Public Economics

ECON7440
Lecture 1

Marco Faravelli
Important Information

Email:
m.faravelli@uq.edu.au

Room 514 Colin Clark

Building

Office hour: Tuesday

9:00-10:00 from Week 2

Email me for an
appointment.
 Tuesday 10:00 – 11:00, starting
from Week 2
Tutor: Dr Bhagya Gunawardena

I will post tutorial question on BB

Tutorials after every lecture
Solutions will be posted after each
tutorial
You are supposed to attempt to
solve exercises before tutorial
 Assessment

Take Home Assignment 1 (weight: 30%): 5 Sep, 4:00 pm

Take Home •It will cover the material discussed up to week 6. The assignment may involve a mix of short answers, problem-solving, and/or short
Assignment essays.

Take Home Assignment 2 (weight: 30%): 24 Oct, 4:00 pm

Take Home •It will cover the material discussed from weeks 7 to 11. The assignment may involve a mix of short answers, problem-solving, and/or
Assignment short essays.

Essay (weight: 60%): 27 Oct, 4:00 pm

Essay •A student could choose to write an essay on a topic selected from the candidate topics posted on Blackboard. With prior approval of
the instructor, an alternative topic may also be acceptable. An essay should be no longer than 10 pages, including graphs, tables, and
references.
 “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 self interest. We address
ourselves, not to their humanity but to their
The self-love, and never talk to them of our own
necessities but of their advantages.”
Invisible
Hand
Adam Smith, The Wealth of Nations (1776)
 “…by directing that industry in such a manner as its
produce may be of the greatest value, he intends
only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end
which was no part of his intention. Nor is it always
the worse for the society that it was not part of it.

The By pursuing his own interest he frequently promotes

that of the society more effectually than when he
really intends to promote it.”

Invisible
Hand
Adam Smith, The Wealth of Nations (1776)
 Invisible Hand, Markets,
and Economics
• Very powerful concept
• Makes economics a very special social science
• Not unique to economics
• Parallel with natural selection (as noticed by R.
Nozick)
• Notice that in 1776 Darwin wasn’t even born!
Public Finance is the
study of the “visible
hand of the market”
Public Finance is the
study of the “visible
hand of the market”
• How important is the
public sector?
Government Expenditure Across
Countries
Government
Expenditure
Over Time
Government
Expenditure
Over Time
Australian Government Expenditure
Public Finance is the
study of the “visible
hand of the market”
• We will study why,
and how the
government
intervenes in the
economy
 Today we start by showing that Smith’s conjecture was right…but not
always right, i.e. we look at the basis on what we can justify government
intervention

Note that I’ve called it a conjecture. The way markets work was not fully
articulated until Walras outlined the first general equilibrium model
(1870s); and the sense in which markets advance society’s interest was first
properly developed by Pareto (1909). Their research program culminated
in Arrow-Debreu general equilibrium model (second half 20th century)

Arrow-Debreu describe conditions under which free markets yield socially

desirable outcome (conditions under which the invisible hand conjecture is
correct)
 • Perfect Competition - Assumptions:
– There is a market for every good
– Participation in the market is costless
– Established and enforceable property
rights for every good
Competitive – Buyers and sellers are price takers
– Symmetric information
Equilibrium – Each person’s welfare depends only
on the goods she consumes, and each
firm’s profit depends only upon its
own use of the factors of production
Exchange •
•
Two individuals 𝑖: 𝐺, 𝐻
Two goods 𝑤: 𝑎, 𝑏

Economy • Endowments 𝑎6 = 𝑎6! + 𝑎6" , 𝑏6 =

𝑏6! + 𝑏6"
• Allocation: 𝑎! , 𝑏! , 𝑎" , 𝑏" 𝑠. 𝑡. ∶ 𝑎6 =
𝑎! + 𝑎" , 𝑏6 = 𝑏! + 𝑏"
• Convex Preferences: 𝑈! (𝑎! , 𝑏! ),
𝑈" (𝑎" , 𝑏" )
#$! % #" $! %
• > 0, < 0 (Decreasing
#&! #&! "
marginal utility)
 𝑎!
𝑎%" 𝑂"

𝑏!

𝑈$
𝑈# 𝑉#

𝑏%! 𝑉$
𝑏%"
𝐸

𝑏"

𝑂! 𝑎"
𝑎%!
 (
• 𝑈( (𝑎( , 𝑏( ) = 𝑈
)*' + )*' +
• 𝑑𝑎 + 𝑑𝑏 = 0
),' )-'
()' %
.- (*'
• .,
=− -()' % ≡ 𝑀𝑅𝑆
(+'

• 𝑖 is willing to give up 1 unit of 𝑎 for 𝑀𝑅𝑆 units of

𝑏 (equivalently, he wants 1 unit of 𝑎 to compensate for 𝑀𝑅𝑆
less units of 𝑏)
 𝑎!
𝑎%" 𝑂"

𝑏!

𝑈$
𝑈# 𝑉#

𝑏%! 𝑉$
𝑏%"
𝐸

𝑏" Slope of the tangent: MRS

𝑂! 𝑎"
𝑎%!
 Pareto Efficiency
• Pareto Efficiency (Optimality): there is no other allocation at which
someone is better off and no one is worse off
• Pareto-improvement: an allocation such that at least someone is better off,
without making anybody worse off
• Advantage: Minimalist - Not based on value judgments
• Disadvantage: Too weak – can’t distinguish between different (possibly
very different!) efficient allocation
 Pareto Efficiency
𝑈!

- 𝑦 Pareto dominates 𝑥
𝑤
- 𝑧 Pareto dominates 𝑦
- 𝑤, 𝑧, 𝑣 Pareto efficient
𝑧 - Can’t rank 𝑤, 𝑧 and 𝑣
𝑦 - Can we rank 𝑤 and 𝑦?
- And 𝑣 and 𝑥?
𝑥

𝑣
𝑈"
 𝑎!
𝑎%" 𝑂"

Pareto improvement 𝑏!

𝑈$
𝑈# 𝑉#

𝑏%! 𝑉$
𝑏%"
𝐸

𝑏"

𝑂! 𝑎"
𝑎%!
 𝑎!
𝑎%" 𝑂"

𝑏!
𝑍 Pareto efficient
Contract curve

𝑈$
𝑈# 𝑍 𝑉#

𝑏%! 𝑉$
𝑏%"
𝐸

𝑏"

𝑂! 𝑎"
𝑎%!
 Pareto
Efficiency and
MRS
• Clear from the previous
graph that Pareto
efficiency described by
𝑀𝑅𝑆! = 𝑀𝑅𝑆"
• Why?
• What if 𝑀𝑅𝑆! ≠ 𝑀𝑅𝑆" ?
 Competitive Equilibrium

• Individuals maximize utility subject to budget constraints

!
&
• # % #
𝑝 𝑎$ + 𝑝 𝑏$ = 𝑝 𝑎&$ + 𝑝% 𝑏&$ → 𝑏$ =𝑏&$ +&" 𝑎&$ − 𝑎$
• Only relative prices matter!
• Set 𝑏 as numeraire and and 𝑝% = 1
• 𝑏$ =𝑏&$ +𝑝# 𝑎&$ − 𝑎$
• Equilibrium: Markets clear
– Walras Law: if 𝑛 − 1 markets clear the 𝑛'( market clears as well
 Excess Demand of ale/Excess supply of bread

𝑎% " 𝑎%" 𝑎!
𝑂"

𝑏!

𝑈#
𝑝′ 𝑌′
𝑏%"
𝑏%! 𝐸
𝑏%"
𝑏%!
𝑉# 𝑋′

𝑏"
𝑂! 𝑎%! 𝑎% !
𝑎"
 Excess Demand of bread/Excess Supply of ale

𝑎% " 𝑎%" 𝑎"" 𝑎!

𝑂"

𝑝"
𝑏!

𝑋"
𝑏"!

𝑝′ 𝑌′ 𝑉$ 𝑏%"
𝑏%! 𝐸
𝑏%"
𝑏%!
𝑋′ 𝑏""
𝑌"

𝑏"
𝑂! 𝑎"! 𝑎%! 𝑎% !
𝑎"
 Demand and Supply (and Walras Law)

Bread price
of ale

S
𝑝′′

𝑝∗
𝑝′ D

Quantity of ale
 Competitive Equilibrium - Markets clear

𝑎∗ " 𝑎%" 𝑎!
𝑂"

𝑝∗ 𝑏!

𝑍
𝑏∗ ! 𝑏∗ "

𝑈'
𝑉'

𝑏%! 𝐸
𝑏%"

𝑏"

𝑂! 𝑎∗ ! 𝑎%!
𝑎"
 First • Equilibrium: 𝑀𝑅𝑆) = 𝑝 = 𝑀𝑅𝑆*
Fundamental subject to the clearing market
condition

Theorem of • Remember how we defined a

Pareto efficient allocation:
Welfare 𝑀𝑅𝑆) = 𝑀𝑅𝑆*
• First Theorem of Welfare
Economics Economics:
Every competitive allocation is
Pareto optimal
 Production Economy
• So far we’ve abstracted away from the production side. Let’s consider that too
• Two factors of production: 𝐾 and 𝐿
• 𝐺 endowed with 𝐾 @! , 𝐿% ! and owns of 𝛼 ∈ 0,1 of the industry producing 𝑎 and
β ∈ 0,1 of the industry producing 𝑏
• 𝐻 endowed with 𝐾 @" , 𝐿% " and owns 1 − 𝛼 of the industry producing 𝑎 and 1 − 𝛽 of
the industry producing 𝑏
𝑎 = 𝑓 𝐾( , 𝐿(
• Production functions: I
𝑏 = 𝑔 𝐾) , 𝐿)
*+ , *"+ ,
• > 0, < 0 (Decreasing marginal productivity) – same for 𝐿 and 𝑔(+)
*-# *-#"
• Allocation 𝑎! , 𝑏! , 𝑎" , 𝑏" , 𝐾( , 𝐿( , 𝐾) , 𝐿) 𝑠. 𝑡.
@! + 𝐾
𝐾 @" = 𝐾( + 𝐾)
𝐿% ! + 𝐿% " = 𝐿( + 𝐿)
𝑓 𝐾( , 𝐿( = 𝑎! + 𝑎"
𝑔 𝐾) , 𝐿) = 𝑏! + 𝑏"
 Production Efficiency
Economy is production efficient if
it is impossible to reallocate the factors of
𝑏 production so that more of one good is produced,
without changing the production of the other.

𝑌
Production Possibility Frontier
is concave because of decreasing
marginal productivity
𝑋
PPF

𝑎
Production on the PPF is efficient (e.g. Y),
while it is inefficient below the frontier (e.g. X)
 Production Efficiency and 𝑀𝑅𝑇
*+ , ( *+ , ( */ , ) */ , )
• *-#
= 𝑀𝑃- , *.#
= 𝑀𝑃. , *-$
= 𝑀𝑃- , *.$
= 𝑀𝑃.
• What are the consequences of reallocating factors of productivity?
) (
• 𝑀𝑃- X𝑀𝑃- : amount by which production of 𝑏 rises if capital is moved out of
the 𝑎 industry and into the 𝑏 industry until the production 𝑎 falls by 1 unit
) (
• 𝑀𝑃. X𝑀𝑃. : amount by which production of 𝑏 rises if labor is moved out of the
𝑎 industry and into the 𝑏 industry until the production 𝑎 falls by 1 unit
$ $
01% 01&
• Efficient allocation of factors: # = #
01% 01&
$ $
01% 01&
• Why? What if # ≠ # ?
01% 01&
$ $
01% 01&
• Slope of PPF is 𝑀𝑅𝑇 = # = #
01% 01&
Production Efficiency and 𝑀𝑅𝑇
Economy is production efficient if
it is impossible to reallocate the factors of
𝑏 production so that more of one good is produced,
without changing the production of the other.
𝑌

$ $
01% 01&
𝑀𝑅𝑇= # = #
01% 01&
𝑋
PPF

𝑎
Production on the PPF is efficient, while it is inefficient below the frontier
The slope of the production frontier is the 𝑀𝑅𝑇
 • Let’s join Exchange and Production
• Efficiency: 𝑀𝑅𝑆 = 𝑀𝑅𝑇
• Why?
• Suppose 𝑀𝑅𝑇 > 𝑀𝑅𝑆. Each
person is willing to give up one
Match Efficiency unite of 𝑎 for 𝑀𝑅𝑆 unit of 𝑏, but if
production of 𝑎 is reduced by 1
unit, 𝑀𝑅𝑇 units of 𝑏 can be
produced: Pareto improvement
• Same if 𝑀𝑅𝑇 < 𝑀𝑅𝑆
 Competitive Equilibrium
• Prices of goods and factors
– 𝑏: numeraire; 𝑝: price of 𝑎; 𝑟: price of 𝐾; 𝑤: price of 𝐿
• Consumer side
𝑝𝑎) + 𝑏) = 𝑟𝐾 -) + w𝐿- ) + 𝛼𝜋 # + 𝛽𝜋%
– * budget constraints
𝑝𝑎* + 𝑏* = 𝑟𝐾 -* + w𝐿- * + (1 − 𝛼)𝜋 # + (1 − 𝛽)𝜋%
– 𝜋 # , 𝜋% : profits
– Equilibrium → 𝑀𝑅𝑆* = 𝑝 = 𝑀𝑅𝑆)
• Production side
– 𝜋 # = 𝑝𝑓 𝐾# , 𝐿# − 𝑟𝐾# − 𝑤𝐿#
– 𝜋 % = 𝑔 𝐾% , 𝐿% − 𝑟𝐾% − 𝑤𝐿%
# # % %
– Profit maximization→ 𝑝𝑀𝑃+ = 𝑟, 𝑝𝑀𝑃, = 𝑤, 𝑀𝑃+ = 𝑟, 𝑀𝑃, =𝑤
" "
-.# -.$
– Equilibrium → ! = ! ≡ 𝑀𝑅𝑇 = 𝑝
-.# -.$
Hence in equilibrium: 𝑀𝑅𝑇 = 𝑀𝑅𝑆! = 𝑀𝑅𝑆"
Together with the clearing markets conditions,
the previous two partial equilibrium conditions
imply that general equilibrium will be at the Pareto frontier

𝑀𝑅𝑇 𝑀𝑅𝑆 The first

fundamental
𝑆 theorem of welfare
𝑥∗ economics also
holds in a general
𝑥# 𝑊 𝑝 equilibrium
framework of
𝑥$ exchange and
production
 • I Theorem: Markets are efficient –
great news!
• However, remember the
assumptions?
– There is a market for every good
– Participation in the market is
costless
Market, – Established and enforceable
property rights for every good
Efficiency and – Buyers and sellers are price
takers

Market Failures – Symmetric information

– Each person’s welfare depends
only on the goods she
consumes, and each firm’s profit
depends only upon its own use
of the factors of production
• Very restrictive!
• Whenever one of them doesn’t hold
we have a market failure
• THIS IS A REASON FOR
GOVERNMENT INTERVENTION!
 • Public Goods (lack of property
rights)
• Externalities (a person’s welfare
doesn’t depend only on the goods
she consumes - a firm’s profit

Market Failures doesn’t depend only upon its own

use of the factors of production)
• Imperfect Competition (no price
takers / participation is costly)
• Asymmetric Information
 Market Failures and the Role of Government

Public Goods: Defence, Externalities : Health, Imperfect Competition: Asymmetric Information:

Infrastructures, Charity Education, Vaccines Telecommunication, Utilities... Insurance, Bank sector (too big
How many supermarkets do we too fail? A typical moral hazard
have in Australia? problem)
 • Public Goods: Defence,
Infrastructures, Charity
• Externalities : Health, Education
• Imperfect Competition:
Telecommunication, Utilities. How

Market Failures many supermarkets do we have in

Australia?

and the Role of • Asymmetric Information:

Insurance, Bank sector (too big too

Government fail? A typical moral hazard

problem)

• Looking at these typical examples

of government intervention, can
you see other reasons for the
government to interfere with
markets?
 Efficiency and Equity
𝑈!

Remember that while 𝑧 is efficient,

𝑤
so are 𝑤 and 𝑣.
Indeed, all of the points on the
𝑧 Pareto frontier.
𝑦
Although market equilibrium is efficient,
it won’t necessarily comply
𝑥
with any fairness judgment

𝑣
𝑈"
 Second
Fundamental • Second Theorem of Welfare
Theorem of Economics:

Welfare Each Pareto optimal allocation is the

competitive allocation under some
Economics distribution of endowments

• Implication: Lump Sum

redistribution to restore equity
 𝑎!
𝑎^" 𝑎%" 𝑂"
𝑝' 𝑏!

𝑝#
𝑍

𝑍# 𝑈'
𝑉'

𝑏%! 𝐸
# 𝑏%"
𝐸

𝑏"

𝑂! 𝑎^! 𝑎%!
𝑎"
 • Public sector: visible hand of the
market
• First theorem: Markets efficient in
perfect competition
• Second Theorem: Any efficient
allocation can be reached by the
market
• Two reasons for the government to
Conclusion intervene:
– Market failures (I theorem)
– Equity (II theorem)