Introduction

(Reference: Hindriks and Myles, 2006, chapter 2, Tresch, 2015, chapter 2)

• Key issues in public sector economics:

– What are the rationales for government intervention in the economy?

– Why might private markets not function efficiently?

– How can we evaluate the usefulness of government policies?

– In which areas should governments intervene?

– How should government policies be designed?

• Public economics provides a framework to evaluate market outcomes and the desirability of
public policies. It defines two key criteria:

– Efficiency
– Equity

 Public policies are desirable if they make the economy more efficient and more equitable.

1
Efficiency – A quick review

• Simple economy:
• Two individuals: A and B
• Two commodities, x1 and x2 (in fixed supply – no production for now)
( )
• Preferences: U h = U h x1h , x2h for h = A, B

(
• Endowments: wh = w1h , w2h )
 Issue: Allocative efficiency

• Pareto efficient allocation: Allocation of commodities between the two individuals such that
there exists no reallocation that would make at least one individual better-off without making
the other worse-off.

• At any Pareto efficient allocation, the indifference curves of the two individuals in an
Edgeworth box are tangent.
 Pareto efficient allocation are such that: MRS1,2 A
= MRS1,2B

(Graphical analysis)

• Contract curve: set of Pareto efficient points, given the fixed supply of each commodity.
• Set of Pareto efficient allocations (contract curve) can be represented as a utility possibilities
curve (UPC).

2
 Production

• Different productive inputs can be shifted between the production of each commodity.

• Production possibilities curve (PPC): maximum quantity of one commodity that can be
produced along with a given quantity of the other.

• Production efficiency is achieved if available inputs are used in such a way that production is
on the PPC (efficiency frontier).

• Marginal rate of transformation ( MRT ): Rate at which the production of one commodity can
be substituted for production of the other. The MRT corresponds to the slope of the
production possibilities curve.

3
Overall Efficiency

• Overall efficiency condition:

=
MRT1,2 =
MRS A
1,2
B
MRS1,2

• The rate at which the technology allows to substitute the production of one commodity with
more production of the other must be equal to the rate at which consumers are willing to trade-
off the two commodities.

 If the first equality above does not hold, we can increase efficiency by reallocating
productive inputs.

 If the second equality does not hold, we can increase efficiency by reallocating output
between the two individuals.

• We can also express the MRT in terms of marginal costs of production

MC1
 MRT1,2 =
MC2

MC
• Therefore Pareto efficiency can also be expressed as:=1
=
MRS A
1,2
B
MRS1,2
MC2

4
The efficiency of private markets

First theorem of welfare economics: Under certain conditions, the allocation resulting from a
competitive equilibrium is Pareto efficient.

Intuition:
• Consumers that maximize utility will choose their consumption bundle such that
P1
=
MRS A
1,2 =
MRS B
1,2
P2
• Profit-maximizing competitive firms will produce output until the marginal cost equals the
price, i.e. P1 = MC1 and P2 = MC2 , therefore
MC1 P1
=
MC2 P2
P1 MC1
=A
 MRS1,2 =B
MRS1,2 = = MRT1,2
P2 MC2

• Pareto efficiency requires that prices be equal to marginal costs.

• Competition guarantees that this condition is satisfied.

(Graphical analysis)

5
 Distributional Equity

• Which Pareto efficient allocation is more desirable?

 The criterion of Pareto efficiency is not enough to rank all possible allocations.
 Value judgments about the fairness of the distribution of utility across individuals are
also required.

Social welfare function (SWF)

 One way to choose a particular allocation along the utilities possibilities curve is to use a
SWF.

(
• SWF: aggregation of individuals’ utility levels, W = W U A ,U B )
– We can represent a SWF graphically by a set of social indifference curves over
individuals utility levels.

• Different forms of SWF, generally representing different degree of aversion to inequality

– Utilitarian: W= W U A ,U =( B
)
U A +U B
=
– Maximin: W W=
U A ,U B( )
Min U A ,U B ( )
– Etc.

6
Optimal allocation

• The optimal allocation is the Pareto efficient allocation that allows to attain the highest social
indifference curve.

 Social welfare maximizing allocation is a tangency point between the utility possibilities
frontier and a social indifference curve.

– May be a conflict between the efficiency and equity criteria – some Pareto inefficient
allocation may achieve higher social welfare than some Pareto efficient allocation.

Second theorem of welfare economics: Under certain conditions, every Pareto optimal allocation can
be realized as the outcome of a competitive equilibrium by an appropriate distribution of initial
endowments.

7
Rationale for government intervention in the economy

• The conditions under which the first theorem of welfare economics holds may not be satisfied
in real-world markets for various reasons.

 Private markets fail to produce Pareto efficient allocations

 Efficiency rationale for policy intervention

• Even if the economy is perfectly competitive and generates a Pareto efficient allocation (i.e. an
allocation on the utilities possibilities frontier), nothing garantees that this allocation will
maximize social welfare.

 Equity rationale for policy intervention

General sources of inefficiency in private markets – sources of failure of the first theorem

1. Market power
2. Externalities
3. Public goods
4. Asymmetric information

8
Efficiency role for policy

• Government intervention is required to:

– Promote competition and limit market power
– Mitigate the distortions generated by asymmetric information problems
– Discourage activities that involve negative externalities
– Encourage activities that have positive external effects
– Produce public goods

• Policy failures

– Market failures imply that the government can potentially implement policies that will
make the economy more efficient.

– But, the government cannot necessarily do better than private markets.

– The government may lack the necessary information and policy instruments to correct for
some market failures.

9
Second-best policies

 May not be possible to achieve the first-best Pareto efficient allocation.

Various reasons:
– Government may not have all the required instruments
Þ Several related markets can be distorted
– Government may not have all the information required to induce the first-best.
– Distortionary taxation
– Etc.

 Second-best policies:

– Trading-off different distortions

 If Pareto efficiency cannot be achieved in all markets, intervention to achieve efficiency
in a subset of markets is not necessarily desirable

– Designing policy measures in order to generate some information (induce agents to reveal
their characteristics, their preferences, etc.)

– Need to take account of distortions induced by policy measures themselves.

• Often difficult to fully characterize second-best policies

 Alternative: evaluate the welfare gains from small changes in policy

10
Public Goods
(Reference : Leach, 2004, chapter 10)

• Two characteristics:

– Consumption is nonrival
Aggregate amount enters everyones’ utility function

– Non-excludable

• Pure public good: perfect joint consumption

• Private good: exclusive consumption

• Common goods : Some rilvary in consumption, non-excludable

• Club goods: Joint consumption, excludable

11
• Problem with private provision: low incentive for individuals to provide the public
good

Free-riding

• Need government intervention to achieve the efficient level of provision

Information problems

• Supplementing private provision may not be very useful

Crowding-out of private provision

• Some mechanisms may be used to improve efficiency in the provision of public

goods.

12
Pareto efficient supply of a public good

• G : public good

• xi : private good consumed by individual i = 1,..., N

N
• X = ∑ xi
i =1

• Production possibilities: F ( X , G )

Assume production efficiency (economy operates along the PPC)

• Utility function: u i ( xi , G )

13
Pareto efficient supply of a public good, continued:

Social welfare function: W ( u1 ,..., u N )

Chooses xi and G to maximize social welfare subject to production possibilities:

=
Langrangian: l W ( u1 ,..., u N ) − λ F ( X , G )

First-order conditions:

(1) xi : Wi u xi − λ Fx =
0

N
(2) G : ∑Wi uGi − λ FG =
0
i =1

From (1), we have Wi u xi = λ Fx , and therefore Wi u xi is equal for all i

We can divide (2) by (1) (with the i th term in the summation on the left side of (2)
N
uGi FG
i
being divided by W u ), to obtain:
i x ∑
i =1
=
u xi FX

14
 N
or equivalently: ∑ MRS
i =1
i
GX = MRTGX

• Samuelson condition: Pareto efficiency requires that G be provided until the sum of
relative marginal valuation for G be equal to the rate at which we can substitute X for
G in production.

• In contrast, efficiency for private good requires that MRS

= i
GX =
MRS j
GX MRTGX ∀ i, j

• The social welfare function determines which point is chosen on the UPC, but any
point on the UPC satisfy the Samuelson condition

• If individuals differ in income or preferences, and depending on how the public good is
financed, individuals may have different preferred levels of G .

15
Decentralized provision of public goods

yi : Income of individual i .

• Individuals choose how much to contribute voluntarily, taking the contributions of

others as given.

 Nash equilibrium

gi : Contribution of i

N
G = ∑ gi
i =1

Define G−i ≡ ∑ g j
j ≠i

16
 Individual i chooses gi taking G−i as given:

Max u i ( xi , gi + G− i ) subject to: xi + gi =

yi
{ xi , gi }

 Max u i ( yi − gi , gi + G−i )
gi

First-order condition: −u xi + uGi =

0

uGi
 i MRS
= = i
GX 1
ux

The Nash equilibrium contributions of all individuals are such that MRSGX
i
= MRTGX

The public good is under-provided in the Nash equilibrium

Free-riding: Everyone has an incentive to free-ride on the contributions of the others

17
Example with Cobb-Douglas preferences:

• Preferences: u i = xiα G β

• Assume that all individuals have the same income: y

Problem of individual i :

( y − gi ) ( gi + G−i )
α β
Max
gi

FOC: −α ( y − gi ) ( gi + G−i ) + ( y − gi ) β ( gi + G−i )

α −1 β α β −1
=
0

or α ( y − gi ) ( gi + G−i ) =−
( y gi ) β ( gi + G−i )
α −1 β α β −1

Dividing both sides by u i , we obtain:

α β
=
y − gi gi + G− i

18
After some manipulations, we get:

β y − α G− i
gi =
α +β

Reaction function of individual i

Nash equilibrium: set of contributions for which all reaction functions are simultaneously
satisfied

All individuals have the same income and preferences

 Symmetric Nash equilibrium

 G=
−i ( N − 1) gi

Substituting in the reaction function of individual i :

β y − α ( N − 1) gi
gi =
α +β

19
Solving for gi , we get

βy
gˆ i =
Nα + β

Contribution of each individual at the Nash equilibrium

No one can make itself better-off by deviating from gˆ i

Nβ y
Level of provision of G : Gˆ i =
Nα + β

20
Is the provision level efficient ?
N
Samuelson condition: ∑ MRS
i =1
i
GX = MRTGX
α β −1
i
u x βG β xi
=
i
MRSGX G
= i α −1 =
β
i
u
x α xi G αG

N β xi
Samuelson condition: =1
αG

G G
With a symmetric allocation: gi = , and therefore xi= y −
N N

  G
Samuelson condition becomes: N β  y −  =αG
N  
Nβ y
 G* =
α +β

 Gˆ < G * if N > 1
Gap between Ĝ and G * increases with N

21
Efficiency conditions with some rivalry in consumption and exclusion

(Reference: Leach, 2004, chapter 12)

• Congestion – population/number of users matters

• May be possible to exclude

 Increasing the population / users will have two effects:

– Lowers the benefits of each individual

– Lowers the per person cost of the public good

 Optimal population/ users balances these two effects

22
Setup:

• X : private good
• G : public good
• W : individual income

• Utility: U i ( X , G, n )

 Utility decreases with number of individuals n, for given X and G

• Cost function: C ( G )

C (G )
• Tax function (equal cost sharing): T =
n

• Individual budget:

C (G )
X = W −T = W −
n

23
• Optimal provision and population solve

Max U ( X , G, n )
{ X ,G ,n}
C (G )
subject to X= W −
n

Lagrangian:

 C (G ) 
=Ω U ( X , G, n ) + λ  X − W +
 n 

FOCs:

X : UX + λ =
0

C '(G )
G : UG + λ =
0
n

C (G )
n : Un − λ =
0
n2

24
 U G C '(G )
 =
UX n

 MRSGX equals the individuals’ share of marginal cost, or

UG
n = C '(G )
UX

 Samuelson condition applies for provision of G , given n

Un C (G )
 = − 2
UX n

 MRSnX , or utility cost of congestion equals the reduced cost per person
associated with an additional contributor.

 ( G*, n *)

25
Public good provision financed by distortionary taxation

(Reference: Myles, 1995, chapter 9)

• The Samuelson rule applies when lump-sum taxes are available

• If public goods needs to be financed by distortionary taxation, the optimal level of

production will have to take into account:

– The direct cost of production

– The efficiency cost of taxation

⇒Distortions in agents’ behaviour

Ex.:
– Individuals’ labour supply
– Firms’ production decisions, investment decisions
– Consumption decisions, etc.

26
• Marginal cost of public funds (MCPF): cost of raising an additional dollar of
government revenue, including the deadweight loss of taxation.

⇒When taxation induces changes in behaviour, MCPF > 1

⇒Total cost of providing an additional unit of public good: MCPF· MC

• Providing a public good may also increase government revenues if the public good is a
complement to other taxed goods (or vice-versa)

• Net revenues required to increase public good provision: MC - MR

• Modified Samuelson rule:

Σ MBi = MCPF · (MC – MR)

ÞThe efficient level of production of the public good is such that the sum of
marginal benefits equals the net marginal revenues required times the MCPF.

ÞThe level of provision of the public good may be higher or lower than under the
basic Samuelson rule

27
Deriving the MCPF – a specific example with labour taxation

• Suppose that G is financed by a proportional labour income tax

• Variable labour supply

⇒The tax will distort labour supply decisions

• N individuals

• All individuals have the same utility function:

U(X, L, G)

– X: private good consumption

– L: labour supply

28
Individual behaviour:

Max U ( X , L, G )
{ X , L}

subject to the individual budget constraint:

=
X w(1 − t ) L

w : exogenous wage rate

t : tax rate on labour income

Lagrangian:

=l U ( X , L, G ) + µ [ w(1 − t ) L − X ]

First-order conditions:
L : U L + µ w(1 − t ) =
0
X : Ux − µ =
0

29
Combining the FOCs, we get
UL
− =(1 − t ) w
UX

The solution to this problem gives:

– Labour supply function: L ( (1 − t ) w, G )

– Demand function for X: X ( (1 − t ) w, G )

– Indirect utility function:

ν ( (1 − t ) w, G ) = U  X ( (1 − t ) w, G ) , L ( (1 − t ) w, G ) , G 

By the envelope theorem, we have:

∂ν ∂l ∂ν ∂l
= = − µ wL and = = UG
∂t ∂t ∂G ∂G

30
Government problem:

Max ν ( (1 − t ) w, G )
{t ,G}

subject to the government budget constraint: PG = NtwL

P : relative cost of G

Lagrangian:

ν ( (1 − t ) w, G ) − λ  PG − NtwL ( (1 − t ) w, G ) 
l =

First-order conditions:

∂ν  ∂L 
G: − λ  P − Ntw  =
0
∂G  ∂G 

∂ν  ∂L 
t: + λ  NwL + Ntw  = 0
∂t  ∂t 

31
By the envelope theorem, we had

∂ν ∂ν
= − µ wL and = UG
∂t ∂G

and by the first order condition on the individual problem, we had µ = U X

∂ν
⇒Therefore, = − wLU X
∂t

Combining the FOCs, and using the above, we get

∂L
P − Ntw
UG
= ∂G
wLU X NwL + Ntw ∂L
∂t

32
Multiplying both sides by wN and dividing the denominator on both sides by L , we can
rewrite the expression above as

∂L
P − Ntw
U
N G = ∂G
UX t ∂L
1+
L ∂t

t ∂L
Define the elasticity of labour supply with respect to t by ε=
L ∂t

∂L
P − Ntw
⇒ N
UG
= ∂G
UX 1+ ε

⇒Modified Samuelson condition

33
 ∂L
• Ntw : Change in government revenues from a change in G
∂G

∂L
• P − Ntw : Additional revenues required to finance an additional unit of G
∂G

∂L
⇒If labour supply was fixed, then ε = 0 and =0
∂G

The condition reduces to the usual Samuelson condition:

UG
N =P
UX

or ∑ MRS = MRT

⇒But with variable labour supply, the optimal provision has to take account of how G
and t affect the size of the tax base

34
 1
We can define the marginal cost of public funds as MCPF =
1+ ε

⇒Social cost of raising an additional dollar of government revenues

Denoting government revenues by R , the modified Samuelson condition can be written

as:

UG  ∂R 
N =  P −  MCPF
UX  ∂G 

⇒The optimal provision of public good is such that the sum of MRS equals the net
revenue required to increase G multiplied by the MCPF

⇒Optimal G takes into account the efficiency cost of taxation

⇒Tends to lower the optimal provision of G

A modified Samuelson condition can be derived for any type of financing instrument
In general, the optimal level of G will decrease with the elasticity of the tax base

35