EC-310 Public Finance Exam 1

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Public finance

The study of the role of the government in the economy.

Four questions of public finance

1. When should the government intervene in the economy?
2. How might the government intervene?
3. What is the effect of those interventions on economic outcomes?
4. Why do governments choose to intervene in the way that they do?

Market failure

A problem that causes the market economy to deliver an outcome that does not maximize efficiency.

Redistribution

The shifting of resources from some groups in society to others.

Price mechanism

government policy is used to change the price of a good in one of two ways:

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Through taxes, or subsidies

Taxes

Raise the price for private sales or purchases of goods that are overproduced (causing demand for those goods to decrease.)

Subsidies

Lower the price for private sales or purchases of goods that are underproduced (causing demand for those goods to increase).

Direct effects

The effects of government interventions that would be predicted if individuals did not change their behavior in response to the interventions.

Indirect effects

The effects of government interventions that arise only because individuals change their behavior in response to the interventions.

Political economy

The theory of how the political process produces decisions that affect individuals and the economy.

In 1930, the federal government’s activity accounted for only about _____ of gross domestic product.

3\.4%

From the 1950s through the present the size of government has averaged around ____ of GDP.

20%

A key feature of governments is the degree of ______ across local and national government units.

Centralization

Any excess of income over spending is a ______.

Cash flow surplus

If revenues exceed spending, then there is a ______.

Budget surplus

Public goods

Goods for which the investment of any one individual benefits everyone in a larger group.

Public goods are

Non-rival; Non-excludable

Social insurance programs

Government provision of insurance against adverse events to address failures in the private insurance market.

Payroll taxes

The taxes on worker earnings that fund social insurance programs

Theoretical tools

The set of tools designed to understand the mechanics behind economic decision making.

Empirical tools

The set of tools designed to analyze data and answer questions raised by theoretical analysis.

Utility function

A mathematical function representing an individual’s set of preferences, which translates their well-being from different consumption bundles into units that can be compared in order to determine choice.

Constrained utility maximization

The process of maximizing the well-being (utility) of an individual, subject to their resources (budget constraint).

Models

Mathematical or graphical representations of reality.

Economists assume that ___ of a good is always better than ____.

More; Less

Indifference curve

A graphical representation of all bundles of goods that make an individual equally well off. Because these bundles have equal utility, an individual is indifferent as to which bundle she consumes.

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a curve that shows all combinations of consumption that give the individual the same amount of utility.

Indifference curves have two essential properties:

1. Consumers prefer higher indifference curves. Individuals prefer to consume bundles that are located on indifference curves that are farther out from the origin because they represent bundles that have more of.

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2. Indifference curves always slope downward.

Utility Function

has a well-defined utility function. A utility function is a mathematical representation **U= f(X₁, X₂, X₃…)** where **X₁, X₂, X₃** and so on are the goods consumed by the individual and **f** is some mathematical function that describes how the consumption of those goods translates to utility.

Utility Function?

√(Q**₁** • Q**₂)**

Marginal utility

The additional increment to utility obtained by consuming an additional unit of a good.

Marginal Rate of Substitution (MRS)

The rate at which a consumer is willing to trade one good for another.

The MRS equals:

The slope of the indifference curve, the rate at which the consumer will trade the good on the vertical axis for the good on the horizontal axis.

MRS ratio:

MRS=-MU₁/MU₂

Budget constraint

A mathematical representation of all the combinations of goods an individual can afford to buy if she spends her entire income.

Budget constraint equation

Y= P₁Q₁ + P₂Q₂

Opportunity cost

The cost of any purchase is the next best alternative use of that money, or the forgone opportunity.

Price Ratio

The rate at which the market allows someone to trade one good for another.

What is the highest indifference curve that an individual can reach given a budget constraint?

The indifference curve tangent to the budget constraint.

Price Ratio equation

MRS=-MU₁/MU₂ = P₁/P₂

Substitution Effect

Holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good.

Income Effect

A rise in the price of a good will typically cause an individual to choose less of all goods because her income can purchase less than before.

Welfare Economics

The study of the determinants of well-being, or welfare, in society.

Elasticity of demand

The percentage change in the quantity demanded of a good caused by each 1% change in the price of that good.

Elasticity of demand equation

E=

percentage change in the quantity demanded

_______________________________________________

Precent chance in price

Elasticity of demand is typically _______ because

Negative; because quantity demanded typically falls as price rises.

Elasticity of demand is typically ______ constant on the demand curve

Not

A vertical demand curve is one in which the quantity demanded ________ when price rises; in this case, demand is ________

Does not change; perfectly inelastic.

A horizontal demand curve is one in which quantity demanded _______ for even a very small change in price; in this case, demand is ________

Changes infinitely; perfectly elastic.

Cross-price elasticity

The effect of one good’s price on the demand for another good.

Marginal productivity

The impact of a one-unit change in any input, holding other inputs constant, on the firm’s output.

Marginal cost

The incremental cost to a firm of producing one more unit of a good.

Profit

The difference between a firm’s revenues and costs, maximized when marginal revenues equal marginal costs.

Market equilibrium

The combination of price and quantity that satisfies both demand and supply, determined by the interaction of the supply and demand curves.

Consumer surplus

The benefit that consumers derive from consuming a good, above and beyond the price they paid for the good.

Producer surplus

The benefit that producers derive from selling a good, above and beyond the cost of producing that good.

Consumer surplus is the area

Under the demand curve and above the equilibrium.

Producer surplus is the area

Under the equilibrium and above the supply curve.

Total social surplus (social efficiency)

The sum of consumer surplus and producer surplus.

First Fundamental Theorem of Welfare Economics

The competitive equilibrium, where supply equals demand, maximizes social efficiency.

Deadweight loss

The reduction in social efficiency from preventing trades for which benefits exceed costs.

Social welfare

The level of well-being in society.

TANF

Temporary Assistance for Needy Families

Second Fundamental Theorem of Welfare Economics

Society can attain any efficient outcome by suitably redistributing resources among individuals and then allowing them to freely trade.

Equity–efficiency trade-off

The choice society must make between the total size of the economic pie and its distribution among individuals.

social welfare function (SWF)

A function that combines the utility functions of all individuals into an overall social utility function.

Utilitarian social welfare

Society’s goal is to maximize the sum of individual utilities

Utilitarian social welfare function

SW F= U₁ + U₂ + …Uₙ

Rawlsian Social welfare

Society’s goal should be to maximize the well-being of its worst-off member.

Rawlsian Social welfare function

SW F= min(U₁ + U₂ + …Uₙ)

Commodity egalitarianism

The principle that society should ensure that individuals meet a set of basic needs, but that beyond that point income distribution is irrelevant.

Equality of opportunity

The principle that society should ensure that all individuals have equal opportunities for success but not focus on the outcomes of choices made.

Empirical tools of public finance

The use of data and statistical methods to measure the impact of government policy on individuals and markets.

Correlated

Two economic variables are correlated if they move together.

Causal

Two economic variables are causally related if the movement of one causes movement of the other.

The “gold standard” for measuring causal effect

Randomized Control Trial (RCT)

Randomized trial

The ideal type of experiment designed to test causality, whereby a group of individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not.

Treatment group

The set of individuals who are subject to an intervention being studied.

Control group

The set of individuals comparable to the treatment group who are not subject to the intervention being studied.

Bias

Any source of difference between treatment and control groups that is correlated with the treatment but is not due to the treatment.

Attrition

Reduction in the size of samples over time, which, if not random, can lead to biased estimates.

Observational data

Data generated by individual behavior observed in the real world, not in the context of deliberately designed experiments.

Time series analysis

Analysis of the co-movement of two series over time.

Cross-sectional regression analysis

Statistical analysis of the relationship between two or more variables exhibited by many individuals at one point in time.

Regression line

The line that measures the best linear approximation to the relationship between any two variables.

Control variables

Variables that are included in cross-sectional regression models to account for differences between treatment and control groups that can lead to bias.

Quasi-experiments

Changes in the economic environment that create nearly identical treatment and control groups for studying the effect of that environmental change, allowing public finance economists to take advantage of randomization created by external forces.

Difference-in-difference estimator

The difference between the changes in outcomes for the treatment group that experiences an intervention and the control group that does not.

Structural estimates

Estimates of the features that drive individual decisions, such as income and substitution effects or utility parameters.

Reduced form estimates

Measures of the total impact of an independent variable on a dependent variable, without decomposing the source of that behavior response in terms of underlying utility functions.

Debt

The amount that a government owes to those who have loaned it money.

Deficit

The amount by which a government’s spending exceeds its revenues in a given year.

Entitlement spending

Mandatory funds for programs for which funding levels are set automatically by the number of eligible recipients, not by the discretion of Congress.

Discretionary spending

Optional spending set by appropriation levels each year, at Congress’s discretion.

The House and Senate Appropriations Committees each take the total amount of discretionary spending available and divide it into:

12 suballocations for each of their 12 subcommittees.

Balanced budget requirement (BBR)

A law forcing a given government to balance its budget each year (spending = revenue).

Ex post BBR

A law forcing a given government to balance its budget by the end of each fiscal year.

Ex ante BBR

A law forcing either the governor to submit a balanced budget or the legislature to pass a balanced budget at the start of each fiscal year, or both.

Real prices

Prices stated in some constant year’s dollars.

Nominal prices

Prices stated in today’s dollars.

Consumer Price Index (CPI)

An index that captures the change over time in the cost of purchasing a “typical” bundle of goods.