FME 323

PUBLIC FINANCE
INTRODUCTION
BY:
ELEANOR P. GAROY Roles/functions:
Short Term, AY 2021-2022 1. Allocation function: (a) provision for
public g/s; (b) ensure competition; (c)
correct externalities
2. Distribution function – ensure
redistribute of wealth and income
3. Stabilization function
 How do we Objectively
Measure Government
Performance?
Positive Economics
- Deals with “what is” (“what is”
analysis)
- cause & effect (theory; scientific
method) – describe the behavior;
what is happening
 e.g. studies on voting (vote
buying/vote selling)

Role of Theory - Poverty, aka..homogeneity in

population (e.g., low income
bracket, age, unemployment)

• Economic theory provides a framework for thinking about the factors

that might influence the behavior of interests, and helps generate
hypotheses that can be tested through empirical research.
• Observe, form hypotheses
• Test hypotheses through continued observation, measurement and
social experiments
• Confirm hypotheses repeatedly and you have theory
• Reject hypotheses and you’re back to the drawing board
• Theory tells us what questions to test Interests:
Individual – welfare: maximize utility
Society – general welfare
If we fail to test our theories and their
assumptions, or continue to believe
them when they fail the tests, they
become ideology, not theory.
Neoclassical Economic Theory
• Assumes humans are rational, self interested utility maximizers
• Empirical studies reject this
• Assumes perfect market competition
• Empirical studies reject this
• Assumes in perfect markets invisible hand leads to efficient
allocation: greatest good for greatest number (issue: g/s – is it really
going to the greatest number? g/s (private g/s) – left in the hands of
those who can only afford – issue – poor sector)
• Can’t be tested in practice, because governments always intervene
with perfect functioning of market
Ecological Economic Theory
• Assume economy is subset of ecosystem
• Ecologically sustainable scale is first priority
• Socially just distribution 2nd
• Efficient allocation 3rd
Georgist Economic Theory
• Ownership of land leads to poverty
• Value of land is created by nature and society, not hard work of
individual
• Land tax could finance all government expenditure, prevent land
speculation and concentration of ownership, end poverty
• Land tax could be extended to include all value created by nature
and society
Empirical methods for Testing
theories
• Interviews
Subjective, hard to interpret
• Social Experiments
Ethical issues, self selection, etc.
Sample size
• Econometrics (statistics)
Torture the data and it will confess
• Theories can be very hard to test
Measurement in a complex system
• Very hard to isolate cause and effect
• E.g. feedback loops
• Rarely have adequate baseline data
• Systems evolve over time
• Values matter
 How do we normatively measure
government performance?
Normative economics
- Deals with “what should be done”
- Policy economics
- Subjective (value judgement)
- Policy-makers (e.g., public officials)
Why do we need normative
measures?
• We need a systematic framework to assess the desirability of various
government actions
• We need some way to measure social welfare, and choose between
alternative states
• Economic theory provides some guidelines
• Theory can be very incomplete
• Different theories make different ethical/simplifying assumptions
• The most commonly taught approach is neoclassical welfare economics
Welfare Economics
• Welfare Economics
- framework used by most public finance specialists
- the branch of economic theory concerned with the social
desirability of alternative economic states
- the theory is used to distinguish circumstances under which
markets can be expected to perform well
- helps us define some circumstances under which we might want
government intervention
- Background in microeconomics: Indifference Curve
 Indifference Curves in Edgeworth
•
Box
Edgework Box (for a simple economy)
- Depicts the possible distributions of
two goods (e.g., apples and fig leaves)
– between two individuals (e.g.,
Adam and Eve).
- Economic problem: to allocate
amounts of the two goods between
the two people
- Os = legth of the box = number of
apples that are available each year
- Or = height of the box = number of fig
leaves that are available each year
 Indifference Curves in Edgeworth
Box
• Edgeworth Box (for a simple economy)
- Distances from O and O’ = quantities
of the goods consumed by Adam and
Eve respectively
- Point v:
Adam consumes Ou fig leaves and Ox
apples
Eve consumes O’y apples and O’w fig
leaves
- Any point with the Edgeworth Box
represents some allocation of apples
and fig leaves between Adam and Eve.
 Indifference Curves in Edgeworth
Box
• Edgework Box (for a simple economy)
- Assumption: Adam and Eve have
conventionally-shaped ICs representing
their preferences for apples and fig
leaves
- Each of the individual’s ICs are
superimposed onto the Edgeworth Box
Adam: labeled as A’s
Eve: labeled as E’s
- Adam’s utility increases as he moves
toward the northeast direction
Eve’s utility increases as she moves
toward the southwest direction
 Indifference Curves in Edgeworth
•
Box
Edgework Box (for a simple economy)
- Can Adam’s welfare be further
increased without doing any harm
to Eve?
• Pareto Efficient
- An allocation of resources so that no
person can be made better off
without making another person
worse off.
- As long as Adam can be moved to
indifference curves farther to the
northeast while still remaining on
Eg, it is possible.
Indifference Curves in Edgeworth
Box
• Pareto Efficient
- Used as a standard for evaluating the desirability of an allocation
of resources.
> An allocation that is not Pareto efficient – “wasteful”
• Pareto improvement
- A reallocation of resources that makes one person better off
without making anyone else worse off.
- Example (Adam): there is pareto improvement when Adam moves
from point g to h, and h to p.
Indifference Curves in Edgeworth
Box
• Pareto Efficient
- Can Eve also be made better off without lowering the utility of
Adam?
- Moving Eve to indifference curves farther to the southwest
suggests that there is pareto improvement, provided that the
allocation remains on indifference curve Ag. And pareto efficiency
is achieved between Adam and Eve at p1.
Indifference Curves in Edgeworth
Box
• Pareto Efficient
Indifference Curves in Edgeworth
Box
• Reallocations making both individuals better off

Reallocations starting at point g:

- At p2, Adam is better off than
at point g, and so is Eve.
- p2 – pareto efficient – at this
point it is impossible to make
either individual better off
without making the other
worse off.
Indifference Curves in Edgeworth
Box
• Reallocations making both individuals better off: Another starting
point

Reallocations starting at point k:

- Reallocation of goods is
possible to make one of
them better off without
hurting the other
- Movement from p3 and p4 –
would represent a Pareto
improvement.
 Indifference Curves in Edgeworth
Box
• Contract Curve
- The locus of all the Pareto
efficient points (denoted
by mm)
- For an allocation to be
Pareto efficient (to be on
mm), it must be a point at
which the ICs of Adam and
Eve are barely touching.
- Indifference curves are
tangent – slopes of the
indifference curves are
equal.
 Indifference Curves in Edgeworth
Box
• Contract Curve
- Any point in the
Edgeworth Box in which
Adam’s IC is just
touching (tangent to)
Eve’s IC is a Pareto
efficient point. The
locus of all the Pareto
efficient points is called
the contract curve.
Indifference Curves in Edgeworth
Box
• Contract Curve
- The absolute value of the slope of the IC indicates the slope at which
the individual is wiling to trade one good for an additional amount of
another = marginal rate of substitution (MRS).
- Pareto efficiency requires that the marginal rates of substitution be
equal for all consumers:

where: = Adam’s MRS of apples for fig leaves

= Eve’s MRS of apples for fig leaves
Production Economy
• The Production Possibilities
Curve
- PPC shows the maximum
quantity of one output that
can be produced, given the
amount of the other output.
Production Economy
• The Production Possibilities
Curve
- Slope of PPC – MRT (marginal
rate of transformation)
- MRT – the rate at which the
economy can transform one
good into other good; it is the
absolute value of the slope of
the production possibilities
frontier
Production Economy
• The Production Possibilities
Curve
- Useful to express MRT in terms
of marginal cost (MC)
- MC – the incremental
production cost of one more
unit of output
- Distance wy – incremental cost
of producing apples (MCa)
- Distance xz = incremental cost
of producing fig leaves (MCf)
Production Economy
• The Production Possibilities Curve
- Slope:

In absolute value, MRTaf is the

amount of fig leaves given up in
order produce additional unit of
apples.
Production Economy
• Efficiency Conditions with Variable
Production
- Supplies of apples and fig leaves -
variable
Condition for Pareto efficiency:
Production Economy
• Efficiency Conditions with Variable
Production
- Example: MRSaf = 1/3; MRTaf = 2/3
MRSaf = 1/3: if Adam lost 3 extra
apples, he would require only one fig
leaf to maintain his original utility
level
MRTaf = 2/3: two additional fig leaves
could be produced by giving up three
3 applies
Production Economy
• Efficiency Conditions with Variable Production
- Example: MRSaf = 1/3; MRTaf = 2/3
Adam could be made better off by giving up 3 apples and transforming them
into two fig leaves, and no one else would be made worse off in the process.
Such trade is always possible as long as the MRS ≠ MRT.
- Only when the slopes of the curves for each are equal is it impossible to make
a Pareto improvement.
- Necessary condition for Pareto efficiency:
The rate at which apples can be transformed into fig leaves (MRT af) must
equal the rate at which consumers are willing to trade apples for fig leaves
(MRSaf).
Production Economy
• Efficiency Conditions with Variable Production
- Conditions for Pareto efficiency: