA 546 Constantine Hadjilambrinos Calculation of Individual Share of Total Benefits and Benefit-Based Cost Share for Example 3 First, calculate the percent share of the total benefit for each individual: For example, for Individual A, the Individual Share of Total Benefit is:

11. PA 546 Constantine Hadjilambrinos Calculation of Individual Share of Total Benefits and Benefit-Based Cost Share for Example 3 Next, calculate the benefit-based cost share for each individual: For example, for Individual A, the benefit-based cost share is: