Public Economics

Chikako Yamauchi
Assistant Professor, GRIPS
Lecture 1
Some Basic Microeconomics
Rosen & Gayer, Textbook Appendix

Introduction to Public Economics

We use a microeconomic framework to
understand the role of the government in the
economy: the way that the government affects
the allocation of resources and the distribution of
income in the economy
Macroeconomic roles: how taxes, governmental
spending and monetary policies affect the overall level
of unemployment and price level -> Macroeconomics,
Finance
Regulatory roles: how regulations on market structure
affect firms profitability and consumers welfare ->
Industrial Organization

Introduction to Public Economics

We study (1) Government expenditures and (2)
Taxation
Should government collect taxes and arrange
public spending?
1. We work with the assumption that the free market
generally is able to produce the best economic results.
However, in some cases the market will not function
properly, which creates an opportunity for the
government to intervene and correct any problems.
2. For the government to act, it needs funding, and so
we will also study how government tax policy affects
the real allocation of resources and distribution of
incomes.

Some Basic Microeconomics:

Supply, Demand and Equilibrium

Supply and Demand

S & D demonstrates how a voluntary
market leads to desired outcomes
Provides us with a framework for thinking
about how the price and output of a
commodity are determined in a free and
competitive market

Demand
What factors affect the amount of goods people are willing
and able to consume in a given period of time?
1. price: increase P - decrease Q
2. income:
normal goods: increase income increase Q
inferior goods: increase income decrease Q
3. price of related goods
substitutes: coffee and tea
complements: coffee and cream
4. tastes: how much people like the good

Demand
Demand schedule:
Holding other factors
constant (income, price
of related goods, tastes)
it shows the relationship
between price and
quantity demanded.
A change in price causes
movement along the
demand curve
What if one of the other
factors changes?

Demand
If one of the other factors
changes, it causes a shift
in the demand curve.
For example, an increase
in the price of tea causes
people to consume more
coffee at each possible
price of coffee.
Remember: A change in
price does not shift the
curve

Supply
What factors affect the amount of goods people are willing
and able to produce in a given period of time?
1. price: increase P - increase Q
2. price of inputs: increased cost of production decrease
Q
3. conditions of production / state of technology: increased
tech. increase Q
Supply schedule: Holding other factors constant (price of
inputs, technology level) it shows the relationship
between price and quantity supplied.

Supply

Equilibrium
Price in which quantity supplied = quantity
demanded
What happens if there are extra supply (Qs >
Qd) or extra demand (Qd > Qs)?
What happens to the original equilibrium if
supply curve shifts towards left due to an
increase in the cost of production?

Equilibrium

Qs > Qd: downward pressure on

prices as firms are forced to compete
Qd > Qs: upward pressure on prices
as consumers are willing to pay a
higher price to get the limited good

Any factor that shifts

supply or demand will
lead to a new
equilibrium price and
quantity.

Elasticity
Demand and supply curves can be flat or steep
Elasticity measures the shape of supply and
demand curves
Price elasticity of demand: the absolute value of
the percent change in quantity demanded %Q
divided by the percentage change in price
% P

Horizontal demand curve: infinitely elastic, a

small change in P causes a huge change in Q.
Elastic demand: price affects quantity

Vertical demand curve: increase in price has no

change in Q
Inelastic demand: price doesnt affect Q, people are
willing to consume regardless of price

Some Basic Microeconomics:

Choice theory

Choice Theory
The fundamental problem in Economics is that resources
available to people are limited relative to their wants
Choice theory shows how people make sensible
decisions in the presence of scarcity
Assume that people derive satisfaction (utility) from
consuming commodities or goods and services
Assume more is always better
Assume people are never satiated: some utility is always
derived from more consumption
Lets consider 2 goods: marshmallows (M) and donuts
(D)

Choice Theory
b provides more utility
than a, while g
provides less utility.
Points in the white area
are unclear: more of
one good but less of the
other. Some points
provide more utility, and
othes provide less utility.
Each point has an
associated level of
utility

Choice Theory
Indifference curve shows all points producing
the same utility
Starting at (a), if I take one donut, how many
M are needed for the same utility?
Suppose 2 M are needed, then (i) is on same
curve
From (a), if I take one M, how
many D are needed? Suppose 2,
then (j).
U0 is an indifference curve
showing all the points with
the same level of utility.

Slope of Indifference Curve &

Diminishing Marginal Rate of substitution
Different points on the
indifference curve can be
flat or steep

MRS DM

M
D
Rate of trading one good for
another: how many M for 1 D?
Diminishing Marginal Rate of
Substitution: at (i), one has lots of M
and few D, so is willing to give up
more M for 1 D (big slope); but at (ii),
this person already has lots of D, so
not willing to give up as much M for
more D (small slope)

Indifference Map
The entire collection of
indifference curves
Shows everything about a
persons preferences
Moving upward and
rightward increases utility
Utility is maximized by
getting to the highest
possible indifference curve

Budget Constraint
Budget constraint shows rate at which
the market allows a person to substitute D
for M.
Suppose a persons income is 60, M
costs 3 each, and D costs 6 each.
Purchases must satisfy equation:
3M+6D <= 60
If D=0, M=20
If M=0, D=10
Slope=-20/10=-2
You can trade 2 M for 1 D

Budget Constraint
More generally:

P M M + PD D = I

If M is on vertical axis, then:

Y-intercept is I / PM
X-intercept is I / PD

y
PM PD
Slope

I
x
PM
PD

Falling Income
Decreasing income
causes a parallel shift
in the budget line
The slope is the same,
but different
intercepts

Changing Price
Causes the budget line to
pivot along the axis of the
good whose price
changes
Suppose PD increases
from 6 to 12
3M+12D=60
if M=0, then D=5
Now PD/PM=12/3=4
trade 4M for 1D

Some Basic Microeconomics:

Consumer equilibrium

Consumer Equilibrium
Indifference Curves: show what consumer
wants to do
Budget constraint: show what consumer is
able to do
Goal of consumer: maximize utility given
the budget constraint

Consumer Equilibrium
What point does consumer
choose to maximize utility
given budget constraint?
(i) consumer cant afford
it, though it has higher
utility

Consumer Equilibrium
What point does consumer
choose to maximize utility
given budget constraint?
(ii) consumer is not
spending all of the income.
We are not considering
savings, so resources are
wasted

Consumer Equilibrium
What point does consumer
choose to maximize utility
given budget constraint?
(iii) feasible point, but
consumer can do better by
going to a higher
indifference curve. At (iii),
willing to give up many D
for another M, and this can
be done at an affordable
price

Consumer Equilibrium
What point does consumer
choose to maximize utility
given budget constraint?
(E) best possible point,
highest utility possible with
given budget constraint
U1 is tangent to budget
constraint
How can we characterize
the condition at E?

Consumer Equilibrium
MRS DM

PD

PM

Marginal rate of substitution = price ratio

In equilibrium, the rate you are willing to
trade must equal the rate that you can
trade; otherwise, there would be an
opportunity to do better

Consumer Equilibrium After

Changing Prices
Suppose that marshmallows become cheaper
The new consumer equilibrium depends on each
consumers tastes, i.e., shape of indifference
curves
Some change

Big change

No change

Derivation of Demand Curve

We can use Choice Theory to find optimal
consumption level of M for different prices of M.
This in turn allows us to plot the demand curve.

Substitution and Income Effects

Suppose the price of donuts
increased
Increase in PD has 2 effects:
Makes D relatively less
attractive
Reduces real income
Increasing PD moves
equilibrium from E1 to E2
This change can be
decomposed into substitution
and income effects

Substitution and Income Effects

Hypothetical situation: suppose that

we are at E2, and PD goes back to
its original level. In order for us to
stay on the same indifference curve,
some of our income needs to be
taken away.

EC is hypothetical equilibrium
D1 to DC: income effect, decrease
D because of income decline
DC to D2: substitution effect
because of change in relative
prices while being compensated for
lower real income

Some Basic Microeconomics:

Consumer & Producer Surplus

Consumer and Producer Surplus

Consumer surplus: the area under the demand
curve and above the horizontal line at the
market price.
Producer surplus: amount of income individuals
receive in excess of what they would require to
supply a given number of units of a factor

Consumer Surplus
The demand curve
shows the maximum
amount that individuals
would be willing to pay
for the good
If the actual price is
lower than that, it
contributes to consumer
surplus
When the price
decreases, consumer
surplus increases

Producer Surplus
When we work, we want to be
paid at least a certain rate
(reservation wage), which
increases as we work longer
The wage exceeding our
reservation wage contributes
to producers surplus (note
that workers are the producer
of labor!)
When the wage rae
falls, it reduces
producer surplus