Chapter 1

The justifications of
public intervention

Res Publica
The word Republic derives etymologically from Latin res publica, literally
public thing. Hence, this word reminds us that any republic must take
charge of managing the public wealth. This is represented by both
material and immaterial goods. The welfare of the citizens (who are the
State itself) should be the first goal of any governmental administration.
This means that all the citizens must behave correctly and responsibly
towards the State. This latter must develop citizens civil responsibility in
the most efficient and least limitative way as possible. Any society is a
collection of individuals, whose individuality must be respected and
enhanced in the name of individual and social welfare.
Any egoistic individualism and any act of parasitism is contrary to the
meaning of res publica; to create and defend this ideal, History has
required thousands of years and millions of human lives. And the
process has not yet ended.

ORIGINS OF THE STATE

Imagine a society without rules for civil
cohabitation (the state of nature in Hobbes
thought)
How do people relate to each other? (homo
homini lupus)? How do scarce resources are
allocated to alternative uses?
Autarchia
Strongest law (Bellum omnium contra omnes)
Definition of rules (Leviathan / social contract)
3

THE MINIMAL STATE

A very libertarian theory:
States should only define a set of rules for civil
cohabitation and a legal system to enforce them
(Nozick)
Exclusive role of the market in allocating goods
and services
However, how to finance the Minimal State?

STYLIZED FACTS
Today, western democratic States go far beyond
the Minimal State:
They set rules on ethic, moral, religious bases
They set rules to influence the behaviour of
economic agents, for instance:
They impose taxes on labour, capital, wealth,
consumption.
They provide goods and services to some individuals
or the whole population.
They directly own and manage companies
5

PUBLIC ECONOMICS
Public economics focuses on three activities
exerted by the States, that have a direct impact
on the economy:
1. Tax collection
2. Public expenditure
3. Regulatory activity

GOALS OF THE STATE

Why do the States intervene in the
economy?
Three goals:
Allocative
Distributive
Stabilization and development
(Musgrave, The theory of public finance, 1959)
7

ALLOCATIVE GOALS
How to organize exchanges of goods
and services to maximize the social
welfare?
Which allocative mechanisms should
we choose?
8

NORMATIVE vs POSITIVE
Positive analysis: we try to answer the question
which is the effect of policy X on variable Y?
i.e.: what happens to labour supply if we
increase the tax rate? What happens to the
quantity produced by a monopolist if we impose
a maximum price?

NORMATIVE vs POSITIVE
Normative analysis: we try to answer the
question what is the best to do in order to get
result Z?
i.e.: how should we structure taxes to minimize
the distortions of labour supply? How must we
structure the tariff for the monopolist in order to
maximize social welfare?
One of the leading normative criterion for
economists is Pareto efficiency
10

PARETO EFFICIENCY
An allocation of goods among individuals
is Pareto-efficient if it is not possible to
increase the utility of at least one
individual without decreasing the utility of
another individual.
Stated differently, any change in the
allocation decreases the utility of at least
one individual.
11

ALLOCATIVE GOALS
When we ask: which allocative
mechanisms should we choose to
maximize the social welfare? we are
answering a normative question.
The market in perfect competition is an
optimal allocative mechamism, as it allows to
reach Pareto-efficient allocations.
Competitive General Equilibrium
12

THE NEOCLASSICAL MODEL

The theory of walrasian markets and the
general economic equilibrium:
egoistic rational subjects
(individuals are self-interested)
perfect competition on markets
(there is perfect competition in ALL markets)
complete markets
(there is a market for ANY possible good!)
13

RATIONAL EGOISM
The invisible hand of the market
(Adam Smith 1776)

It is not from the benevolence of the butcher, the

brewer, or the baker that we expect our dinner, but
from their regard to their own interest. We address
ourselves, not to their humanity but to their self-love,
and never talk to them of our own necessities but of
their advantages
14

COMPETITIVE MARKETS
All the agents are price-taker, that is firms are
too small to influence the price
Homogeneous good
All the agents share the same information set
Perfect mobility of production factors in the longrun
All the firms are equal

15

COMPLETE MARKETS
There exists a market for any goods,
including:
Externalities
(there is a market for noise, for buildings in
landscapes, for clean air, for private flowers)
Public goods
(there is a market for homeland security, for
public health, for police)
16

THE NEOCLASSICAL MODEL

If the previous assumptions hold, then
markets attain the maximum efficiency in
allocationg resources in Paretos meaning.
1 MINIMAL COSTS
2 PARETO EFFICIENCY
3 DYNAMIC EFFICIENCY
17

The market
Price
cookies
(euro)

P*

D
Q*

cookies
18

Equilibrium efficiency
Price
cookies
(euro)
The competitive
market exhausted
all the
advantageous
exchange
opportunities of
contract
The surplus of
consumers and
producers is
maximum

P*

D
Q*

cookies
19

1. MINIMAL COSTS
S

uro

Economic
profit

Marginal cost
Average cost

Market
price
D

Quantity
MARKET

Quantity
SINGLE FIRM
20

Entry of new firms because of profits tends to increase

the supply
S0 S1

uro

Economic
profit

Market
price

Marginal cost

Average cost
D

Quantity
MARKET

Quantity
SINGLE FIRM

hence market price and economic profit decrease

21

The equilibrium of perfect

competition in the long run
Marginal cost
uro
Minimum average
production cost
Market
price

Quantity

22

2. PARETO EFFICIENCY
Robert
s utility

Pareto inefficient
alocation

Pareto efficient
allocations

Marys
utility
23

3. DYNAMIC EFFICIENCY
uro

Technological
progress tends
to reeduce
average
production
costs

Market
price

Quantity
Those firms with the most advanced technological solutions will tend
to make profits and to increase their production
24

THE TWO THEOREMS OF

WELFARE ECONOMY
Some scholars resume these properties of equilibrium in
the two theorems of Welfare Economy
First Theorem: the equilibrium of a system of
competitive markets is Pareto efficient
Second Theorem: any Pareto-efficient allocation can be
attained as equilibrium of a system of competitive
markets, through an opportune redistribution of the
existent resources

25

ALLOCATIVE GOALS
On the basis of these results, the
perfectly competitive market is the
allocative mechanism to be chosen in
order to maximize social welfare.
Normative result: the State should only
set the rules such that the economic
system satisfies the previous assumptions.
This is exactly the theory of the minimal
State.

26

CRITICISMS TO THE
NEOCLASSICAL MODEL
Are the assumptions at the basis of the neoclassical
model reasonable?
This idea of market is:
- optimistic (the assumptions are not always satisfied);
- insufficient as, for instance:
1) it does not account for altruistic individuals;
2) it does not explain disequilibria (e.g.. unemployment or
credit rationing)
3) it imposes the actual income distribution
27

MARKET FAILURES
The traditional theory of Public Economics
states that the market does not generate a
Pareto-efficient allocation of resources in
presence of:
1. INSUFFICIENT COMPETITION
2.EXTERNALITIES
3. PUBLIC GOODS
4. ASYMMETRIC INFORMATION
28

MARKET FAILURES
Market failures are one of the reasons that motivate
public intervention
Indeed, market failures prevent the market mechanism to
reach a Pareto-efficient allocation
In each of these cases the public intervention tries to
correct the result of the market, in order to improve
individuals welfare
In these circumstances the public intervention is led by
efficiency reasons (allocative goals):
It is possible to improve the welfare of one individual
without reducing the welfare of other individuals
29

THE GOVERNMENT AS
ALLOCATIVE MECHANISM
Resource allocation through the market let the
individuals free to choose. On the basis of prices
individuals decide what and how much to purchase or to
sell. The equlibrium depends on all the subjects choice.
At least in Western democracies the allocation of the
resources through the Government is the result of a
political process (from elections to the formation of a
government). The resulting equilibrium is a political
equilibrium

30

THE OPTIMISTIC CONCEPT OF

PUBLIC INTERVENTION
If markets, under some conditions, do not work
properly as mechanisms to allocate resources, also the
public intervention can be imperfect
In

this course we will discuss about:

the problem of optimal design of political institutions to
minimize these imperfections (i.e. Is it better a federal State or
a unitarian State?)
the problem of individual preference composition and of
collective preferences (i.e. which voting mechanism?)

31

THE OPTIMISTIC CONCEPT OF

PUBLIC INTERVENTION
...experience highlights that often this intervention
produces allocative and distributive distortions;
sometimes they are more costly than those the
intervention aims at correcting.
As a consequence, the choice is not between
market and intervention, but between two
types of imperfections... (Reviglio)

32

DISTRIBUTIVE GOALS
The allocation of resources generated by the market,
although efficient, can be considered as unfair
How should the economic resources be distributed within
a society?
Which leading criterion? The political philosophy
answers:

Bentham and utilitarianism

Egalitarianism
Rawls and the maximin criterion
Sen and the equality of opportunities
33

DISTRIBUTIVE GOALS
The public intervention tries to correct the
distribution of incomes generated in the markets through
the redistribution of resources
The redistribution of the resources implies (positive or
negative) transfers among individuals
The public intervention is led by reasons of equity
(distributive goal)

34

DISTRIBUTIVE GOALS AND THE

NEOCLASSICAL MODEL
According to the Second Theorem of Welfare
Economics any Pareto-efficient allocation can be
obtained as equilibrium of a system of competitive
markets, through an opportune redistribution of
resources
Lump-sum transfers: the agents do not modify their
behaviours because there is only income effect (labour,
consumption and saving choices are not distorted)
It is difficult to design and enforce such a type of
transfers that, in any case, need all the assumptions of
the FTWE to work properly.
35

DISTRIBUTIVE GOALS AND THE

NEOCLASSIC MODEL
Generally the redistribution works through labour taxes,
capital or consumption taxes
As we will see, these taxes are distortionary (agents
modify their choices because of the substitution effects)
The larger the redistribution, the larger the distortionary
effects

36

DISTRIBUTIVE GOALS AND THE

NEOCLASSICAL MODEL
For these reasons the literature deals with a trade-off
between efficiency and equity:
Often, in order to reach allocations characterized by a
higher level of efficiency, markets should be let free of
working. Unfortunately the distribution they generate is
unfair. (of course, it depends on personal preferences!)
To pursue a higher equity implies the use of distortionary
taxes; they reduce the obtained degree of allocative
efficiency

The two goals, thus, can not be attained jointly:

efficiency or equity?
37

STABILIZATION AND
DEVELOPMENT GOALS
What to do in order for the economy to
grow on a stable path in the long run?
What to avoid recessions? What to avoid
growth with inflation?
What to do to increase the potential GDP?
What to ensure a long run growth?
38

STABILIZATION AND
DEVELOPMENT GOALS

-.1

5000

10000

-.05

15000

20000

.05

25000

.1

30000

Evolution of Italian GDP

1940

1960

1980
year

2000

2020

Source: Datastream

Per-capita GDP growth

Per-capita GDP

39

STABILIZATION AND
DEVELOPMENT GOALS
Evolution of Italian per-capita GDP
(euro; 1982 2001)
25,000

20,000

15,000

Nord-Ovest
Nord-Est
Centro
Meridione
Isole

10,000

5,000

0
1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Source: ISTAT
40

STABILIZATION AND
DEVELOPMENT GOALS
Is it correct to measure development only through percapita income? GDP (relatively) easy to measure but
there are some critiques:
The human development: people are the true wealth of
nations. It is important to build what a person can do or can be in
the life (importance of health, education, resources for a decent
life, participation to the community)
The sustainable development: responding to the needs of
actual generations without undermining the future generations
possibility to satisfy their own.
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