Chapter 1: Introduction to public economics

Learning outcomes

After completing this chapter and the relevant readings, you should be able to:
• describe public economics
• distinguish positive and normative analysis
• explain the role of modelling
• discuss the equity-efficiency trade-off.

1.1 Public economics

Public economics is about the interaction of the government and the economy. It considers the effects of taxes and government expenditures, with particular emphasis upon how the choices of the government can improve or hinder economic efficiency.

Public economics attempts to understand how the government makes decisions and what decisions it should make. The subject encompasses topics as diverse as responses to market failure due to the existence of externalities and the philosophy behind the measurement of economic

1.2 Normative and positive analysis

When thinking about economic policy it is helpful to focus upon the distinction between positive and normative analysis.
• Positive analysis is about explaining why there is a public sector how government policies are chosen and how these policies affect the economy.
• Normative analysis investigates what the best policies are, and aims to provide a guide to good government.

Positive analysis and normative analysis are not entirely distinct. To proceed with a normative analysis it is first necessary to conduct the positive analysis: it is not possible to determine the best policy without knowing the effects of alternative policies upon the economy.

[This is incorrect. Philosophically conscious human beings start with a normative perspective, then test it against a positive environment, then re-evaluate etc.


1.3 Modelling

Public economics uses economic models to provide simplified descriptions of the parts of the economy relevant for the analysis.

The two basic forms of model are:
• Partial equilibrium models that focus only on one or two markets, taking behaviour elsewhere in the economy as given.
• General equilibrium models that provide a complete economic system with prices equilibrating supply and demand on all markets simultaneously.

The institutional setting for the study of public economics is the mixed economy where individual decisions are respected but the government intervenes to affect choices.

1.4 Methodology

The method of analysis is to build models of the economy that consist of a government, consumers and firms. It is assumed that firms seek to maximise their profits and that consumers seek to maximise their privatepersonal welfare.

Normative analysis is conducted under the assumption that the government has a specified set of objectives and chooses the economic policy that best achieves these. Positive analysis investigates alternative explanations for the choice of government actions, for the emergence of objectives and the consequences of actions.

[*sigh* This author has not studied philosophy]

When considering policy choice, the focus of the analysis is upon the equilibrium achieved by the economy. The subject matter of public economics is both the comparison of alternative policies (including the policy of laissez faire or doing nothing!) and the choice of the optimal policy. A change in policy can be viewed as resulting in a different equilibrium for the economy. To treat the question of comparison of policies, the equilibria for different policies are contrasted with respect
to how well they satisfy the government’s objectives. The same approach is taken to the selection of the optimal policy, which is defined as the policy yielding the highest level for the government’s objective.

1.5 The minimal state

An economy could not function effectively if there were no property rights (the rules defining the ownership of property). [Read: Access rights].. Theft discourages enterprise since the gains accrued may be appropriated by others. It also results in the use of resources in the unproductive business of theft prevention.

An economy also needs contract laws (the rules governing the conduct of trade)... Law enforcement cannot be provided free of cost as enforcement officers must be employed and courts provided
to hear litigation.... Once a country develops its economic activity it will need to defend its gains from being stolen by outsiders. This implies the provision of a means of defence for the nation
which is also costly.

The minimal state provides contract law, polices it, and defends the economy against outsiders. The minimal state does nothing more than this, but without it organised economic activity could not take place.

1.6 Market failure

The minimal state intervenes only to ensure the smooth functioning of the economy... Outside of
this setting, there are many circumstances in which efficiency will not be achieved.

Market failure is said to arise when efficiency is not achieved. The sources of market failure are:

• monopoly
• public goods
• externalities
• asymmetric information.

When market failure is present, the argument for considering whether government intervention would be beneficial is compelling. But this does not imply that intervention will always be beneficial.

1.7 Redistribution

An argument for government intervention can also be made if the economy has widespread inequality of income, opportunity or wealth. Such inequalities can occur even if the economy is efficient in a narrow economic sense.

In conducting an economic policy the state will have two conflicting aims. On the one hand, it will aim to raise revenue to finance the policy with the minimum loss to society. The raising of revenue leads to losses due to the resources used in the collection process and from the economic distortions that it causes. Minimising these losses is the efficiency aspect of policy design. Conversely, the state may also feel that it is desirable to intervene in the economy in order to attain a more equitable distribution of the economy’s resources. This is often accompanied by a corresponding reduction in the degree of concern for the aggregate level of economic activity. This motivation represents the equity side of policy design.

Given this, the design of optimal policy is concerned with reaching the correct trade-off between equity and efficiency objectives.


Chapter 1 An Introduction to Public Economics

1.1 Public Economics

Public economics studies the government and how its policies affect the economy. It considers how the choices of the government are made and how they can improve or hinder economic efficiency. Public economics also investigates the extent to which it is possible for the government to influence the distribution of income and wealth and whether this is desirable. p3

Public economics attempts to understand both how the government makes decisions and what decisions it should make. p4

1.2 Methods

The feature that most characterizes modern public economics is the use made of economic models. These models are employed as a tool to ensure that arguments are conducted coherently with a rigorous logical basis. Models are used for analysis because the possibilities for experimentation are limited and past experience cannot always be relied upon to provide a guide to the consequences of new policies. p4

Alternative policies are contrasted by comparing the equilibria to which they lead. p5

In conducting the assessment of policy, it is often helpful to emphasize the distinction between positive and normative analysis. The positive analysis of government investigates topics such as why there is a public sector, the emergence of government objectives and how government policies are chosen. It is also about understanding what effects policies have upon the economy. In contrast, normative analysis investigates what the best policies are, and aims to provide a guide to good government. To proceed with a normative analysis it is first necessary to conduct the positive analysis: it is not possible to say what is the best policy without knowing the effects of alternative policies upon the economy. p5 [Still wrong, same author]