Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 31: Revision Revision

Introduction Public Finance

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.”

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

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

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

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

Major Fiscal Functions Allocation Function Distribution Function Stabilization Function

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

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

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.

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

Marginal Conditions for Efficiency Total Social Benefit Total Social Cost Net Benefit = TSB – TSC Maximum Net Benefit occurs where MSB = MSC

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.

If These Conditions are Met P = MPB = MSB and P = MPC = MSC so P = MSB = MSC

When Does the Market Interaction Fail to Achieve Efficiency? Monopoly Taxes Subsidies

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

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 .

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.

Social Costs MSC = MPC + MEC

Figure 3.1 Market Equilibrium, A Negative Externality and Efficiency Price, Benefit, and Cost (Dollars) Tons of Paper Per Year (Millions) 110 105 100 4.5 5 D = MSB S = MPC MPC + MEC = MSC A B G 10 10

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.

Social Benefit MSB = MPB + MEB

Figure 3.2 Market Equilibrium, A Positive Externality and Efficiency Price, Benefit, and Cost (Dollars) Inoculations Per Year (Millions) 10 25 30 45 12 S = MSC MPB + MEB = MSB H Z U V

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

1- Corrective Taxes to Negative Externalities Setting a tax equal to the MEC will internalize a negative externality.

3- Corrective Subsidies Setting a subsidy equal to MEB will internalize a positive externality For example: Garbage collection, tree plantation

Public Goods Public Finance

Public Goods 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.

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.

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.

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.

Marginal Costs of distributing a Pure Public Good-Figure A 200 Cost (Dollars) Marginal Cost of Allowing an Additional Person to Consume a Given Quantity of Pure Public Good 1 Number of Consumers

Marginal Costs of Consuming and Producing a Pure Public Good--Figure B Marginal Cost of Producing a Pure Public Good 200 MC = AC Cost (Dollars) Units of a Pure Public Good per Year

Example Bread 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.

Provision of Private Good and Public Goods: Markets and Government Price Excludable Public Goods vs Congestible Public Goods

Price Excludable Public Goods Excludability but no rivalry Another type of good is a price-excludable public good: no rivalry but exclusion is easy. Examples: Country Clubs, Cable TV

Congestible Public Goods Rivalry 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

A Congestible Public Good Marginal Cost Marginal Cost per User 1 Number of Consumers per Hour

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.

Demand For a Private Good 7 6 5 Price per Loaf of Bread (Dollars) DC = MBC 4 DB = MBA E S = MC = AC DA = MBA 3 D = QD 2 1 1 2 3 4 5 6 7 8 9 10 Loaves of Bread Purchased per Week

Demand For A Pure Public Good 800 Z 1 Z 2 Z 3 Z4 700 600 500 Marginal Benefit (Dollars) 400 300 DA= MBA 200 DA = MBA DB = MBB 100 DC = MBC 1 2 3 4 5 Security Guards per Week

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.

Efficient Output for a Pure Public Good 800 700 600 500 E Marginal Benefit (Dollars) MC = AC = MSB 400 DA= MBA = MSB 300 200 MBA MBB 100 MBC 1 2 3 4 5 Security Guards per Week

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.

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

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

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.

Tax Shares or 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

The Most Preferred Political Outcome of A Voter Tax per Unit of Output Z ti Tax MB i Q * Output per Year

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.

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)

Political Equilibrium Under Majority Rule With Equal Tax Shares SMB E MC = AC 350 Marginal Benefit,Cost, and Tax (Dollars) MBM MBF MBG MBH MBC t 50 MBB MBA 1 2 3 4 5 6 7 Security Guards per Week

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.

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

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

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

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

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.

Figure 5.3 Voter Rankings of Alternatives Multiple Peaks Single Peak Net Benefit for A Net Benefit for B 1 2 3 1 2 3 Fireworks Displays per Year Single Peak Net Benefit for C 1 2 3 Fireworks Displays per Year

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

Existence of Multiple-Peaked preferences Multiple Peaked Preferences are inconsistent with declining Marginal Benefit

Net Benefit Marginal Benefit and Tax per Unit t MB Q * Declining Marginal Benefit of a Pure Public Good Meaning That Preferences are Single Peaked Q * Net Benefit MB Marginal Benefit and Tax per Unit t Output of a Pure Public Good

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

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

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

Political Processes Majority Rule Simple majority rule 51% Number of dissatisfied voters declines to 33%

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

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

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

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

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

The Median Voter And Political Platforms Net Benefit Net Benefit for the Median Voter Q * Output of Government Goods and Services per Year

Number of Voters and Government Output Output of Government Goods and Services per Year Q *

Public Choice and the Political Process Public Finance

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.

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

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

Economic Analysis for the Budget Process: Achieving the Least-Cost Means of Accomplishing an Authorized Objective 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

Cost-Effectiveness Analysis Allows policy makers to see trade off between programs of various agencies with similar objectives Not visible under line budgeting

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

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.

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

Figure 6.3 Cost-Benefit Analysis and Efficiency Net Social Gain from DQ1 MSC A MSB B G F Marginal Social Cost and Benefit Net Social Loss E from D Q2 C D J H DQ1 DQ2 Q1 Q2 Q* Q3 Q4 Miles of Highway per Year

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

Poverty It breeds crime and social unrest Can the charitable institutions be trusted? Not sustainable What about recessions Welfare Trap

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

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

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?

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