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1

First Welfare Theorem

and the underlying assumptions

Under certain assumptions, competitive equilibrium is Pareto efficient 

Assumptions: 

  1. No market power (agents are price taker) 
  2. Complete Markets (no transaction cost &symmetric information)
  3. No externalities 

2

Competitive Equilibrium

  • Individuals maximize utility
  • Firms maximize profits 
  • Equilibrium prices clear markets 

3

Pareto Efficiency

A state where on individual cannot be made better off without making anyone WORSE off by reallocating resources 

4

Defintion of Public Finance

  • Normative and positive analysis of public expenditures and revenues 
  • But restriction on expenditures and revenues are sometimes artifical 

 

Broad definiton: 

  • Economic analysis of goverments 

5

Musgraves three brances of GOVERNMENT

1. ALLOCATION: correctin market failures 

  • dealing with externalities, public goods, market power, information asysmmetries

2. DISTRIBUTION: correcting efficient but perceived unjust distribution 

  • Redistributive taxation, equal opportunities

3. STABILIZATION: avoiding econmoic fluctuations 

  • Installing built-in stabilzers, discretionary stimuli 

6

The CLASSICAL public finance view

  • PF econmists as advisers of benevolent goverments 
  • PF as NORMATIVE ECONOMICS 

7

How to measure the size of governments

1. Public Expenditre Quota:

= Total Gov. Expenditure / GDP 

 

2. Public Revenues Quota: 

= Total revenues/GDP 

 

etc. 

8

The Benevolent view of the growing Gov. sector

WAGNER's LAW: (or the law of growing state expenditur) 

  • assumes that the growth of state expenditures and government quotas is not merely proportional, but disporportional to the GNP
  • Econmic development requires more and more goverment services 

9

Public Choice View: 

  • “Leviathan” governments grow at the expense of taxpayers

  • Leviathan = Allmacht des Staates!

10

Baumol's cost dieses View 

  • The public sector cannot substitute capital for labor (e.g. nurses)
  • The Wage increase in the private sector feed through into cost increase in the public sector 
  • Maintaining a constant level of public sector output must therefore result in public sector expenditure increasing