Introduction to Public Finance

The purpose of this introductory chapter is to give you the flavor of the material that
will follow in the rest of this book. Its aim is to whet your appetite, not satisfy it.
Don’t
be concerned when questions are raised but answers aren’t given or when terms are
used that are not fully explained. That’s the purpose of the rest of the book.
Let’s begin our tour of public finance economics with a basic question: Why do
we have a government? Why are there taxes and government spending? Why public
finance? Most courses in economics correctly teach that the free market usually does
a
good job in producing goods and services. Economists therefore find it useful to
begin
by asking the following questions:
Why not leave everything to “the market”?
Why have any taxes and government spending?

THE ROLE OF GOVERNMENT IN MAKING A FREE MARKET

POSSIBLE
In a state of nature with no government, there would be no free market. A free
market
consists of the voluntary interaction of producers and consumers of goods and
services.
Without a government, criminals would prey on productive people, stealing the
goods
they produce and the income they earn. Anticipating theft, potentially productive
people would stop producing. Almost everyone agrees that a government is necessary
to protect producers and their property and thereby to make a free market possible.
True, it is possible to imagine private vigilante groups trying to protect themselves
from
criminals. But most agree that it would be much more effective to establish a
government
to provide protection for everyone against criminals. Thus, there is little dispute
that a government should be established to operate a police force and a court system
to
protect private property and make a free market possible.
Of course, only a small limited government with low taxes would be needed to
protect property and make possible a free market. So the question becomes: Is it
necessary
or desirable for government to do more than protect people and their property
from criminals? To answer this question, we must first appreciate why the free
market
usually works well for consumers and also appreciate why it nevertheless has certain
particular problems that may provide a reason for further government intervention.

WHY THE FREE MARKET USUALLY WORKS WELL FOR

CONSUMERS
It is not hard to see why the free market usually works well for consumers. Producers
can profit only if they produce what consumers want and avoid producing what
consumers don’t want. Producers can profit by offering consumers higher quality at
the same price as the competition or the same quality at a lower price than the
competition.
Producers of the same quality product can retain customers and profit only if
they charge a price no higher than their competitors. The lower their cost, the lower
the
price they can afford to charge, so producers have an incentive to try to hold costs
down
by more efficient management and use of resources. If any producer is temporarily
able to set a price well above cost and to make a large profit because there is
currently
no competition, new firms will enter and compete, forcing the producer to lower the
price. Firms find it profitable to compensate workers more when they work hard and
efficiently, so individuals have an incentive to work hard and efficiently. Producers
can
profit by developing new products or better-quality products. Consumers benefit
from
these competitive pressures on producers and workers.
Economists go further and show that the free market will usually generate just the
right quantity—the socially optimal quantity—for consumers of each good or
service.
When economists say that the free market usually results in efficiency , they mean
that
the market not only pressures producers to minimize the cost of producing any
product
of a given quality—this is called productive efficiency —but also that it usually
allocates the optimal quantity of resources to the production of good X versus good
Y,
which is called allocative efficiency.
But what is the “right” quantity of good X for consumers? The production of each
unit
of good X uses resources (labor, materials, etc.) that could have been used to produce
other goods like good Y. If consumers value the next unit of good X more than its
cost,
then it is best for consumers if the next unit of X is produced. But if consumers value
the
next unit of good X less than its cost, then it is best for consumers if the next unit of
X
is not produced and the resources are allocated to make a different good, Y or Z.
Figure 1.1 shows the market supply-demand diagram for good X. The market price
is $10, and the quantity bought and sold is 100. The price is set in the competitive
market,
and given the price, each buyer decides the quantity he wants to demand, and each
seller decides the quantity he wants to supply; hence, buyers and sellers are price
takers.
At a price of $10, the buyers want to buy 100 (demand D is 100) and the suppliers
want to supply 100 (supply S is 100). If the price is initially $8, demand would
exceed
supply so that the price would get bid up to $10. If the price is initially $12, supply
would exceed demand and competition would drive the price down to $10.
Note that in the supply-demand diagrams in this book, supply and demand curves
are drawn as straight lines, but the term curve will generally be used because the
actual
relationship between price and quantity may be curved rather than straight.
Thus far our discussion of Figure 1.1 illustrates positive economics —an explanation
of what happens without saying whether it is good or bad. Now comes a key
question in normative economics, which does try to say whether it is good or bad:
In Figure 1.1 is 100—the quantity at the intersection of curves S and D —the right
quantity of good X for consumers? The answer is usually yes. To see why, we must
first
establish that the height of the supply curve is the marginal cost (MC) of producing
that
unit and the height of the demand curve is the marginal benefit (MB) to a consumer
of that unit.
Why is the height of the S curve the marginal cost (MC) —the cost of producing
the next unit? Producers find it profitable to increase production of X another unit as
long as the MC is less than the price P , and they find that it is profitable to stop
when
MC is about to rise above P . If the price is $8, the S curve says that producers would
supply 90—this means they would find it profitable to produce the 90 th unit but not
the 91 st . So it must be the case that the MC of the 90 th unit is slightly less than $8,
and
the MC of the 91 st unit is slightly greater than $8. We say that the MC of the 90 th
unit
is (approximately) $8—the height of the S curve.
Why is the height of the D curve the MB? Consumers buy another unit of X as long
as its marginal benefit (MB) — the maximum dollar amount they would be willing to
pay for it—exceeds its price P . If the price is $12, consumers would demand 90—
this means they would buy the 90 th unit but not the 91 st . So it must be the case that
the
MB of the 90 th unit is slightly greater than $12, and the MB of the 91 st unit is
slightly
less than $12. We say that the MB of the 90 th unit is (approximately) $12—the
height
of the D curve.
Now we can see why it would be best for consumers if more than 90 units of X were
produced. Consider the 91 st unit. The height of the supply curve is the marginal cost
(MC), so the MC of the 91 st unit is about $8. The height of the demand curve is the
marginal benefit (MB) to the consumer of that unit, so the MB of the 91 st unit is
about
$12. Since the consumer values the 91 st unit more than it costs, it should be
produced.
The same is true of each additional unit until the 100 th .
Symmetrically, it would be best for consumers if fewer than 110 units of X were
produced. Consider the 110 th unit. Its MC is about $12, and its MB is about $8.
Since
the consumer values the 110 th unit less than it costs, it should not be produced—it
would be better if the resources were used elsewhere to make other goods. The same
is
true of each unit until the 100 th .
Thus, 100 units of good X is just the right quantity for consumers. This is exactly
the quantity produced in a free market by competitive firms seeking profit. The
market
produces the quantity at the intersection of the D and S curves. The quantity that is
best for consumers is the quantity at the intersection of the MB and MC curves. Since
the height of the D curve equals MB and the height of the S curve equals MC, the
free
market produces the optimal quantity of good X.
Of course, not every market is perfectly competitive, but many markets are
competitive
enough so that Figure 1.1 conveys the basic reason why the free market usually
works well for consumers and tends to produce roughly the right quantity of most
goods
and services.
It should be emphasized that this analysis assumes that the marginal cost paid by
each producer equals the entire marginal cost to society—the marginal social cost
(MSC) —and the marginal benefit to each consumer equals the entire marginal
benefit
to society—the marginal social benefit (MSB) .

TAXES, SUBSIDIES, REGULATIONS, AND INEFFICIENCY

Whenever the free market generates just the right quantity for consumers, any
government
intervention that changes the quantity causes an inefficiency (“deadweight
loss ”)—a reduction in society’s welfare. Note that by “inefficiency” in this context
economists mean an allocative inefficiency: the government intervention causes too
many or too few resources to be allocated to the production of good X relative to
other
goods and services; if the free market produces the quantity of good X that is best for
consumers, then a government intervention that changes the quantity is not best for
consumers.
A tax imposed by the government causes a decrease in the quantity below the
optimal quantity. Figure 1.2 shows the effect of a $4 per unit tax levied on producers
.
Figure 1.3 shows the effect of a $4 per unit tax levied on consumers . Let’s explain
each.
In Figure 1.2, a tax of $4 per unit levied on producers increases their MC by $4
because the producer has to send $4 to the government for each unit sold. This shifts
up their supply curve $4 to S _, so the market moves to the intersection of S _ and D ,
decreasing the quantity from 100 to 90. Note that the consumer pays a price of $12 to
the producer who sends $4 to the government and keeps $8.
In Figure 1.3, a tax of $4 per unit levied on consumers decreases the price that
consumers are willing to pay producers by $4 because the consumer has to send $4 to
the government for each unit bought. This shifts down their demand curve $4 to D _,
so the market moves to the intersection of D _ and S , decreasing the quantity from
100
to 90. Note that the consumer pays a price of $8 to the producer and a tax of $4 to the
government.
Whether the $4 tax is levied on producers or consumers, it causes the same decrease
in quantity from 100 to 90 and therefore the same amount of inefficiency. The
magnitude
of the inefficiency from the $4 per unit tax (whether levied on producers or
consumers) equals the area of the triangle BAD in Figure 1.4 . Why? Starting at 90
units (the quantity under the tax), for each additional unit there would be a net gain to
society equal to the vertical distance MB-MC; no further net gains would be possible
once MB equals MC. Adding the vertical distances MB-MC, unit by unit, yields the
area of the triangle BAD . The tax prevents this net gain, BAD , from taking place, so
the area of the BAD triangle equals the inefficiency (deadweight loss) from the tax. In
this example, the inefficiency is $20 because the area of a triangle equals ½ (base _
height) _ ½ ($4 _ 10).
Note that if MB and MC were curves rather than straight lines, then BAD would
be a “triangle” with two sides curved rather than straight so that the formula for the
area, ½ (base _ height), would be an approximation. Throughout this book, we
simplify
by assuming that BAD is a triangle with three straight sides so that the formula
gives its exact area.
Symmetrically, a subsidy given by the government causes an increase in the quantity
above the optimal quantity. Figure 1.5 shows the effect of a $4 per unit subsidy given
to producers . Figure 1.6 shows the effect of a $4 per unit subsidy given to
consumers .
Let’s explain each in turn.
In Figure 1.5, a subsidy of $4 per unit given to producers decreases their MC by $4
because the producer receives $4 from the government for each unit sold. This shifts
down their supply curve $4 to S _, so the market moves to the intersection of S _ and
D,
increasing the quantity from 100 to 110. Note that the consumer pays a price of $8 to
the producer who also receives $4 from the government.
In Figure 1.6, a subsidy of $4 per unit given to consumers increases the price they are
willing to pay producers by $4 because the consumer receives $4 from the
government
for each unit bought. This shifts up their demand curve $4 to D _, so the market
moves
to the intersection of D _ and S , increasing the quantity from 100 to 110. Note that
the
consumer pays a price of $12 to the producer and receives a subsidy of $4 from the
government.
Whether the $4 subsidy is given to producers or consumers, it causes the same
increase in quantity from 100 to 110 and therefore the same amount of inefficiency.
The
magnitude of the inefficiency from the $4 per unit subsidy (whether given to
producers
or consumers) equals the area of the triangle BAD in Figure 1.7 . Why? Starting at
110
units (the quantity under the subsidy), for each unit less there would be a net gain to
society equal to the vertical distance MC-MB; no further net gains would be possible
once MC equals MB. Adding the vertical distances MC-MB, unit by unit, yields the
area of the triangle BAD . The subsidy prevents this net gain, BAD , from taking
place, so
the area of the BAD triangle equals the inefficiency from the subsidy. In this
example,
the inefficiency is $20 because ½ (base _ height) _ ½ ($4 _ 10).
Instead of the $4 tax, suppose the government imposed a regulation limiting the
quantity to 90. Then the inefficiency would be the same as under the $4 tax and
would
be equal to the area of the triangle BAD in Figure 1.4.
Instead of the $4 subsidy, suppose the government imposed a regulation requiring a
quantity of 110. Then the inefficiency would be the same as under the $4 subsidy and
would be equal to the area of the triangle BAD in Figure 1.7.
It is important to emphasize that a tax, subsidy, or regulation causes an inefficiency
whenever the free market would generate just the right quantity for consumers. The
free
market does this for most goods and services. However, it does not do it for all goods
and services. When it doesn’t, the proper tax, or subsidy, or regulation, would
increase, not decrease, consumer welfare. So whether a tax, subsidy, or regulation is
a villain or
hero depends on whether the free market would generate the optimal quantity of the
particular good or service.
It is also important to emphasize that even when the free market would generate the
optimal quantity, a tax on good X to raise revenue to finance a beneficial government
program might raise welfare. A tax on X would raise welfare as long as the benefit
from the government program financed by the tax is greater than the burden from the
tax including the inefficiency caused by the tax.