1. Public Finance (MPA405)
Dr. Khurrum S. Mughal

2. Lecture 31: Revision
Revision

3. 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

12. 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.

15. 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
and
P = MPC = MSC so
P = MSB = MSC

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.

21. 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
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

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
Price, Benefit, and Cost (Dollars)
Inoculations Per
Year (Millions) 10 25 30 45 12
S = MSC
MPB + MEB = MSB H Z U V

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

32. Public Goods
Public Finance

33. 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.

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

38. 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

39. 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.

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

41. 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

42. 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

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

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. Demand For a Private Good7 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

46. 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

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
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

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.

51. 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 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

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

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

58. Equilibrium model (majority rule)

59. 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

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
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

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. 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

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

71. 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%
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 Platforms
Net Benefit
Net Benefit for the Median Voter Q *
Output of Government Goods and Services per Year

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

82. 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

86. Cost-Benefit Analysis and Government Investments
Public Finance

87. 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

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
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

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

94. 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