ECON Terms

Public Finance

Study of the role of the government in the economy.

What is a government?

Set of institutions with the legal authority to make rules, collect taxes, and provide goods and services on behalf of society.

What is a government’s goal?

To maximize social welfare

Social Welfare Function (SWF)

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

Utilitarian

Cares about the size of the pie.

Rawisian

Cares about the smallest slice.

Pareto Efficient

There does not exist an alternative that makes someone better off without making anyone else worse off.

Pareto Efficient Conditions

Well-defined property rights, no missing markets, no externalities, no transaction costs, no asymmetric information, no monopolist.

Reasons why we need government

We don’t always get Pareto efficiency and we want more than Pareto efficiency

Externality

Situation when an action of an economic agent directly affects the well-being of a bystander, but the economic agent does not bare any consequences of that effect.

Positive Production Externality

When production increases the well-being of others, but the producer is not compensated by the others.

Positive Consumption Externality

When consumption increases the well-being of others, but the consumer is not compensated by those others.

Negative Consumption Externality

When consumption decreases the well-being of others who are not compensated by the consumer.

Negative Production Externality

When production decreases the well-being of others, but the others are not compensated by the producer.

Social Optimum

The outcome that is most efficent for society as a whole.

Market with Negative Externality

The private market over-produce compared to what society wants.

Market with Positive Externality

The private market under-produce/under-consume compared to what society wants.

Coase Theorem

When there are well-defined property rights and costless bargaining, then negotiations between the party can solve the externality problems.

The Assignment Problem

Property right is hard to define.

The Holdout Problem

Shared ownership of property rights gives each owner power over all the others (because joint owners have to all agree to the Coasian solution).

The Free-Rider Problem

When an investment has a personal cost but a common benefit, individuals will under-invest.

Transaction Costs and Negotiating Problems

The Coasian approach ignores the fundamental problem that it is hard to negotiate when there are large numbers of individuals on one or both sides of negotiation.