Public Finance

Instructor: John Hartman

Today: An introduction to Econ 130

A review of microeconomics
Introduction to public finance
Before we begin…

 Remember that this is a small class  Ask

questions if things are not clear
 The syllabus is posted online  See
http://econ.ucsb.edu/~hartman/
 For most of you, attendance is important if
you want to get a good grade
Before we begin…

 I expect you to know the following tools

 Calculus
 Derivatives, integrals, partial derivatives
 Microeconomics
 Econ 1, Econ 100A or 104A, Econ 100B or 104B
 Macroeconomics (although not as important for public
finance)
 Econ 2, Econ 101 or 105
 If you are lacking on any of these skills, please
make sure you are comfortable with these skills by
next week
Structure of learning

 Expected time to spend on this class

 3 hours per unit per week
 12 hours per week total
 Format of learning
 Read first
 Lecture
 Do problems on your own
 Solve problems in class and review sessions
Textbook for this class

 Rosen/Gayer
 Public Finance, 8th edition
 Published by McGraw-Hill/Irwin
Office hours and review sessions

 Office: NH 2028
 Office hours:
 Mondays 10:30-11:30 am
 Wednesdays 9:30-10:30 am
 I plan on conducting one review session
before each test
 Time and location to be announced
Tests

 Three tests, as of now scheduled for:

 Monday, April 28 (in lecture)
 Monday, May 19 (in lecture)
 Monday, June 8 (final, 4-6:30 pm)
 Some problems on tests will be similar to
what we cover in practice problems
 Some questions will require you to learn
material and think your way through
Lecture slides

 I will post a subset of lecture slides on-line

 Usually posted 2 days to a week before lecture
 Tables and figures from your textbook will often
not be posted
 On-line slides are not meant to be a
replacement to lecture
Grading

 If you do not miss a test:

 Two best tests count 40% each
 Lowest test counts 20%
 Exception: If your best test is the final, the final
will count 60% and the other two tests count 20%
each
 If you do miss a test, check the syllabus for
details
Grading

 Typical upper division Econ field class curve

 20-25% A+, A, or A-
 30-35% B+, B, or B-
 25-30% C+, C, or C-
 Remaining students: D+, D, D-, or F
 However, I will reward the class if you score
well as a group
More on this class

 Early on, I will lecture the entire time

 Later on many lectures will be about 55-60
minutes, followed by problem solving
 Some classes will be devoted to a single
topic
 Some classes will consist of two to four “mini-
lectures”
Problems

 Each week, I will post a few problems

 The following week, I will solve some of the
problems at the end of each lecture, as time
permits
 I will also solve some problems at each
review session
Today

 An introduction to Econ 130

 What will we cover over the next 10 weeks?
 A brief review of Microeconomics (read Appendix)
 Supply, demand, and equilibrium
 Utility
 Budget constraints
 Substitution and income effects
 Consumer and producer surplus
 Introduction to public finance: Begin Chapter 1
An introduction to Econ 130

 This class covers four “units,” each with three

to five lectures
 Unit 1: Introduction and Microeconomic tools
 Unit 2: Public goods, externalities, and
government
 Unit 3: Health care and income redistribution
 Includes guest lecture by Ted Bergstrom
 Tentative topic: Bone marrow as a public good
 Unit 4: Primary and secondary effects of taxes
Unit 1 (begins today)

 Introduction and Microeconomic tools

 Appendix: Microeconomics review and marginal
analysis
 Chapter 1: Introduction to public finance and
government
 Chapter 2: Empirical tools
 Chapter 3: Economic theory tools
 Chapter 8: Cost-benefit tools
Unit 2

 Public goods, externalities, and government

 Chapter 4: Public goods
 Chapter 5: Externalities
 Chapter 6: Government and political economy
 Chapter 7: Government spending on education
Unit 3

 Health care and income redistribution

 Chapter 9: Problems of insurance in the health
care market
 Chapter 10: Government’s role in health care
 Chapter 11: The structure of Social Security;
stresses caused by the baby boom generation
 Chapter 12: Conceptual issues of income
redistribution
 Chapter 13: Programs for the poor
Unit 4

 Primary and secondary effects of taxes

 Chapters 14 and 15, and parts of Chapter 16:
Taxation, income distribution, and efficiency
 Parts of Chapters 17-21: Taxation on the national
level
 Personal taxes
 Corporate taxes
 Deficit finance
 Tax reform
 Chapter 22: Taxation on a state and local level
Microeconomics review

 Some topics you should already know

 We will assume standard cases
 If you need review on these topics, look in the
Rosen/Gayer (“R/G”) appendix, or books that you
used in introductory or intermediate
microeconomics classes
Supply, demand, and equilibrium

 In equilibrium, the supply and demand curves

intersect
 When quantity supplied is higher than
quantity demanded, there is a push for prices
to go down
 Excess supply
 When quantity supplied is lower than quantity
demanded, there is a push for prices to go up
 Excess demand
Supply and Demand
Equilibrium: Q = 4, P = 6
Example of excess demand
Factors of demand

 Price: Higher price  lower quantity

demanded
 Income: Most goods are normal
 Normal goods: Higher income means higher
demand
 Price of related goods (complements,
substitutes)
 “Tastes and preferences”
Factors of supply

 Price: Higher price  higher quantity

demanded
 Price of inputs
 Technology
 Weather
Shift in demand;
movement along supply curve
Utility

 Utility is used by economists to note a level of

satisfaction
 The higher the utility, the higher the
satisfaction
Bananas and utility

 Notice this example, Banana Total utility

quantity (utils)
where the utility (bananas)
level is a function of 0 0
the number of 1 70
bananas consumed
2 120
 Common unit of utility
is called a “util” 3 150
 Typically assume 4 160
non-satiation
5 165
Two goods and utility

 An indifference curve
that is further from the
origin has higher
utility
 U2 > U1 > U0

U2
Increasing U1
utility U0
Budget constraints

 We assume each person has wants that are

above the resources available to her/him
 Consumption must be made from resources
available
Budget constraints with no money

 Becky has a
given number of
hours per day
 Feasible
bundles: t, v, w,
x, y, z
 Point t does not
use up her time
allotment
 Point u is
infeasible
Budget constraints with no trade

 If there is no
trade:
 Becky chooses
production to
maximize her
utility
 This occurs where
budget constraint E1
is tangent to an
indifference curve
 Point E1
Substitution and income effects

 When the price of a good changes, two

things happen
 Income effect: How much does quantity change
due to lower income?
 Substitution effect: How much does quantity
change due to change in relative prices?
Substitution and income effects

 Income effect
 E1 to Ec
 Substitution effect
 Ec to E2
 Note that budget lines
to calculate income
effect are parallel
Consumer surplus

 Height of triangle is
($6 – $3), or $3.
 Length of triangle is
(6 – 0), or 6
The area of this
 Area of triangle is one- triangle is a good
half times length times approximation of
CS
height
 CS = $9
Producer surplus

 When P = 25 per unit,

shaded area is
approximate producer
surplus
 Area is a triangle, one-
half times length times
height
 0.5  10  25 = 125
Summary: Microeconomics review

 Many microeconomic tools are needed to do

public finance
 Some of the tools that we will use are based
on supply, demand, utility, and budget
constraints
Introduction to public finance

 This class is meant to cover public finance to

students that have no direct background in the topic
 Some knowledge on public goods and externalities is
useful, but not required
 Two topics will be covered in this “mini-lecture”
 What is studied in a public finance class?
 What kinds of views do people have about public finance?
 Government will be addressed more in later lectures
 Size of government will be covered in the next lecture
 Growth of government will be covered in week 4
Public finance

 Public finance, as defined by R/G (p. 2)

 “The field of economics that analyzes government
taxation and spending policies”
 Public finance, as described by Former
Czech Prime Minister Vaclav Klaus (From
R/G, p. 2)
 “Public finance is nothing else than a
sophisticated discussion of the relationship
between the individual and the state”
Public finance

 We will study topics in which many argue that

government intervention is justified
 Public goods and markets with externalities
 Subsidized education
 Health care, Social Security, and income
redistribution
Public finance and taxes

 Many programs require tax money to operate

 We will study how the governments on the
local, state, and national level operate
 Personal income tax
 Reaction to labor/leisure choices
 Corporate taxes
 Deficit financing
 Potential reforms to the current tax structure
Public _____

 There are at least two other terms that mean

the same thing as public finance
 Public sector economics
 Public economics
 Although I may use the three terms
interchangeably to mean the same thing, I
will usually use the term “public finance”
What views do people have?

 Different people have different views about

public finance
 Organic view of government
 Mechanistic view of government
Organic view of government

 Government treats an entire society as a

natural organism
 Each individual is part of the organism
 The government is the heart
 Although individual goals differ, some goals
are naturally needed for the societal
organism
Mechanistic view of government

 Government is needed for individuals to

pursue their individual goals
 “Invisible hand” (Adam Smith)
 Efficient markets under certain sets of conditions
 Property rights and lack of violence needed to have
efficient markets
 How much government beyond this is
debatable
 Libertarian: Small government
 Social democrats: Larger government needed
What this class does

 Some analysis is done on a society-wide

scale
 Social costs and benefits
 Cost-benefit analysis on a nationwide scale
 Other topics talk about individual analysis
 Voting theory
 Individual reaction to taxes and credits on labor
Determining what is “good”

 What is “good” to one person may be viewed

as bad as others
 Let’s do an activity to illustrate this
 Everyone starts by standing up
 I will show a statement
 Stay standing if you agree with the statement
 Sit down if you disagree with the statement
 There is no “right” answer to any question
 Time to stand up
Statements 1-3

 I believe that reckless driving should be

stopped through government actions (such
as the use of police)
 I think that government should build and
maintain roads and highways
 I believe that each baby needs to be securely
buckled into a car seat while riding in a car, to
be enforced by the government
Statements 4-6

 I believe that each person in a moving car

needs a seat belt on, to be enforced by the
government
 I believe each driver needs liability insurance,
to be enforced by the government
 I believe the government has a right to
regulate when each person can use the
roads, and the route they take, in order to
control traffic patterns
Statements 7-9

 I believe that the government has a right to

prevent pilots of commercial aircraft from
using a cell phone while actively flying
 I believe that the government has a right to
prevent drivers of cars from using a cell
phone while driving
 I believe that the government should charge
a 90% tax rate on all income I earn in my
lifetime
Does everyone agree?

 No
 Different people have different opinions about
what the government should do
 Experts often disagree about what
government should do
 We will often assume that the experts in other
disciplines have gotten costs and benefits
right
Summary: Introduction to Public Finance

 Many topics studied in public finance

 Topics related to government intervention
 Tax-related topics
 Different viewpoints about government
 Organic view
 Society is an organism
 Mechanistic view
 Government used to reach individual goals
Some ground rules at the end of lecture

 I will always try to be done by 3:15 pm

 In return, I expect your attention until the final
slide
 If you must leave early:
 Please do so no later than 3:05 pm
 Sit near an exit
 Leave quickly and quietly

Example of final slide

Some ground rules at the end of lecture

 After many of the lectures

 Problem solving
 Your questions (especially near test time)
 Review of test questions
 You are welcome to leave after lecture is
finished
 Please do so quickly and quietly