1. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 1 of 28

2. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 2 of 28 Q0: Why Government in the First Place? A0: Creating Institutions and Defending Them. 1. 1  Nozick: The “Minimal State’’: “A minimal state, limited to the narrow functions of protection against force, theft, fraud, enforcement of contracts and so on.”  No trade without having property rights and enforcing them!

3. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 3 of 28 1. 1 “According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.” Adam Smith, The Wealth of Nations, Book IV, chapter IX

4. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 4 of 28 Example 1 – A Coordination Game 1. 1  Two ranchers (A raises sheep and B cattle).  Two grazing pastures (1 better than 2) ABAB Grazing on 1 Grazing on 2 Grazing on 1 3333 4848 Grazing on 2 8484 2222  Equilibrium:4or8 8484

5. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 5 of 28 Example 2 – A Prisoner’s Dilemma Game 1. 1 ABAB StealsDoes Not Steals M-C 0 2M-C Does Not 2M-C 0 MMMM  Equilibrium: (Nash + dominant strategy) M-C M-C A ``better’’ outcome:M M

6. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 6 of 28 Q1: When Should the Government Intervene in the Economy? 1. 1 Market failure 2: Monopoly Market failure 3: Asymmetric information

7. Chapter 1 Why Study Public Finance? © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 7 of 28 What Did We Learn? Public Economics is about the proper role of government in the economy, and the implications of its policies. Main role: Minimal State Reasons for government intervention in the economy: 1. Efficiency due to “market failures’’: (i) Monopoly, (ii) Externality, (iii) Asymmetric information. 2. Equity. How? (i) Taxes/Subsidies, (ii) Public Provision, (iii) Mandates and regulations. Other concepts: Pareto superior, unintended consequences, a prisoner’s dilemma game.