Chapter 1 Why Study Public Finance?
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
Q0: Why Government in the First Place?
A0: Creating Institutions and Defending Them.
 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!
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
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“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
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
Example 1 – A Coordination Game
 Two ranchers (A raises sheep and B cattle).
 Two grazing pastures (1 better than 2)
A
Grazing on
1
Grazing on
2
Grazing on
1
3
3
4
8
Grazing on
2
8
4
2
2
B
 Equilibrium: 4
8
or
8
4
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
Example 2 – A Prisoner’s Dilemma Game
A
Steals
Does Not
Steals
M-C
M-C
0
2M-C
Does Not
2M-C
0
M
M
B
 Equilibrium: (Nash + dominant strategy) M-C
M-C
A ``better’’ outcome:
M
M
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
Q1: When Should the Government Intervene in the
Economy?
Market failure 2: Monopoly
Market failure 3: Asymmetric information
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
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Chapter 1 Why Study Public Finance?
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
dilemma game.
© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e
prisoner’s
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