introduction to public finance

LECTURER, ABD ELRAHMAN ALFAR
Faculty of Economics and Admin. Sciences
Department of Economics

Chapter 1
Introduction to Public Finance
Public Finance
Laurence S. Seidman

Chapter outlines:
The Role of Government in Making a Free Market
Why the Free Market Usually Works Well for Consumers
Taxes, Subsidies, Regulations, and Inefficiency
◦ Problems for the Free Market
◦ Externalities
Problems for the Government
◦ Political Economy
◦ Cost-Benefit Analysis
◦ Which Level of Government
◦ Borrowing Instead of Taxing

The role of government in making a free
market possible
If there is no government there is not free market
the government is necessary to protect producers and their property in order to create a
possibility for free markets.
Free market: consist of the voluntary interaction between producers and consumers
of goods and services

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.
•If there is one firm act in the market, this firm has a potential to achieve high profits because
there is no competition.
•Other firms will start to enter the market in order to achieve profits, the competition will start
and force the producers to decrease their prices or to increase the quality, in this case firms
maximize profits and customers

Definitions
Efficiency: the process of minimizing the producers cost for a given good by the time they allocate the
optimal quantity of resources to produce good X versus good Y
productive efficiency: minimizing the producers cost for a given good
allocative efficiency: allocates the optimal quantity of resources to the production of good X versus good
Y
the socially optimal quantity : the right quantity that produced by the free markets

Definitions
positive economics: an explanation of what happens without saying whether it is good or bad.
normative economics: which does try to say whether it is good or bad.
Marginal cost: is the additional cost you incur to produce one more unit.
Marginal benefit: the increase in satisfaction from consuming one additional unit of the good.
Free markets emphasize that the marginal cost paid by each producer equals the entire marginal cost to
society and the marginal benefit to each consumer equals the entire marginal benefit
to society.

Which is better to produce good X or 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
Free market efficiency
productive efficiency (Optimal cost)
allocative efficiency (optimal quantity)

Supply and Demand The market goes to
the intersection.

Income Distribution, Taxation, and
Efficiency
 Economists disagree about whether the distribution of income generated by the free market is
fair.
 Economists agree that the tax system can be used to modify the after-tax distribution of
income.
Economists also agree that such modification would cause some efficiency loss to the economy.
BUT, whether the resulting distribution of after-tax income would be fairer than the market
distribution.
So it is an outweigh between gain from fairness and loss in efficiency.

Income Distribution
The free market usually distributes higher income to people who have higher economic
productivity.
individuals have an incentive to obtain the education and training needed to raise their
productivity and to work hard on the job to increase their productivity.
Investors have an incentive to channel funds into productive ventures that pay high returns.
Inventors have an incentive to develop new products and processes that yield high profits and
hence high rewards.
In fact, Some people may exert extraordinary effort but still generate low productivity
 moreover, income received in a free market may reflect good or bad luck rather than simply
high or low productivity.

Taxation
Taxation
Progressive tax Proportional tax Regressive

Taxation (cont.)
Progressive tax applies a higher tax rate to high-income households.
Proportional tax applies the same tax rate to all households.
Regressive tax applies a higher tax rate to low-income households.
In progressive tax makes the ratio of after-tax incomes less than the ratio of before-tax incomes.
In proportional tax the after-tax income ratio is the same as the before-tax income ratio.

Is a progressive tax fairer than a
proportional tax?
If the main reason that high-income people earn more than low-income people is that they try
harder, then a progressive tax might seem unfair.
If the main reason is economic aptitude or luck, then a progressive tax might seem fair.

Efficiency
It should be recognized that there is an efficiency loss to the economy from a progressive tax
because it discourages efforts to earn more, and the greater the progressivity, the greater the
efficiency loss.
The higher the tax rate set on H and the lower the tax rate on L, the less would be the incentive
to educate and train yourself as an individual.
Thus, there is a trade-off: The more progressive the tax system, the greater its reduction in
inequality, but the greater its efficiency loss to the economy.

PROBLEMS FOR THE GOVERNMENT
When the free market works poorly, it is often the case that government intervention will work
better, but not always. Government sometimes performs poorly when in attempts to remedy
poor market performance.

Cost-Benefit Analysis
Cost-benefit analysis is the measuring of the costs of a project and the benefits of a project to
help decide whether to undertake the project and what the scale of the project should be.
cost-benefit analysis guide government decisions. It explains mistakes to be avoided when
doing cost-benefit analysis.

Which Level of Government?
When the free market works poorly and government intervention seems warranted, a question
arises: Which level of government should intervene?
 If all households have similar incomes; local government would often (though not always) be
preferable to a higher level of government .The reason is that numerous local governments
would compete to attract households by offering an attractive mix of public services and taxes.
But when incomes differ, as a consequence, a separation process develops whereby high-
income people locate in high-income communities and use zoning to exclude middle- and low-
income households.
To reduce this inequality, at least some of the financing must come from a higher level of
government—state or federal—which can collect more tax dollars from high-income than low-
income households and then distribute more dollars to low-income than high-income schools.

What kind of tax should a local
government use?
The federal government relies on income tax and payroll tax, state governments rely on sales tax
and income tax, but local governments rely on property tax.

Borrowing Instead of Taxing
By borrowing, a government can provide more programs that voters want without levying the
taxes they don’t want

introduction to public finance

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