Lecture 1

Introduction

Expenditure
theory

GE Model

Pareto-optimal
Lecture 1: Introduction to Public Finance
conditions

IE conditions
Beat Hintermann

FS 2012, University of Basel

28 February 2013

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 Lecture 1

1 Introduction
Introduction
Course limits
Limits of the course
Credits
Fundamental
Credits
questions of PF
Course outline
Fundamental normative questions of public finance
Expenditure Course outline
theory

GE Model

Pareto-optimal
2 Government expenditure theory: Overview
conditions

IE conditions
3 Samuelson General Equilibrium Model

4 Pareto-optimal conditions

5 Inter-personal equity conditions

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 Lecture 1

Introduction
Introduction
Course limits
Credits
Fundamental
questions of PF
Course outline

Expenditure
theory
What is public finance?
GE Model

Pareto-optimal
conditions
• Synonyms: Public economics, public sector economics
IE conditions
• Study of government economic policy

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 Lecture 1

Limits of the course

Introduction
Course limits
Credits
Focus on:
Fundamental
questions of PF
Course outline
• Microeconomic theory of public sector
Expenditure • Normative perspective
theory
• positive theory where necessary
GE Model

Pareto-optimal • Fiscal federalism

conditions

IE conditions
Exclude:
• Macroeconomic theory ("fiscal policy")
• Financial market regulation
• Public choice
• Cost-benefit analysis

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 Lecture 1

Credits for this course

Introduction
Course limits
Credits
Fundamental
questions of PF
Course outline

Expenditure • 6 KP
theory

GE Model
• 4 Discussion sections
Pareto-optimal • 2 Homework sets (15 % each)
conditions
• Homework 1: expenditure theory (due April 4)
IE conditions
• Homework 2: tax theory and capital tax competition
(due May 27)
• Written final exam (70 %), May 30

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 Lecture 1

Fundamental normative
questions of public finance
Introduction
Course limits
Credits
Fundamental
questions of PF
Course outline

Expenditure
theory

GE Model
1 Legitimacy and goals of government economic activity
Pareto-optimal
conditions 2 Decision rules
IE conditions
3 Financing of expenditures
4 Government hierarchy and sorting of population

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 Lecture 1

1.) Legitimacy and goals

Introduction • In what economic activity should gov. be involved?
Course limits
Credits
Fundamental
• What are goals of public policy?
questions of PF
Course outline

Expenditure
theory
Government activity
GE Model

Pareto-optimal
⇒ Starting point: Markets take precedence for solving
conditions economic problems and allocating resources
IE conditions
⇒ Government activity legitimized by market failure

Goals
⇒ Primary goal: Maximize social welfare
⇒ Proximate goals:
• Efficiency
• Equity (process, horizontal and vertical equity)

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2.) Decision rules

Introduction
Course limits
Credits
• How should government become involved?
Fundamental
questions of PF (public choice: How does gov. become involved?)
Course outline

Expenditure
• What is the optimal level of involvement?
theory

GE Model

Pareto-optimal
conditions Government-as-agent
IE conditions • Limitation for political theory of government
• Useful for
a Providing benchmark
b Understanding efficiency-equity trade-offs
c Analyzing market failures

Legitimacy and decision rules: Expenditure theory

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3.) Financing of expenditures

Theory of taxation
Introduction
Course limits
Credits
Fundamental
questions of PF • How should government finance expenditures?
Course outline

Expenditure
• Taxation theory becomes relevant if
theory
A expenditure theory defines need for government
GE Model
intervention
Pareto-optimal
conditions
B does not specify how expenditures are to be financed
IE conditions • Same principal goals as public expenditure theory
• Allocational theory of taxation: Efficiency
design taxes that minimize distortions for given amount
of required revenue (optimal taxation)
• Second goal of taxation: Equity
Efficiency-equity tradeoff
Tax incidence

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4.) Gov. hierarchy and sorting

"Fiscal federalism"
Introduction
Course limits
Credits
Fundamental
questions of PF
Course outline

Expenditure • Taking 1.)-3.) as given: Which tasks should each level

theory
of government perform?
GE Model

Pareto-optimal
• Optimal sorting of consumers / voters / firms across
conditions
jurisdictions
IE conditions
Positive analysis:
• How do people sort? (income, tastes etc.)
• What are the welfare losses/gains relative to a
centralized government?

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 Lecture 1

Course outline
Introduction
Course limits
Credits Check syllabus, incl. reading list!
Fundamental
questions of PF
Course outline
1 Expenditure theory under first-best
Expenditure
theory • Lectures 1-4
GE Model • SWF, externalities, decreasing cost production
Pareto-optimal
conditions
2 Theory of taxation
IE conditions • Lectures 5-8
• Commodity and income taxation, corrective taxation
under second-best
3 Fiscal federalism
• Lectures 9-11
• Capital, property and income tax competition;
environmental federalism

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 Lecture 1

Introduction
1 Introduction
Expenditure
theory
Market failure 2 Government expenditure theory: Overview
Welfare theorems
Market failure
GE Model

Pareto-optimal
The fundamental theorems of welfare economics
conditions

IE conditions
3 Samuelson General Equilibrium Model

4 Pareto-optimal conditions

5 Inter-personal equity conditions

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 Lecture 1

Market Failure
Introduction

Expenditure
theory
Market failure
Welfare theorems

GE Model
• If a set of assumptions hold, competitive markets
Pareto-optimal
conditions generate efficient allocation of resources
IE conditions • If assumptions are violated: Market failure
⇒ Government intervention to fix problem
⇒ Market failure vs. government failure
• Inequality can be interpreted as market failure

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Market assumptions
"perfect competition"
Introduction

Expenditure
theory
Market failure
Welfare theorems

GE Model

Pareto-optimal
conditions a Large number of buyers and sellers in each market
IE conditions
b No product differentiation within each market
c Everybody has complete information
d No barriers to entry or exit

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Technical assumptions
Preferences and prod. activities "well behaved"
Introduction

Expenditure
theory
Market failure
1 Non-Satiation
Welfare theorems
i no consumer is satiated
GE Model
ii some consumer is not satiated
Pareto-optimal
conditions 2 Preferences are convex
IE conditions
3 Preferences are continuous
4 Consumption possibilities set is convex
5 Individual utility is a function of own consumption and
factor supplies
6 An individual firm’s production possibilities depend only
upon its own inputs and outputs
7 Aggregate production possibilities are convex

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Fundamental Theorems of
Welfare Economics
Introduction

Expenditure
theory
Market failure First Fundamental Theorem of Welfare Economics
Welfare theorems

GE Model
If assumptions 1i, 2, 4, 5 and 6 hold, then a competitive
Pareto-optimal
conditions equilibrium is a Pareto optimum
IE conditions

Second Fundamental Theorem of Welfare Economics

If assumptions 1ii, 2, 3, 4, 5, 6 and 7 hold, then any Pareto

optimum can be achieved by a competitive equilibrium with
the appropriate distribution of income

(Proof: G. Debreu, 1959)

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Utility-possibilities frontier
Introduction

Expenditure
theory
U2
Market failure A
Welfare theorems •
GE Model

Pareto-optimal C E
conditions
• •
IE conditions

D
•

•B
U1
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Utility-possibilities frontier
Introduction

Expenditure
theory
U2
Market failure A
Welfare theorems •
GE Model

Pareto-optimal C E
conditions
• •
IE conditions

D • F
•

•B
U1
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Relevance of Welfare Theorems

Introduction

Expenditure
theory • If either of the welfare theorems hold, government has
Market failure
Welfare theorems no role in allocation of resources (efficiency)
GE Model • Does not apply to distribution
Pareto-optimal
conditions • Departure from pure principle of consumer sovereignty
IE conditions • Social welfare function (SWF) needed
• If market and/or technical assumptions do not hold:
• market failure, possible government intervention
• More recently: Distinction less clear due to private
information
• Freeriding, moral hazard, adverse selection
• Problem with government-as-agent model
• Justification for fiscal federalism

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 Lecture 1

1 Introduction
Introduction

Expenditure
theory 2 Government expenditure theory: Overview
GE Model
Ingredients
Problem setup
FONCs 3 Samuelson General Equilibrium Model
Pareto-optimal Model ingredients
conditions

IE conditions
Problem setup
FONCs

4 Pareto-optimal conditions

5 Inter-personal equity conditions

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Model for gov. economic policy

Necessary characteristics
Introduction

Expenditure
theory

GE Model
Ingredients
Problem setup
FONCs
• General equilibrium (GE) model
Pareto-optimal • GE effects crucial for public policy
conditions
• Must capture broad range of problems
IE conditions
• Externalities, decreasing cost production, private
information etc.
• Tradeoff btw. equity and efficiency
• Must be comparable to market economy

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General equilibrium modeling

Introduction
Base ingredients
Expenditure
theory • Consumer preferences
GE Model
Ingredients • Technology
Problem setup
FONCs • Market clearance
Pareto-optimal
conditions • Equity: Social welfare function
IE conditions

Types of GE models
Quantities Social planner chooses quantities; prices
adjust.
Prices Market economy. Assumptions about market
behavior / structure and behavior of
government; quantities adjust.

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Base model
Introduction

Expenditure
theory

GE Model
Ingredients
Problem setup
FONCs
• Start with quantities model by Samuelson
Pareto-optimal
conditions
• Assume that market and technical assumptions
IE conditions
satisfied
• Relate solution to market economy

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Individual preferences
Introduction
H individuals or households
Expenditure
theory G goods and services
GE Model
Ingredients F factors
Problem setup
FONCs

Pareto-optimal Xhg := consumption of good g by person h h=1,...,H

conditions

IE conditions
g=1,...,G

Vhf := supply of factor f by person h h=1,...,H

f=1,...,F

U h := U h (Xh1 , ..., XhG ; Vh1 , ..., VhF )

or simply
U h = U h (Xhg ; Vhf )

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Production technologies
Introduction

Expenditure
theory

GE Model rgf := factor f used in production of good g g=1,...,G

Ingredients
Problem setup f=1,...,F
FONCs

Pareto-optimal
conditions X g := aggregate amount of g produced g=1,...,G
IE conditions

X g = φg (rg1 , ..., rgF )

or
X g = φg (rgf ) g = 1, ..., G

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Market clearance
Introduction

Expenditure
theory Goods markets:
GE Model
Ingredients H
X
Xhg = X g
Problem setup
FONCs g = 1, ..., G
Pareto-optimal h=1
conditions

IE conditions

Factor markets:
H
X G
X
Vhf = rgf f = 1, ..., F
h=1 g=1

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Social welfare function

Introduction

Expenditure
theory

GE Model
Ingredients
Individualistic Samuelson-Bergson SWF:
Problem setup
FONCs

Pareto-optimal
conditions
W = W U 1 (X1g ; V1f ), ..., U H (XHg ; VHf )
 
IE conditions

or
W = W U h (Xhg ; Vhf )
 

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Maximizing social welfare

Introduction

Expenditure
theory

GE Model
Ingredients
Problem setup
FONCs
• Maximize efficiency: "Size of pie"
Pareto-optimal
conditions
• Equity: Optimize distribution according to SW function
IE conditions
• First-best environment: Efficiency and equity conditions
independent

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Social planner’s optimization

problem
Introduction

Expenditure
theory

GE Model
Ingredients

W U h (Xhg ; Vhf )
 
Problem setup
FONCs
maxg
Xhg ;Vhf ;X ;rgf
Pareto-optimal
conditions

IE conditions
s.t. φg (rgf ) ≥ X g g = 1, ..., G
H
X
Xg ≥ Xhg g = 1, ..., G
h=1
H
X G
X
Vhf ≥ rgf f = 1, ..., F
h=1 g=1

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 Lecture 1

Lagrangian
Introduction

Expenditure
theory

L =W U h (Xhg ; Vhf )
 
GE Model
Ingredients
maxg
Problem setup
Xhg ;Vhf ;X ;rgf
FONCs
G
Pareto-optimal
X
µg φg (rgf ) − X g
 
conditions +
IE conditions g=1
G
X  H
X 
+ δg X g − Xhg
g=1 h=1
F
X H
X G
X 
+ πf Vhf − rgf
f =1 h=1 g=1

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First-order necessary conditions

Choice variables
Introduction

Expenditure
theory
∂L ∂W ∂U h
GE Model = − δg = 0 h = 1, ..., H
Ingredients ∂Xhg ∂U h ∂Xhg
Problem setup
FONCs
g = 1, ..., G
Pareto-optimal
conditions ∂L ∂W ∂U h
= + πf = 0 h = 1, ..., H
IE conditions
∂Vhf ∂U h ∂Vhf
f = 1, ..., F
∂L
= δ g − µg = 0 g = 1, ..., G
∂X g

∂L ∂φg
= µg − πf = 0 g = 1, ..., G
∂rgf ∂rgf
f = 1, ..., F
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First-order necessary conditions

Shadow prices
Introduction

Expenditure
theory

GE Model
Ingredients ∂L
: φg (rgf ) − X g · µg = 0


Problem setup g = 1, ..., G
FONCs ∂µg
Pareto-optimal
conditions

IE conditions  H 
∂L g
X
: X − Xhg · δg = 0 g = 1, ..., G
∂δg
h=1

H
X G 
∂L X
: Vhf − rgf · πf = 0 f = 1, ..., F
∂πf
h=1 g=1

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 Lecture 1

Balance of FONCs and

variables
Introduction

Expenditure
theory

GE Model
Ingredients
Problem setup
FONCs HG+HF+GF+3G+F equations and variables
Pareto-optimal
conditions

IE conditions
of which

2G+F shadow prices

HG+HF+GF+G economic variables

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 Lecture 1

Efficiency-equity dichotomy
Introduction

Expenditure
theory

GE Model
Ingredients
Problem setup Equations for economic variables can be combined into
FONCs

Pareto-optimal
conditions
• Pareto-optimal (PO) conditions
IE conditions
• Interpersonal equity (IE) conditions

First-best: PO conditions contain no welfare terms!

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 Lecture 1

Pareto-optimal conditions
Pairing of FONCs
Introduction

Expenditure
theory

GE Model
Optimal consumption
Pareto-optimal
conditions P1 Any two goods demanded by same person
MRS
MRTS
MRS=MRT
P2 Any two factors supplied by same person
Market economy
P3 Any good demanded and any factor supplied by same
IE conditions
person

Optimal production
P4 Any one factor used in production of any two goods
P5 Any two factors used in the production of same good

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Pareto-optimal conditions
Pairing of FONCs (cont.)
Introduction

Expenditure
theory

GE Model
Optimal relationship between consumption and
Pareto-optimal production
conditions
MRS P6 Rate at which any one person is willing to trade two
MRTS
MRS=MRT goods (P1) combined with their efficient rate of
Market economy
exchange in production (P4)
IE conditions
P7 Rate at which any one person is willing to substitute any
two factors (P2) with their efficient rate of exchange in
production (P5)
P8 Rate at which any one person is willing to substitute any
one good for any one factor (P3) with their efficient rate
of exchange in production (P4)

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Interpersonal equity conditions

Pairing of FONCs
Introduction

Expenditure
theory

GE Model

Pareto-optimal
conditions
MRS
MRTS
MRS=MRT
Market economy E1 Any one good demanded by two different people
IE conditions
E2 Any one factor supplied by two different people

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Pareto-optimal conditions
Introduction

Expenditure
theory

GE Model

Pareto-optimal If factor supply is fixed:

conditions
MRS
MRTS
MRS=MRT
Market economy
• Factors are not choice variables
IE conditions • Conditions P1, P5 and P6 (incl. P4) sufficient
• Derivation in discussion section
• Next: Review and interpret these conditions

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 Lecture 1

P1: Marginal rate of substitution

"Bottom-up efficiency"
Introduction

Expenditure
theory
∂U h
dg ∗
 
GE Model ∂Xhg δg
∂U h
= MRSg,g ∗ = =−
Pareto-optimal
conditions
δg ∗ dg
∂Xhg ∗
MRS
MRTS
MRS=MRT

any g, g ∗ = 1, ..., G
Market economy

IE conditions
all h = 1, ..., H

Interpretation:
• Nr. of units of g ∗ consumer h is willing to give up to
obtain an additional unit of g, or vice versa.
• g ∗ : Numeraire good
• (negative of) slope of indifference curve
• MRS between two goods the same for all consumers
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 Lecture 1

Edgeworth-Bowley Box
Ih : Indifference curve of person h
Introduction
X1g*
Expenditure Person 2
theory

GE Model X2g
Pareto-optimal
conditions
MRS
MRTS
I22 •D I21
MRS=MRT
Market economy
C
IE conditions
•
I23
B I13
•
•
A
I12

I11

X1g
Person 1 X2g*
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 Lecture 1

Mapping to UPF
X1g*
Person 2
Introduction X2g
Expenditure
theory I22 •D I21
GE Model C
•
I23
Pareto-optimal B I13
•
conditions •
A
MRS
I12
MRTS I11
MRS=MRT
Market economy
X1g
IE conditions Person 1 X2g*

U2 A
•
•B

•C

Utility possibilities
frontier (UPF)

U1
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 Lecture 1

P5: Marginal rate of technical

substitution (MRTS)
Introduction
"Top-down efficiency"
Expenditure
theory

GE Model
∂φg
drgf ∗
 
Pareto-optimal ∂rgf πf MPf (g)
conditions
∂φg
= MRTSf ,f ∗ = = =−
MRS πf ∗ MPf ∗ (g) drgf
MRTS ∂rgf ∗
MRS=MRT
Market economy

IE conditions
all g = 1, ..., G; any f , f ∗ = 1, ..., F

Interpretation:
• Nr. of units of rgf ∗ needed to replace one unit of rgf in
the production of g
• ratio of marginal products (MP) of f and f ∗ for g
• (negative of) slope of iso-production curve
• MRTS between two factors the same for all goods
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 Lecture 1

Mapping to PPF
Lg
Xg*
Introduction Kg*

Expenditure
theory qg*2 qg*1
•D
GE Model C
qg*3 •
Pareto-optimal B qg3
•
conditions •
A
MRS
qg2
MRTS qg1
MRS=MRT
Market economy
Kg
IE conditions Xg
Lg*

Xg* A
•
•B

•C

Production possibilities
frontier (PPF)

Xg
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 Lecture 1

P4: Marginal rate of

transformation (MRT)
Introduction

Expenditure
theory
∗
GE Model ∂φg
MPf (g ∗ ) drg ∗ f
 
∂rg ∗ f µg
Pareto-optimal
∂φg
= = MRTg ∗ ,g = =−
conditions µg ∗ MPf (g) drgf
MRS ∂rgf
MRTS
MRS=MRT
Market economy

IE conditions all f = 1, ..., F ; any g, g ∗ = 1, ..., G

Interpretation:
• Nr. of units of g ∗ that can be produced if one less unit
of g is produced by reallocating factor f
• ratio of marginal products for f in g and g ∗
• (negative of) slope of PPF
• MRT between two goods the same for all factors
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 Lecture 1

P6: MRS=MRT
"Overall efficiency"
Introduction

Expenditure
theory

GE Model ∗
∂φg
Pareto-optimal
conditions ∂rg ∗ f µg δg
MRS
MRTg ∗ ,g = ∂φg
= = =MRSg ∗ ,g
MRTS µg ∗ δg ∗
MRS=MRT
∂rgf
Market economy

IE conditions
all f = 1, ..., F
∗
any g, g = 1, ..., G

Interpretation:
• Rate of exchange in production between two goods has
to equal rate of exchange in consumption
• "Correct" production mix

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 Lecture 1

MRT=MRS
Introduction

Expenditure
Xg*
theory

GE Model

Pareto-optimal
conditions
MRS
MRTS
MRS=MRT A
• Person 2
Market economy

IE conditions

A‘ MRTg*,g
X1g*

MRSg*,g

Xg
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 Lecture 1

Correspondence to competitive
market economy
Introduction

Expenditure
theory

GE Model P1: MRS equalized across consumers

Pareto-optimal
conditions Utility-maximizing, price taking consumers equalize MRS to
MRS
MRTS price ratio
MRS=MRT
Market economy

IE conditions X X
max U h (Xhg , Vhf ) s.t. pg Xhg ≤ wf Vhf
Xhg ,Vhf
G F

∂U h
∂Xhg pg
∂U h
≡ MRSg ∗ ,g =
pg ∗
∂Xhg ∗

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 Lecture 1

Introduction
P5: MRTS equalized across firms
Expenditure
theory
Cost-minimizing, price taking firms equalize MRTS to input
GE Model
price ratio
Pareto-optimal
conditions
MRS
MRTS X
MRS=MRT
min wf rgf s.t. φg (rgf ) ≥ X g
Market economy
rgf
IE conditions F

∂φg
∂rgf wf
∂φg
≡ MRTSf ,f ∗ =
wf ∗
∂rgf ∗

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P6: MRS=MRT
Introduction

Expenditure
theory
Price taking firms equalize marginal costs to output price
GE Model

Pareto-optimal pg MC(g)
conditions ∗ =
MRS p g MC(g ∗ )
MRTS
MRS=MRT
Market economy

IE conditions
1 Consumers equate MRS to price ratio
2 Efficient production: Ratio of MC equals MRT

pg MC(g)
MRSg ∗ ,g = = = MRTg ∗ ,g
pg ∗ MC(g ∗ )

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Competitive market economy

and social welfare
Introduction

Expenditure
theory

GE Model

Pareto-optimal
conditions
MRS • Perfectly competitive markets generate full set of PO
MRTS
MRS=MRT conditions (P1-P8)
Market economy

IE conditions • But: They do not generate IE conditions

• Equilibrium from free market is somewhere on
utility-possibilities frontier
• To reach "Bliss Point", need social welfare function

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 Lecture 1

E1: Demand of same good by

two people
Introduction

Expenditure
theory

GE Model

Pareto-optimal
conditions

IE conditions
∗
∂W ∂U h ∂W ∂U h
=
∂U h ∂Xhg ∂U h∗ ∂Xh∗ g

all g = 1, ..., G; any h, h∗ = 1, ..., H

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 Lecture 1

How many goods to

redistribute?
Introduction

Expenditure
theory

GE Model

Pareto-optimal
conditions

IE conditions

• G+F interpersonal equity conditions

• Not independent
• If one holds, all of them hold!

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 Lecture 1

Suppose E1 holds for good g:

Introduction ∗
∂W ∂U h ∂W ∂U h
Expenditure =
theory ∂U h ∂Xhg ∂U h∗ ∂Xh∗ g
GE Model

Pareto-optimal
conditions

IE conditions Restore welfare terms in P1:

∗
∂W ∂U h ∂W ∂U h
∂Uh ∂Xhg ∂Uh∗ ∂Xh∗ g ∗
MRSgh∗ ,g = = = MRSgh∗ ,g
∂W ∂U h ∂W ∂U h∗
∂Uh ∂Xhg ∗ ∂Uh∗ ∂Xh∗ g ∗

• Numerators equal from E1 → denominators equal too!

• Only holds if P1-P8 apply (no distortions)

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 Lecture 1

How to achieve E1
Introduction

Expenditure
theory

GE Model

Pareto-optimal Lump-sum redistribution of one good

conditions

IE conditions • Pareto-optimal conditions not affected

• Moves equilibrium along utility-possibilities frontier to
social optimum
• Demand, supply, prices, MRTs, MRTS’s, MRS’s
change, in general

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