Public Finance (MPA405)

Dr. Khurrum S. Mughal

Lecture 31: Revision

Revision

Introduction

Public Finance

4

What Is Public Finance?

• Public Finance, field of economics concerned with how governments raise money, how that money is spent, and the effects of these activities on the economy and on society

• Also known as “public sector economics” or “public economics.”

5

Government—What is it good for?

• Set common rules of behavior

• Protect citizens from external threats

• Pool resources for the common good• Intervene in the system since Individuals may

be unable to evaluate utility of certain products– Elementary Education for children

6

Government—What is it good for?

• Address and correct market failures– To provide the institutions that allow market to function

(e.g. protection of property rights)

– To provide the essential goods and services that markets

fail to adequately provide

– Regulating the behavior business entities

• Monopoly Control Authorities

7

The Activities of Government

• Government is comprised of thousands of government units

• Three levels: • Federal• Provincial• Local

• Each level allocates different levels and types of resources

8

Why Public Finance Is Needed?

• Taxation• Protection to Infant Industries• Providing Employment Opportunities• Economic Planning• Equality• Economic Stability• Optimum Utilization of Resources• Savings and Investments• Subsidies and Grants• Provision of Public Goods

9

Major Fiscal Functions

• Allocation Function

• Distribution Function

• Stabilization Function

10

Major Fiscal Functions

• Allocation Function

– Allocation of total resources between private goods and

social goods

– Choosing the mix of social goods

– Taxation and spending as major instruments

– Importance of non-fiscal regulatory instruments

11

Major Fiscal Functions

• Distribution Function

– Distribution of income and wealth between various classes

– Taxes and subsidies as major tools

– Under Allocation function, taxes are used to distribute

resources between private and public wants

• Stabilization Function

– Influencing the unemployment, price level and output

– To tone down the effects of economic cycles

Efficiency:Criterion and Government

Public Finance

13

Positive and Normative Economics

• Positive Economics explains “what is” without making judgments about the appropriateness of “what is.”

• Normative Economics: designed to formulate recommendations on what should be.

14

Normative Evaluation of Resource Use: The Efficiency Criterion

• Pareto Optimality• The efficiency criterion is satisfied

when resources are used over any given period of time in such a way as to make it impossible to increase the well-being of any one person without reducing the well-being of any other person.

Efficiency, Markets and Government

Public Finance

16

Marginal Conditions for Efficiency

• Total Social Benefit • Total Social Cost • Net Benefit = TSB – TSC • Maximum Net Benefit occurs where MSB

= MSC

17

Conditions under which the Market is Pareto Optimal

• All productive resources are privately owned.• All transactions take place in markets and in each

separate market many competing sellers offer a standardized product to many competing buyers.

• Economic Power is dispersed in the sense that no buyers or sellers alone can influence prices.

• All relevant information is freely available to buyers and sellers.

• Resources are mobile and may be freely employed in any enterprise.

18

If These Conditions are Met

P = MPB = MSB

P = MPC = MSC

P = MSB = MSC

and

so

19

When Does the Market Interaction Fail to Achieve Efficiency?

• Monopoly

• Taxes

• Subsidies

20

Market Failure: A Preview of the Basis for Government Activity

Government intervention may be warranted if there is:

• Monopoly power. • Effects of market transactions on third parties.• Lack of a market for a good where MSB>MSC

(i.e. a public good).• Incomplete information about goods being sold.• An unstable market.

Externalities and Public Policy

Public Finance

22

I- Externalities

• Externalities are costs or benefits of market transactions not reflected in prices.– Negative externalities are costs to third

parties.– Positive externalities are benefits to third

parties .

23

II- Externalities and Efficiency

• The marginal external cost is the dollar value of the cost to third parties from the production or consumption of an additional unit of a good. This occurs when there is a negative externality.

24

Social Costs

MSC = MPC + MEC

25

Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency

D = MSB

S = MPC

MPC + MEC = MSC

10

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Tons of Paper Per Year (Millions)

110

105

100

4.5 5

A

B

G

10

26

Positive externalities

• The marginal external benefit is the dollar value of the benefit to third parties from an additional unit of production of consumption of a good. This occurs when there is a positive externality.

27

Social Benefit

MSB = MPB + MEB

28

Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency

S = MSC

MPB + MEB = MSBH

Z

U

V

Pri

ce,

Ben

efit

, an

d C

ost

(D

oll

ars)

Inoculations Per Year (Millions)

10

25

30

45

10 120

29

III- Internalization of Externalities

• An externality can be internalized if there is a policy that causes market participants to account for the costs of benefits of their actions.

• Requires:– to indentify the participants– Monetary value of External Cost or Benefit

30

1- Corrective Taxes to Negative Externalities

• Setting a tax equal to the MEC will internalize a negative externality.

31

3- Corrective Subsidies

• Setting a subsidy equal to MEB will internalize a positive externality

• For example:– Garbage collection, tree plantation

Public Goods

Public Finance

33

• Public Goods are goods for which exclusion is impossible. – One example is National Defense: A

military that defends its citizenry from invasion does so for the entire public.

Public Goods

34

Characteristics of Public Goods

• Nonexclusion: The inability of a seller to prevent people from consuming a good when they do not pay for it.

• Nonrivalry: The characteristic that if one person “consumes” a good, another person’s pleasure is not diminished nor is another person prevented from consuming it.

35

Pure Public Goods and Pure Private Goods

• Pure Public Good: There is no ability to exclude and there is no rivalry for the benefits.

• Pure Private Good: There is a clear ability to exclude and there is rivalry for the benefits.

36

Marginal Costs for Provision of Public Goods

• The marginal cost of allowing another person to benefit from a pure public good is zero while the marginal cost of a greater level of public good is positive.

37

Marginal Costs of distributing a Pure Public Good-Figure ACo

st (D

olla

rs)

Number of Consumers 0

200

Marginal Cost of Allowing anAdditional Person to Consume aGiven Quantity of Pure Public Good

1

38

Marginal Cost of Producing a Pure Public Good

Marginal Costs of Consuming and Producing a Pure Public Good--Figure B

Units of a Pure Public Good per Year

Cost

(Dol

lars

)

MC = AC200

0

39

ExampleBread versus Heat

• Bread – Clearly a pure private good because there is the ability to exclude and there is rivalry.

• Heat – Clearly a pure public good because there is no ability to exclude and there is no rivalry.

40

Price Excludable Public Goods

vs

Congestible Public Goods

Provision of Private Good and Public Goods: Markets and Government

41

Price Excludable Public GoodsExcludability but no rivalry

• Another type of good is a price-excludable public good: no rivalry but exclusion is easy.

Examples: Country Clubs, Cable TV

42

Congestible Public GoodsRivalry but no excludability

• There are public goods where, after a point, the enjoyment received by the consumer is diminished by crowding or congestion. These are called Congestible Public Goods.– Examples: roads and parks

43

Marginal Cost per User

A Congestible Public Good

Number of Consumers per Hour 0 1

Mar

gina

l Cos

t

44

Demand For a Pure Public Good

• Demand for a Pure Private Good is derived by adding quantities at each price.

• Demand for a Pure Public Good is derived by adding how much people will be willing to pay at each quantity.

45

Pric

e pe

r Loa

f of B

read

(Dol

lars

)

Loaves of Bread Purchased per Week

Demand For a Private Good

7

6

5

4

3

2

1

0 1 2 3 4 5 9 10 6 87

E S = MC = AC

DC = MBC

DB = MBA

DA = MBA

D = QD

46Security Guards per Week

Demand For A Pure Public Good

Z 1

Z 2

Z 3

Z4

100

200

300

400

500

600

700

800

Mar

gina

l Ben

efit (

Dol

lars

)

0 1 2 3 4 5

DA = MBA

DB = MBB

DC = MBC

DA= MBA

47

Efficient Output of a Pure Public Good

• The socially optimal level of the public good requires that we set the Marginal Social Benefit of that good equal to its Marginal Social Cost. MSB = MSC

Lindahl Pricing: Everyone in a group cooperates and pays their marginal benefit. We can demonstrate this issue mathematically, numerically (using a

table), and graphically.

48

Efficient Output for a Pure Public Good

Security Guards per Week

E

100

200

300

400

500

600

700

800

Mar

gina

l Ben

efit (

Dol

lars

)

0 1 2 3 4 5

MBA

MBB

MBC

DA= MBA = MSB

MC = AC = MSB

49

Freeriding

–Freeriding occurs when people are not honest in stating their Marginal Benefit because if they understate it, they can get a slightly reduced level of the public good while paying nothing for it.

50

Freeriding is easier with

• Anonymity: If everyone knows who contributes, there can be powerful social stigmas applied to shirkers.

• Large numbers of people: It’s easier to determine the shirkers in a small group and the punishment is more profound when people close to you shun you.

Public Choice and the Political Process

Public Finance

52

The Supply of Public Goods Through Political Institutions

– Public Choice is when decisions are made through political interaction of many persons according to pre-established rules.

– Public choice vs. private choice• Taxes Vs Voluntary Cost-Sharing

53

Political Equilibrium

• A political equilibrium is an agreement on the level of production of one or more public goods given the specified rule for making the collective choice and the distribution of tax shares among individuals.

54

Tax Sharesor tax prices

• Tax shares, sometimes called tax prices, are pre-announced levies assigned to citizens.

• They are a portion of the unit cost of a good proposed to be provided by government.

• Increase in cost – increase in tax

ti = tax share to individual i ti = average cost of good

55

The Most Preferred Political Outcome of A Voter

Tax

Tax per Unit of Output

Output per Year 0

ti

Q*

MB i

Z

56

The Choice to Vote or Not• Decision to vote depends on benefits, costs and the probability

that voting will achieve the anticipated benefits.– Costs: Time visit poll and information collection

• Not to Vote:– Ability to influence the outcome– Closer the alternatives– Preferred position is too far from offered alternatives– Poor information

• Rational Ignorance is the idea that, to many voters, the marginal cost of obtaining information concerning an issue is greater than the marginal benefit of gaining that information. This leads the voter not to gather the information and not to vote.

57

Determinants of Political Equilibrium

• the public choice rule• average and marginal costs of the public

good• information available on the cost and

benefit• the distribution of the tax shares• distribution of benefits among voters

Equilibrium model (majority rule)

59

Political Equilibrium Under Majority Rule With Equal Tax Shares M

argi

nal B

enefi

t,Cos

t, a

nd T

ax (D

olla

rs)

Security Guards per Week 0

50

350 MC = AC

t

MBA MBB MBC

SMB

E

1 2 3 4 5 6 7

MBFMBG MBHMBM

60

Median Voter Model

• The median voter model assumes that the voter whose most-preferred outcome is the median of the most-preferred political outcomes of all those voting will become the political equilibrium.

61

Implications of Median Voter Model

• Only the median voter gets his most-preferred outcome (not 51% of voters).

• Others get too little or too much.• The greater the dispersion, the greater the

dissatisfaction• The more voters’ preferences are

clustered, the greater the satisfaction

62

Political Externalities

• Political Externalities are the losses in well-being that occur when voters do not obtain their most-preferred outcomes given their tax shares.

• Equal to zero if tax shares are adjusted to marginal benefits

• Political externalities don’t exist under unanimous consent.

• More inclusive majorities protect minorities

63

Political Transactions Costs

• Political Transactions Costs are the measure of the value of time, effort, or other resources expended to reach or enforce a collective agreement.

• Citizens must weigh political externalities and political transaction costs

64

Uniqueness and Cycling

• A unique political equilibrium may not emerge under majority rule– Two or more public good outputs may recieve majority

vote

• The outcome can depend on factors other than cost vs benefits– order in which alternatives are presented– Inclusion or exclusion of alternatives– Disturbing possibility

65

Preferences • Single-peaked preferences

– a unique optimal outcome exists • Multi-peaked preferences

– as a person moves away from their most preferred outcome they become worse off until a certain point when moving further away from their most-preferred outcome makes them better off.

66

Figure 5.3 Voter Rankings of Alternatives

Net

Ben

efit f

or A

Single Peak

0

Fireworks Displays per Year

Net

Ben

efit f

or B

Multiple Peaks

0

Net

Ben

efit f

or C

Single Peak

0

Fireworks Displays per Year

1 2 3 2 3

1 2 3

1

67

Implications

• Arbitrary results• Results are order dependent – any can emerge

winner – phenomena of Cycling• Disturbing:

– No rhyme or reason explains the emerging choices

• Public Choices can be influenced by– Order in which issues are placed on the agenda– Elimination of one alternative can change the way

others are ranked

68

Existence of Multiple-Peaked preferences

• Multiple Peaked Preferences are inconsistent with declining Marginal Benefit

69

Declining Marginal Benefit of a Pure Public Good Meaning That Preferences are Single Peaked

0

MB

t

Mar

gina

l Ben

efit

and

Tax

per

Uni

t N

et B

enefi

t

Q* Output of a Pure Public Good

70

Existence of Multiple-Peaked preferences

• Multiple Peaked Preferences are inconsistent with declining Marginal Benefit

• Can exist in real life:– Example:

• Public vs Private schooling Budgets• Vietnam War

Political Process

72

Political Processes

• Constitutions– Accepted set of rules by which decisions are

made– Evolve over time– Are generally accepted– Some decisions require rules some doesn’t

• Choice of apparel vs choice of war

– Viable constitutions have social contracts inherent in their rules

• Uncertainty of skills and future opportunities

73

Political Processes

• Minority Rule– Might not satisfy majority of community– Political externalities imposed by minority of

citizens– Decisions by minority – oligarchy– One single individual – dictatorship

(monarchy)– No population involvement – colonial rule

74

Political Processes

• Majority Rule – Simple majority rule 51%– 2/3 ,majority rule

• Number of dissatisfied voters declines to 33%

75

Costs and Benefits of Collective Action

• Benefit: decrease in political externalities

– Cost an individuals bears due to actions of others through political process

• Cost: increase in political transactions cost

76

Costs and Benefits of Collective Action

• Political externalities are zero in unanimous decisions.– Political Externality – not the only costs– Transaction costs

• Cost of reaching the decision

– Knowledge of ability to prevent action• Extortion

• Rational choice– Rule that minimizes political externalities and transaction costs

• Generalization for individuals who have– extreme preferences – may choose majority rule– higher opportunity cost of time – may choose minority rule

77

Possible Alternatives Methods

• Unanimity• Relative unanimity (2/3, 7/8 etc.)• Plurality rule (more than 3 outcomes

possible)• Point-count voting (enables voters to

register the intensity of their preference)• Instant Runoffs

78

Political Parties and Political Equilibrium

• Politicians seek elective office for variety of reasons:– Power– Prestige– Desire to serve others

• Politicians having similar ideas group together in Political parties

• Political Parties Vote Maximizers– e.g. Beneficial program for minority and spreading

cost on the majority

79

Political Parties and Political Equilibrium

• If parties can be scaled on the quantity of Govt Activity per year– Median Position vs Extreme position

• If most preferred outcomes of voters are normally distributed then parties can maximize their votes by having a central position

80

The Median Voter And Political PlatformsN

et B

enefi

t

Output of Government Goods and Services per Year 0

Net Benefit for the Median Voter

Q*

81

Number of Voters and Government OutputN

umbe

r of

Vote

rs

Output of Government Goods and Services per Year 0 Q*

Public Choice and the Political Process

Public Finance

83

Special Interests

• Special Interests are groups that lobby on a particular issue and put pressure on– Politicians– Bureaucrats– Voters

• An example of a special interest is unions and/or steel companies lobbying for Tariffs and Import Quotas to protect their jobs or profits.

• Efficiency losses per job saved almost always exceed the pay of the retained worker.

84

Bureaucracy and the Supply of Public Output

• Bureaucracy for implementing the Public Choices made through public institutions

• Involved in delivery and production of Public goods

• Efficiency is difficult to measure– Output is not quantifiable– Nor easily sold for profit in market

• Do not own the outputs that produce

85

Bureaucracy and the Supply of Public Output

• William Niskanen– Bureaucrats seek to

• Maximize the power• Power is correlated with resources at hand• Resources are correlated with the size of the

budget allocated

– Would either increase output ir increase the inputs

Cost-Benefit Analysis and Government Investments

Public Finance

87

Economic Analysis for the Budget Process:

• A Program is a combination of government activities producing a distinguishable output.

• Program Budgeting is the system of managing government expenditures attempting to compare the program proposals of all government agencies authorized to achieve similar objectives.

• Cost-Effectiveness Analysis is a technique for determining the minimum-cost combination of government programs to achieve a given objective

Achieving the Least-Cost Means of Accomplishing an Authorized Objective

88

Cost-Effectiveness Analysis

• Allows policy makers to see trade off between programs of various agencies with similar objectives– Not visible under line budgeting

89

Cost-Effectiveness Analysis

• Reduce the cost of achieving a specific goal• Encourage competition among various Govt

agencies– Improve effectiveness– Encourage innovation– Improve productivity– Reduced cost– Reduced burden to tax payer

90

Cost-Benefit Analysis • A practical technique for relative merits of alternative

government projects

• Projects where MSB is less than MSC are not

considered

• A statement of pros & cons of an activity

• Benefits must include indirect effects and costs must

include opportunity cost.

91

Cost-Benefit Analysis • Three main steps:

– Enumerate all costs and benefits of a proposed project

– Evaluate all costs and benefits in dollar terms

– Discount future net benefits

92

Figure 6.3 Cost-Benefit Analysis and Efficiency

Mar

gina

l Soc

ial C

ost a

nd B

enefi

t

Miles of Highway per Year 0 Q1 Q*

from D Q2

G F

E

B A

C D H J

DQ1

Net Social Gain from DQ1

Net Social Loss

Q2 Q3 Q4

DQ2

MSC

MSB

93

How is Human Health Valued?

• Discounted present value of future earnings

– Old vs young

– Rich vs poor

• Treating as a public good

– Free rider problem

– Survey Questionnaire

– Willingness to pay

– Average Dollar Response as crude index

Government Subsidies and Income Support for the Poor

Public Finance

95

Poverty

• It breeds crime and social unrest

• Can the charitable institutions be trusted?

– Not sustainable

– What about recessions

• Welfare Trap

96

Why We Have Government Programs to Aid the Poor

• Market outcomes may result in earnings less that minimum required.– Considered unacceptable by many citizens– Support for Safety net

• Disagreement on minimum requirement for survival

• Policies that would consider would require equity in distribution.– Belief that reward according to belief

97

Why We Have Government Programs to Aid the Poor

• Earning according to work but provide minimal support– Coupled with equal opportunities in the labor markets

• We are concerned about Equity-Efficiency Trade-Offs.

• Pragmatic approach:– Needs to alter income distribution for Poverty Alleviation– Effect on efficiency

98

Why We Have Government Programs to Aid the Poor

• If net benefits from resource use is less, ultimately everyone would be worst off (Size of the pie should not decrease)– Losses in efficiency reduces the economy’s potential for jobs

and more production

• Increased efficiency increases Job creation– Question: How many people are poor just because they

cannot work?

99

Why We Have Government Programs to Aid the Poor

• It creates the Positive Externality of Social Stability.

• Many citizens support because benefits emerge that can be collectively enjoyed– Safety needs can help

• Out of genuine compassion– Feels satisfaction

• Poverty breeds unrest