CHAPTER I: ECONOMY OF MARKET AND PUBLIC INTERVENTION Public finance is a field of economics concerned with paying for collective or governmental activities, and with the administration and design of those activities. The field is often divided into questions of what the government or collective organizations should do or are doing, and questions of how to pay for those activities. The broader term (public economics) and the narrower term (government finance) are also often used. The proper role of government provides a starting point for the analysis of public finance. In theory, private markets will allocate goods and services among individuals efficiently (in the sense that no waste occurs and that individual tastes are matching with the economy's productive abilities). If private markets were able to provide efficient outcomes and if the distribution of income were socially acceptable, then there would be little or no scope for government. In many cases, however, conditions for private market efficiency are violated. For example, if many people can enjoy the same good at the same time (non-rival, non-excludable consumption), then private markets may supply too little of that good. National defense is one example of non-rival consumption, or of a public good. "Market failure" occurs when private markets do not allocate goods or services efficiently. The existence of market failure provides an efficiency-based rationale for collective or governmental provision of goods and services. Externalities, public goods, informational advantages, strong economies of scale, and network effects can cause market failures. Public provision via a government or a voluntary association, however, is subject to other inefficiencies, termed "government failure." Under broad assumptions, government decisions about the efficient scope and level of activities can be efficiently separated from decisions about the design of taxation systems (Diamond-Mirlees separation). In this view, public sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest efficiency losses caused by distortion of economic activity as possible. In practice, government budgeting is substantially more complicated and often results in inefficient practices. Government can pay for spending by borrowing (for example, with government bonds), although borrowing is a method of distributing tax burdens through time rather than a replacement for taxes. A deficit is the difference between government spending and revenues. The accumulation of deficits over time is the total public debt. Deficit finance allows governments to smooth tax burdens over time, and gives governments an important fiscal policy tool. Deficits can also narrow the options of successor governments. Public finance is closely connected to issues of income distribution and social equity. Governments can reallocate income through transfer payments or by designing tax systems that treat high-income and low-income households differently. The "Public Choice" approach to public finance seeks to explain how self-interested voters, politicians, and bureaucrats actually operate, rather than how they should operate. The virtues of Theorem of Welfare Economy Pareto Efficiency A central concept in economics is Pareto efficiency. A situation is said to be Pareto efficient if there is no way to rearrange things to make at least one person better off without making anyone worse off. What makes Pareto efficiency important is that almost everyone would agree that society should avoid situations that are not Pareto efficient. That is, when something could be done to make at least one person better off without hurting anyone, most people would agree we should do it. Much of economics is concerned with identifying inefficient situations and designing policies and institutions that will promote efficiency and reduce inefficiency. A policy or action that makes at least one person better off without hurting anyone is called a Pareto improvement. The term is named for an Italian economist, Vilfreo Pareto. Efficiency between production and consumption The relation between production and consumption in a simple seven equation model (2x2x2 model) can be shown graphically. In the diagram below, the aggregate production possibility frontier, labeled PQ shows all the points of efficiency in the production of goods X and Y. If the economy produces the mix of good X and Y shown at point A, then the marginal rate of transformation (MRT), X for Y, is equal to 2. 1. Efficiency between production and consumption. Point A defines the boundaries of an Edgeworth box diagram of consumption. That is, the same mix of products that are produced at point A, can be consumed by the two consumers in this simple economy. The consumers' relative preferences are shown by the indifference curves inside the Edgeworth box. At point B the marginal rate of substitution (MRS) is equal to 2, while at point C the marginal rate of substitution is equal to 3. Only at point B is consumption in balance with production (MRS=MRT). The curve 0BCA inside the Edgeworth box (sometimes called a contract curve) defines the locus of points of efficiency in consumption (MRS1=MRS 2). As we move along the curve, we are changing the mix of goods X and Y that individuals 1 and 2 choose to consume. The utility data associated with each point on this curve can be used to create utility functions. Social welfare maximization Utility functions can be derived from the points on a contract curve. Numerous utility functions can be derived, one for each point on the production possibility frontier (PQ in the diagram above). A social utility frontier (also called a grand utility frontier) can be obtained from the outer envelope of all these utility functions. Each point on a social utility frontier represents an efficient allocation of an economy resource that is it is a Pareto optimum in factor allocation, in production, in consumption, and in the interaction of production and consumption (supply and demand). In the diagram below, the curve MN is a social utility frontier. Point D corresponds with point B from the earlier diagram. Point D is on the social utility frontier because the marginal rate of substitution at point B is equal to the marginal rate of transformation at point A. Point E corresponds with point C in the previous diagram, and lies inside the social utility frontier (indicating inefficiency) because the MRS at point C is not equal to the MRT at point A. Although all the points on the grand social utility frontier are Pareto efficient, only one point identifies where social welfare is maximized. This is point Z (2nd picture) where the social utility frontier MN is tangent to the highest possible social indifference curve labeled SI. 2. Pareto efficient. CHAPTER II: OBJECTIVES AND INSTRUMENTS OF THE GOVERNMENT INTERVENTION Economists generally cannot perform controlled experiments with the economy, the effects of economic policy are difficult to determine. Economic theory helps specify the factors that might affect a given kind of behavior. However, theory alone cannot say how important any particular factor is. Empirical research attempts to measure both the direction and size of the effect of government policy changes on behavior. Common types of empirical studies are interview studies, social and laboratory experiments, and econometric analysis. Interview studies consist of directly asking people how various policies affect their behavior. However, people may not actually react to policies in the way they say they do. Social experiments subject one group of people to some policy and compare their behavior with that of a control group. Problems can arise because: the experiment itself may affect people's behavior; it is difficult to obtain a random sample; and social experiments are quite costly. Economic interventionism is an action taken by a government in a market economy or market-oriented mixed economy, beyond the basic regulation of fraud and enforcement of contracts, in an effort to affect its own economy. Economic intervention can be aimed at a variety of political or economic objectives, such as promoting economic growth, increasing employment, raising wages, raising or reducing prices, promoting equality, managing the money supply and interest rates, increasing profits, or addressing market failures. The term economic intervention assumes the state and economy are inherently separate, and therefore state action in the economy is an intervention in a market or market-oriented mixed economy.
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