Chapter 2

Introduction to Public Finance

Prepared and Taught by Lecturer: YIN SOKHENG, Master in Finance

Public Finance Defined

Public finance is about the taxing and spending activities of the government. Public Finance analyzes the implication of such income and expenditure activities on the allocation of resources and distribution of income as well as overall stability of the economy.

Instructed by YIN SOKHENG, Master in Finance

Public Finance: Subject Matters

Focus is on microeconomic functions of government polices that affect overall unemployment or price levels are left for macroeconomics. Public sector decisions impact private sector decisions in many ways both large and small.

Instructed by YIN SOKHENG, Master in Finance

The Role of Government

The govt. should be established to operate a police force and a court system to protect private property and make a free market possible.
Providing the economy with a legal structure Maintaining competition Redistribution of income Supplies public goods Promoting growth and stability

Instructed by YIN SOKHENG, Master in Finance

Why the free market usually works well for consumers The Free Market generates just the right quantity for consumers.
Productive efficiency: When producers minimize the cost of producing a product of a given quantity. Allocative efficiency: When producers allocate the optimal quantity of resources to the production of goods X versus goods Y.

Instructed by YIN SOKHENG, Master in Finance

Figure 2.1 Supply and Demand

P S (MC)

$12 $10 $8

D (MB) 90 100 110 Q

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Instructed by YIN SOKHENG, Master in Finance

Taxes, Subsidies, Regulation, and Inefficiency Any govt. intervention that changes the quantity causes an inefficiency (allocative inefficiency) a reduction in societys welfare. A tax imposed by the govt. causes a decrease in the quantity below the optimal quantity.
Figure 2.2 shows the effect of a $4 per unit tax levied on producers. Figure 2.3 shows the effect of a $4 per unit tax levied on consumers.

Instructed by YIN SOKHENG, Master in Finance

Figure 2.2 A Tax on Producers

P $14 $12 $10 T= $4 $8 T= $4 S S

D Q 90 100
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Figure 2.3 A Tax on Consumers

P S

$12 $10 $8 $6 D 90 100

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T= $4

T= $4

D Q

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Figure 2.4 Inefficiency from the Tax

P MC B $12 T= $4 D $8 A MB Q 90 100
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Instructed by YIN SOKHENG, Master in Finance

Figure 2.5 A Subsidy to Producers

P S S

$12 $10 $8 S= $4 $6 D 100

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S= $4

110

Q
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Figure 2.6 A Subsidy to Consumers

P $14 S= $4 $12 $10 $8 S= $4 D S

D Q 100
Instructed by YIN SOKHENG, Master in Finance

110
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Figure 2.7 Inefficiency from the Subsidy

P MC B $12 D $8 A MB Q 100
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S= $4

110
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Taxes and Government Spending

Surplus or Deficit Budgeting = Govt. taxes Govt. spending

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