University of Maastricht

Faculty of Economics and Business Administration

ANSWER FORMAT TO EXAM QUESTIONS

COURSE Public Finance and Public Choice (IES/AE)

CODE 1316

EXAM DATE 3-4-1998

PROFESSOR Dr J.G.A. van Mierlo

Question 1:

Economists are fond of the concept of 'Pareto-efficiency'. It allows for deriving the two celebrated fundamental theorems of welfare economics, but it contains some problems.

1a. Define Pareto efficiency (in words and in a mathematical equation).

1b. What are the two celebrated fundamental theorems of welfare economics?

1c. Explain two fundamental problems with the concept of Pareto-efficiency.

Answer 1: Related to Task 1, Efficiency, Equity and Second Best

See the following quotation from the tutorial instruction:

Purpose: Reviving knowledge about Pareto-efficiency, equity and second-best.

Prior knowledge: Block 1.2.

Keywords: Pareto-efficiency, fundamental theorems of welfare economics, interpersonal comparison of utility, equity, social welfare function, second-best allocation

Problems: -What is the definition of Pareto efficiency?

-What is the contents of the two celebrated fundamental theorems of welfare economics and how can they be derived?

-How does Pareto efficiency avoid interpersonal comparison of utility?

-How can an interpersonal comparison of utility lead to an equitable allocation?

-What are the characteristics of a second-best allocation?

Analysis: See Cullis and Jones, Ch. 1; Rosen, Chapter 4.

1a.

Verbal definition of Pareto criterion; formal-mathematical definition of the over-all Pareto-condition; Edgeworth-box.

1b. The first fundamental theorem of welfare economics says that perfect competition guarantees Pareto-efficiency (C and J, p. 7; R, p. 46). The second fundamental theorem of welfare economics states that any Pareto-efficient allocation can be achieved as the result of a competitive equilibrium with a suitable redistribution of initial resource endowments (C and J, pp. 8-9; R, pp. 46-47).

1c.

Problem 1: interpersonal comparison of utilities not allowed;

Problem 2: for every income distribution, a Pareto-optimum can be found, hence judgement on distributive justice is impossible.

Question 2

The 'Coase theorem' states that externalities are irrelevant.

2a. Define externalities (in words and in a mathematical equation).

2b. What is the central line of argument in the Coase theorem?

2c. Explain why and how this theorem makes externalities irrelevant.

2d. Which other policy measures are available to solve the externality problem?

Answer 2: Related to Task 3, Internalizing external effects

2a.

Externalities are positive (benefits) or negative (costs) side-effects of production or consumption on production or consumption conditions which work outside the market and which hence are not included in the market prices. By consequence, the market prices do not reflect relative scarcities and the over-all Pareto-condition is not fulfilled. You should illustrate this with a graphical exposition OR with a mathematical formulation!

2b.

Negotiations between the individuals causing an externality and the individuals suffering from it, will result in an optimal quantity of output with a corresponding amount of externality. Note that it does not matter what the status quo is (are externalities present or not, are they allowed or not), who the initiative for the negotiation process takes (causers versus victims) and that the optimal outcome may be >0!

2c.

Give a very short summary of Cullis and Jones' treatment of the Coase argument (pp. 40-45) or of Rosen's explanation (pp. 105-106)!

2d.

Other policy measures to be presented and discussed are:

-Pigovian taxes/subsidies (changing prices);

-Physical regulations (setting quantities);

-Tradeable permits.

Question 3:

In recent years, a 'theory of government failure' has been developed.

3a. Give a description of the concept of government failure.

3b. Present a taxonomy (or classification) of government failure.

3c. Show the analogy between market failure and government failure and discuss the problems with this analogy.

Answer 3: Related to Task 7, Public production, to Task 18, Government failure, and to Lecture 2

3a.

Government failure implies, that due to structural characteristics of the public sector, Pareto-efficiency is not established. As a result, the over-all Pareto-condition is not realised and the highest possible Social Welfare Function (SWF), given the Production Possibility Frontier, is not reached.

In theory, the government and the public sector produces an efficient allocation of resources:

-Perfect match of demand and supply of public goods;

-Pareto optimality;

-Marginal Pareto conditions;

-Overall condition.

3b.

Taxonomy or classification of four categories of 'Government Failure':

-redundant and rising costs (X-inefficiency);

-'internalities': development of own internal standards and organisational goals;

-derived externalities of government intervention;

-unequal distribution of power positions and privileges.

Explain how the specific demand and supply characteristics in the public sector result in government failure! See Cullis and Jones, p. 370-371; Rosen, Chapter 7.

3c.

See Cullis and Jones, p. 372!

Question 4:

Taxation is said to induce 'efficiency losses' (consisting of excess burdens, welfare costs, etc.). The so-called Harberger-model attempts to analyse these efficiency losses in the framework of general equilibrium.

4a. Give a short presentation of the Harberger-model, using a general equilibrium analysis of a tax on the return to capital in the corporate sector.

4b. Present a short assessment of the pros and cons of the Harberger-model.

Answer 4: Related to Task 10, Efficiency and Equity; to Task 11, Tax Incidence

The central problems of this question can be addressed by conducting a partial or a general equilibrium analysis of taxation. An example of a graphical partial equilibrium analysis is shown in figures 7.1 (for an excise tax and a non compensated demand curve) and 7.2 (for an excise tax and a compensated demand curve) of Cullis and Jones.

4a. An example of a general equilibrium analysis in terms of an analysis of the resource allocation effects of taxes is provided in section 7.3 of Cullis and Jones (pp. 189-193). The specific general equilibrium analysis presented by Cullis and Jones in section 7-6-2 (pp. 202-210) should be summarised to answer question 4a. General equilibrium models and the Harberger-model can be found in Rosen, pp. 292-301.

4b. The pros of the Harberger-model are the same as of those of all general equilibrium models. The cons are connected with the strict assumptions underlying the Harberger-model, as discussed by Cullis and Jones on pp. 209-210 and by Rosen on pp. 298-299. Students must summarise either the one or the other assessment!

Question 5:

Income distribution is an eternal subject of public economics. However, normative principles for and positive accounts of redistribution should be separated.

5a. Present John Rawls' 'Theory of Justice' as an example of the normative approach.

5b. Present the 'negative income tax scheme' in the framework of a positive approach.

5c. Does a negative income tax fit into Rawls' 'Theory of Justice'?

Answer 5: Related to Task 13, Criteria for Optimal Income Distribution; to Task 14, Supporting the Poor

5a. The 'Rawlsian social welfare function' should be presented and discussed here. See Cullis and Jones, section 9-3-1, on 'Normative Principles of Redistribution', or Rosen, pp. 159-161. Rawls' Theory of Justice is presented by Cullis and Jones on pp. 241-243. You should be able to summarise his theory in words (two lexicographic principles) and present either a graphical analysis (Figure 9-4, p. 242) or the model in mathematical equations (pp. 241-243). Rosen discusses the matter rather briefly on pp. 159-161.

5b. Cullis and Jones discuss 'Negative Income Tax Type Schemes' in section 9-5-1 (pp. 255-257). You must be able to summarise their discussion and to present and comment on Figure 9-11 (p. 256)!

Rosen discusses NIT on pp. 181-184. You must be able to summarise his presentation and to present Figures 9.6 and 9.7!

5c. Explain how the NIT-scheme fits into Rawl's two principles of Justice!

Question 6:

Housing is a policy field with a long tradition of government intervention. Consider the market for social housing, i.e. houses not owned by individual house-owners but rented from so-called 'social housing institutions'.

6a. Analyse the reasons for government intervention in the social housing system by applying the theory of public goods (as discussed in the first part of the course).

6b. Does the theory of public goods in your opinion provide sufficient argumentation for government intervention in social housing? Apply also a public choice approach in answering this question 6b! A personal view will be welcomed!

Answer 6: Related to Task 4, Public goods, and Task 5, Public production

6a.

Reasons for government intervention are to be found in: positive externalities (housing investment increases via health promotion economic growth!), merit considerations (paternalistic government knows better that housing is good for you than you yourself do!) and distributive justice (equal access!).

6b.

Broadly speaking, socialists emphasise arguments of distributive justice and merit aspects, whereas liberals limit themselves to the externality argument. Hence socialists tend to go further with government intervention than liberals. However, the arguments themselves do not say anything about the specific instruments of intervention in housing: at the demand side (income transfers, price subsidies), or at the supply side (public ownership of housing institutions, price subsidies, quality standards, access regulations). The public choice approach points to the (narrow) self-interest argument as a sufficient or insufficient condition for public provision versus private provision!

6c.

Your personal opinion should be the result of a critical examination of all the arguments pro and contra public or private provision! Pay also attention to the specific instruments of government intervention in housing: information, pricing measures (at the demand or at the supply level?), quantity measures (physical regulation?), government ownership of housing institutions?

Question 7:

Business-cycles are a common phenomenon in market economies. Keynesian policies (fiscal and monetary policies) and functional finance are remedies to smoothen the business cycle (stabilisation branch of the public sector). However, in public choice theory a 'political business cycle' has been discovered.

7a. Explain the essentials of the political business cycle, as formulated in the so-called Nordhaus-model.

7b. Explain how according to public choice theorists Keynesian policies are the principal cause for the occurrence of a political business cycle.

7c. How can according to the same public choice theorists the political business cycle be coped with in representative democracy?

Answer 7: related to Task 15, Fiscal Aspects of Macro-Economic Theories

Students should be able to explain in words, with mathematics and with graphical analysis to different approaches. The keynesian real side approach elaborates on the well-known IS-LM model (Cullis and Jones, section 10-2), which also forms the basis for the monetary approach (section 10-3). The aggregate supply approach is presented in section 10-4. Subsequently, students must understand the essentials of table 10-1, macro-economic schools of thought.

7a. The role of political incentives is different in each school of macro economic thought. This is discussed in section 10-5 of Cullis and Jones. An example of a specific (public choice-)perspective on the role of political incentives in macro-economic policy-making is the political business cycle (section 10-6). Various explanations for the problem of labour unemployment, provided by different macro economic schools of thought, are presented in section 10-7. Students must be able to understand the structure of the various explanations and to explain the differences between these macro-economic schools of thought in this respect.

7b. Keynesian policies assume a two-sided flexibility of the budget: in times of economic prosperity a budget surplus in the public sector is necessary to balance overspending in the private sector; in times of economic decline a budget deficit in the public sector is necessary to balance underspending in the private sector. However, in a representative democracy vote maximising politicians cannot sell to their voters a budget surplus in a time of economic prosperity. Hence, there is only a one-sided flexibility of the budget, towards budget deficits. The inevitable result is not a anti-cyclical but a pro-cyclical fiscal policy.

7c. Budget restrictions, setting limits to discretionary behaviour of politicians, either by law or even by the Constitution, are appraised as policy measures by public choice theorists. See Cullis and Jones, Chapter 10; Rosen, pp. 146-149.

Question 8:

Cullis and Jones end their text book with a chapter on the 'traditional approach' to public finance and the 'public choice approach'.

8a. What are the main differences between both approaches?

8b. What does public choice-theory add to the economist's view on the role of economic policy advises and advisers in democratic processes of (economic) policy-making?

Answer 8: Related to Task 24, Traditional versus Public Choice Approach, and to Lecture 1

8a.

See:

-chapter 18 of Cullis and Jones;

-the introduction in the block book;

-and lecture 1!

8b.

Every personal opinion is okay, as long as you can present your arguments for that opinion and as long as you have considered the pro's and con's of every argument and of every alternative!