1.1) Public Economics: What is its Purpose of Existence?
At the center of any country’s political life are some basic economic questions concerning the
role of government and that of the public sector in the economy: How does the government
affect the economy? What is the appropriate role and size of government? Why are some
economic activities undertaken in the public sector and others in the private sector? Should
government do more than it is currently doing, or less? Should government change what it is
doing, and how it is doing it? Public economics helps us in answering these various questions.
Public economics is the study of government policy through the lens of economic efficiency
and equity. At its most basic level, public economics provides a framework for thinking about
whether or not the government should participate in economics markets and to what extent its
role should be. In order to do so, microeconomic theory is utilized to assess whether the private
market is likely to provide efficient outcomes in the absence of governmental interference.
Public economics builds on the theory of welfare economics and is ultimately used as a tool to
improve social welfare. Welfare can be defined in terms of well-being, prosperity, and overall
state of being.
2.1) Welfare Economics: Role of The Public Sector .
At the core of the economy are profit-maximizing firms interacting with households in
competitive markets. Under certain idealized conditions, a competitive economy is efficient. If
those conditions were satisfied, there would be a very limited role for government. To
understand the role of the public sector then, we have to understand when markets work well,
and when, and in what ways, they do not. In most modern industrial economies, primary reliance
for the production and distribution of goods lies in the private rather than the public sector. One
of the most enduring tenets of economics holds that this form of economic organization leads to
an efficient allocation of resources. However, if private markets are efficient, why should there
be an economic role for government? To answer this question, a precise understanding of the
meaning of economic efficiency is needed.
2.2) The Invisible Hand: Is There a Need for Government?
Adam Smith, in his book; The Wealth of Nations, argued that competition would lead the
individual in the pursuit of his or her private interests (profits) to pursue the public interest, as if
by an invisible hand. A person intends only their own gain, and they are in this, as in many other
cases, led by an invisible hand to promote an end which was no part of their intention. By
pursuing their own interest they frequently promote the interest of the society more effectually
and efficiently than when they really intend to promote it. Thus, Smith argued that it was not
necessary to rely on government or on any moral sentiments to do good. The public interest, he
maintained, is served when each individual simply does what is in his or her own self-interest.
Self-interest, Smith argued, is a much more persistent characteristic of human nature than a
concern to do good, and therefore provides a more reliable basis for the organization of society.
Moreover, individuals are more likely to ascertain with some accuracy what is in their own self-
interest than they are to determine what is in the public interest.
The intuition behind Smith’s insight is simple: if there is some commodity or service that
individuals value but that is not currently being produced, then they will be willing to pay
something for it. Entrepreneurs, in their search for profits, are always looking for such
opportunities. If the value of a certain commodity to a consumer exceeds the cost of production,
there is a potential for profit, and an entrepreneur will produce the commodity. Similarly, if there
is a cheaper way of producing a commodity than that which is presently employed, an
entrepreneur who discovers this cheaper method will be able to undercut competing firms and
make a profit.
There is widespread consensus among economists that competitive forces do lead to a high
degree of efficiency, and that competition does provide an important spur to innovation.
However, over the past two hundred years, economists have come to recognize that in some
important instances the market does not work as perfectly as the more ardent supporters of the
free market suggest.
2.3) Pareto Efficiency: The Heart of Welfare Economics.
Welfare economics is the branch of economics that focuses on what is termed as normative
issues. It looks into how the economy ought to be run and how it needs to function in order to
obtain efficient outcomes. In today's world we know that most economies are mixed, with some
decisions made by the government but most left up to the private firms and individual
households. But there are many “mixes.” How are we to evaluate the alternatives? Most
economists embrace a criterion called Pareto efficiency. Resource allocations that have the
property that no one can be made better off without someone being made worse off are said to be
Pareto efficient, or Pareto optimal. Pareto efficiency is what economists normally mean when
they talk about efficiency.
2.4) Efficient Markets: Two Fundamental Theorems
Two of the most important results of welfare economics describe the relationship between
competitive markets and Pareto efficiency. These results are called the fundamental theorems of
welfare economics.
The first theorem tells us that if the economy is competitive (and satisfies certain other
conditions), it is Pareto efficient. Basically it implies that every competitive economy is Pareto
efficient.
The second theorem states that Every Pareto efficient resource allocation can be attained
through a competitive market mechanism, with the appropriate initial redistributions.
By transferring wealth from one individual to another, we make the second individual better
off and the first worse off . After we make the redistribution of wealth, if we let the forces of
competition freely play themselves out, we will obtain a Pareto efficient allocation of resources.
This new allocation will be different in many ways from the old. If we take wealth away from
those who like chocolate ice cream and give it to those who like vanilla, in the new equilibrium,
more vanilla ice cream will be produced and less chocolate, but no one can be made better off in
the new equilibrium without making someone else worse off.
3.1) Market Failure: The Bars to Efficiency.
Market failure, in economics, is a situation defined by an inefficient distribution of goods and
services in the free market. In market failure, the individual incentives for rational behavior do
not lead to rational outcomes for the group. In other words, each individual makes the correct
decision for themselves, but those prove to be the wrong decisions for the group. In traditional
microeconomics, this can sometimes be shown as a steady-state disequilibrium in which the
quantity supplied does not equal the quantity demanded.
A market failure occurs whenever the individuals in a group end up worse off than if they had
not acted in perfectly rational self-interest. Such a group either incurs too many costs or receives
too few benefits. The economic outcomes under market failure deviate from what economists
usually consider optimal and are usually not economically efficient. Commonly cited market
failures include externalities, monopoly, information asymmetries, and factor immobility. One
easy-to-illustrate market failure is the public goods problem. Public goods are goods or services
that, if produced, the producer cannot limit its consumption to paying customers and for which
the consumption by one individual does not limit consumption by others. Public goods create
market failures if some consumers decide not to pay but use the good anyway.
3.2) Asymmetric Information: A Form of Market Failure.
In a perfectly competitive market structure, one of the key assumptions defining the market is
that of complete and symmetric information among the parties involved in the transaction. That
is, we assume that no seller knows more about a product’s characteristics than a buyer, and no
buyer knows more about the product’s costs than a seller. However, in reality we know that one
party to a transaction often has more information than another about the characteristics of the
good or service to be traded. This condition is referred to as that of asymmetric information.
For instance, the seller of a product usually knows more about the quality of the good than the
buyer; workers usually know more about their abilities than the potential employers; in the
market for second-hand cars, sellers have more information regarding the true status of the car
than the buyer.
As per the first welfare theorem of Economics, perfect competition leads to a Pareto efficient
allocation of resources. A key assumption for the theorem to hold is that all the information
related to the trade in the market should be equally observed by all the agents involved. When
such an assumption fails to hold and information tends to be asymmetric, then prices are
distorted and we do not get a Pareto efficient allocation of resources. This is referred to as the
situation of market failure.
3.3) The Market for Lemons: Example of Asymmetric Information.
The concept of asymmetric information was first analyzed by George Akerlof. He considered
an example of the automobile market. Asymmetric information exists, when amongst different
parties in the trade, an unequal information set persists. Thus, in the market for second-hand cars,
also called the market for lemons, sellers of the second-hand cars have more information about
the real value of the car than the buyer. This information asymmetry gives the seller an incentive
to sell goods of less than the average market quality. The average quality of goods in the market
will then reduce as will the market size. Moreover, a buyer possessing lesser information, is
often is discouraged to go in trade, as he wants to reduce the risk of buying a damaged car, called
a ‘lemon’. Thus the presence of asymmetric information, may result in no trade taking place at
all. Another example would be that of insurance providers not having full information about the
customers health status. Therefore we see that asymmetric information can lead to market failure
since the amount supplied does not meet the demand or the amount demanded does not meet the
supply.
To correct for the market failure resulting from asymmetrical information, one way out is when
such asymmetries in information can be nullified, in other words when more equal distribution of
information is possible. For instance, in markets for second-hand cars, some certification or
quality accreditation with some years of guarantee from an organization can help spread
information about the true real value of the second-hand car amongst buyers and sellers. In the
market for health insurance, a thorough medical check-up can reveal true status of the buyers’
health.
3.4) Adverse Selection: The Reason for Asymmetric Information.
Asymmetric information exacerbates inefficiencies. One reason behind why presence of
asymmetric information leads to market failure is due to adverse selection. Adverse selection
refers to a situation when parties gaining from the presence of asymmetric information are more
likely to enter into a trade than the parties suffering from information asymmetries. In our
examples mentioned in the previous section, if buyers of the second- hand cars cannot
distinguish good cars from bad ones, sellers may be inclined to sell only lemons (bad-quality
cars).
A seller may have better information than a buyer about products and services being offered,
putting the buyer at a disadvantage in the transaction. For example, a company’s managers may
more willingly issue shares when they know the share price is overvalued compared to the real
value; buyers can end up buying overvalued shares and lose money. Thus we can see that when
there is information asymmetry it leads to adverse selection. This basically implies that the party
with more information and who usually stands to gain more in the trade is more inclined to enter
into the trade.
3.5) Market for Labor: Consequences of Asymmetric Information.
The figure shows demand curves for high-ability and low-ability workers when workers’
abilities are observable to the potential employers. They are labeled as DH and DL respectively.
The figure also shows the supply curves for high-ability and low-ability workers labeled as SH
and SL respectively. The higher the monthly wage, more the high-ability workers are willing to
accept employment. Initially we assume the ideal market situation where the potential employer
can easily differentiate between a high-ability and a low-ability worker. Accordingly, a high-
ability worker will be paid where curve DH intersects SH. The number of high-ability worker
employed will be 500 and they will be paid a monthly wage of Rs. 12,000. The equilibrium for
low-ability worker is where curve SL intersects DL, that is, at 400 low-ability workers paid a
monthly wage of Rs. 6000 per month. Low-ability workers are paid lower than the high-ability
workers when the labor market is in equilibrium. In this case, we do not face a situation of
asymmetric information, as the abilities of the workers to be hired are common knowledge.
Now consider the case when we have a situation of asymmetric information in the labor
market. Given that there is information asymmetry, the potential employer is not able to
distinguish between the high- and low-ability workers. So for the employer the demand for labor
is depicted by the demand for an average worker. Thus D represents the demand for an average
worker which is given by the average of low-ability and high-ability workers. DH represents
demand for high-ability workers and DL is the demand for low-ability workers. Let curve S
represents the total supply of high- and low- ability workers together. Curve SH and SL are the
supply of high-ability and low-ability workers, respectively. Thus in the presence of information
asymmetry, the labor market equilibrium is defined by the intersection of the S and D curve,
depicting the total employment of labor in the equilibrium as 900 workers. Out of 900, the
existing 400 low-ability workers should be paid a monthly wage of Rs. 4000, while the existing
500 high- ability workers should be paid a monthly wage of Rs. 12,000. This would be the
feasible outcome when the quality of labor was observable. But since in this case ability of labor
cannot be distinguished, 900 workers in the market are paid a uniform monthly wage of Rs.
6000. This is due to the presence of asymmetric information to the potential employer about the
abilities of the workers. As a result of this, a high-ability worker is underpaid and a low-ability
worker is overpaid. At Rs. 6000 per month, only 300 high-ability workers will participate (as
shown by the intersection of SH with D curve). As low-ability workers are overpaid, they will be
encouraged to participate more in the market. So instead of 400, 600 low-ability workers
participate in the labor market in the equilibrium at the monthly wage of Rs. 6000 (as shown by
the intersection of SL with D curve).
3.6) Signaling and Screening: Asymmetric Information Solutions.
Signaling: The concept of market signaling is where the buyer or the seller signals the other
uninformed party, to increase their information about the product in trade. To see how market
signaling works, let us consider the case of asymmetric information in the labor market. In the
labor market where high- and low- ability workers are present and are not easy distinguishable,
employing somebody can be very costly to the potential employer. If an employer hires a low-
ability worker for a job requiring high-ability, he will be in severe loss. In such a case market
signaling works great. The high-ability worker can signal the employer about his abilities, which
stand out amongst all the other low-ability candidates. Signals could be in the form of better
resume, being highly qualified, education level, showing good etiquettes, speaking in decent
language, etc.
Screening: There is another way to take care of the information asymmetries, which is when
uninformed parties initiate communication by conducting a test either for the informed parties or
the goods those parties seek to trade. For instance, in the market for second-hand cars, the
potential buyer of a second-hand car can learn about its quality by getting it checked from a
mechanic or learn about the accident record of the car. Similarly, a life insurance company can
gain information regarding the health of an insurance policy applicant by obtaining the
applicant’s medical records, contacting his current physician, or subjecting him to a physical
examination.
3.7) Moral Hazard: Consequence of Asymmetric Information.
Moral hazard is also a result of asymmetric information where asymmetry arises due to hidden
action by agents such that the action of one party is not observed by the other party in trade,
which in turn affects the benefits of the latter. For example, in the case of the insurance market,
an insured individual’s risk of death or disability may increase in the post insured stage because
of his unhealthy lifestyle including smoking, excessive drinking, or a lack of exercise. However,
the insurance company is likely to have difficulty in monitoring his behavior and adjusting its
premiums accordingly.
Moral hazard is an effect of the principle agent problem. Here one party (the principle) does
not necessarily align their views, opinions and/or goals with that of the other party (the agent).
Thus there is a disconnect in communication which leads to moral hazard.
4.1) Externalities: Positive and Negative.
In recent decades, governments and other organizations (both local to global) have increasingly
shown concern about degradation of environment through pollution, a lot of which is being
caused by human activities of production and consumption. The important fact is that most of the
economic activities also impact people other than those who are directly involved (i.e. the
producers and consumers). For instance, paper is produced along with its obnoxious gases and
liquid effluents, which affect people who are neither its producers nor consumers.
Producers earn income from the activity and consumers derive utility while using the product
(e.g. writing, printing, painting, and packaging) whereas other people bear the cost in terms of
suffering. Thus, social cost of producing a commodity may be higher than the private cost, which
is often ignored by the private parties while making a decision on quantum of output. These are
known as externalities which market do not automatically take care of. Solutions to externalities,
particularly negative externalities, needs to be devised so as to internalize them. This is an arena
of public policy. However, all externalities are not negative. For instance, my activity of having a
well maintained garden in the foreyard of my house, may please the neighbors who do not share
its cost. This is a case of positive externality.
Externalities are the costs borne by (or benefits accrued to) third parties who are neither
producers nor consumers. Social costs/benefits are costs/benefits from an activity which touches
the entire society either directly or indirectly. Such effects would accrue irrespective of whether
one is voluntarily or involuntarily involved. If a road is constructed near my house (which is
definitely not constructed only for me), valuation of my house improves. On the other hand, if a
flyover is constructed opposite to my house, valuation of my house comes down. Such
externalities therefore emanate from production activities. But they may also emanate from
consumption activities. For instance, if I get vaccinated against a contagious disease, people who
come into contact with me would have smaller chance of getting infected with that disease. This
is a case of positive externality from consumption. But if I smoke, I am likely to make many
people smoke passively and thus harm them. This is a case of negative externality from
consumption.
External costs/benefits are the wedge between private costs/benefits and social costs/benefits.
Thus we have: 1) MSC = MPC + MEC and 2) MSB = MPB + MEB
5.1) Theory of Public Goods: Public and Private Goods.
Goods are classifiable in several ways but there is a special classification that puts all goods
into two distinct categories viz. private goods and public goods. In economics, a public good
refers to a commodity or service that is made available to all members of a society. Typically,
these services are administered by governments and paid for collectively through taxation.
Examples of public goods include law enforcement, national defense, and the rule of law. Public
goods also refer to more basic goods, such as access to clean air and drinking water.
Competitive Markets which are found to be an efficient allocator of resources for optimum
supply of private goods, fail to carry out this function in the case of public goods. It therefore
calls for the State to undertake their provisioning out of its revenue proceeds. Thus we can see
that the role of government is indeed essential when it comes to the distribution of public goods.
5.2) Distinction Between Public and Private Goods: Rivalry and Excludability.
Rivalry: We observe that there are goods which we gladly share with others like air or sun-
shine in the open or bathe in a lake or watch TV show together in our living room. This is
because my consumption does not get diminished or depleted when others consume it
simultaneously. Such goods are non-rival in consumption. In this case, all the consumers, if they
so wish, can consume the whole of it. Rivalry is the inability of other consumers to consume
together simultaneously and non-rivalry is their ability to do so.
Excludability: Among the non-rival consumption goods, there are goods where certain
consumers can be excluded from consuming it. For example, in the case of street light, no
passer-by can be excluded from its consumption. But, in the case of cricket match, those who
have not bought the ticket or received the pass can be excluded. Producers are able to exclude
certain consumers.
Private goods possess both the characteristics of rivalry in consumption and excludability from
consumption. By contradistinction (i.e. the quality of being), public goods are non-rivalries and
non-excludable.
5.3) Free Riders Problem:
An important issue that is related to public goods is referred to as the free-rider problem. Since
public goods are made available to all people–regardless of whether each person individually
pays for them–it is possible for some members of society to use the good despite refusing to pay
for it. People who do not pay taxes, for example, are essentially taking a "free ride" on revenues
provided by those who do pay them, as do turnstile jumpers on a subway system. This can
ultimately lead to market failure.
6.1) Wagner's Hypothesis:
Adolf Wagner a noted German political economist (1835-1917) propounded an empirical law
to analyses and explains the trend in the growth of public expenditure. Wagner argued that a
functional, cause and effect relationship exists between the growth of an industrializing economy
and the relative growth of its public sector. According to Wagner, relative growth of the
government sector is an inherent characteristic of industrializing economies. He came to the
conclusion that as per capita income and output increases in industrializing nations, the public
sectors of these nations necessarily grow as a proportion of total economic activity.
6.2) Statement of the Hypothesis:
Wagner tried to explain the cause of growth in public expenditure in terms of his famous “Law
of Increasing State Activities”. According to Wagner there are inherent tendencies for the
activities of different layers of a government (such as center and state) to increase both
intensively and extensively. Intensive increase means expansion of traditional functions of the
state on a large scale. Extensive increase relates to coverage of new welfare functions.
Wagner presented his law in the following words “Comprehensive comparisons of different
countries and different times show that among progressive people, with which we alone are
concerned an increase regularly takes place in the activity of both the central and the local
governments. This increase is both extensive and intensive. The central and local governments
constantly undertake new functions, while they perform both old and new functions more
efficiently and completely.” Wagner’s law of increasing state activities is a universal truth in
recent years. It is a fact that economic growth of a country has always been accompanied by
increasing state activities and hence increasing public expenditure.
According to Wagner’s law, the expenditure of public authorizes has a continuous increasing
trend due to three reasons.
1) Expansion of Traditional Functions: Traditional functions mainly include defense,
administration of justice, maintenance of law and order and provision of social overheads. The
coverage and variety of such functions have gradually increased. Defense expenditure has
expanded rapidly because of a change in military arts and sciences. Defense outlays on men,
materials and maintenance have been on a rising trend in modern times. Similar is the case with
expenditure on internal protection and administration.
2) Coverage of New Functions: The activities of the state were increasing in their coverage.
Traditionally the state activities were limited to only defense, justice, law and order, maintenance
of the states over heads etc. But with the growing awareness of its responsibilities to the society,
the governments started expanding its activities in the field of various welfare measures to enrich
the cultural life of the society. Along with this new welfare programs were designed to provide
social security to the people. This required increasing government expenditure on education,
public health, low cost housing, subsidized provision of food, agricultural inputs, old age
pension, sickness benefit etc.
3) Expanding Sphere of Public Goods: Almost all modern democratic governments have
increasingly recognized the need to provide and expand the sphere of public goods. The need and
necessity to provide social and merit goods through budgetary allocation was increasingly
recognized by the modern state. The state was trying to shift the composition of national product
more in favor of public goods. As a result state activities expanded to areas like irrigation and
flood control projects, construction and maintenance of public parks, provision of education and
health care facilities, creation of economic overhead capital etc., Provision of these public goods
and merit goods means heavy investment in public enterprises.
6.3) Criticisms of the Hypothesis:
It Lacks comprehensiveness in analysis Wagner’s law lacks comprehensiveness. Political
science, economics and sociology are among the several disciplines to be incorporated in any
theory of public expenditure. The Wagner’s hypothesis excludes all these characteristics.
It is based on an organic self-determining theory of the state, which is not the prevailing theory
of the state in most western countries.
The theory ignores the influence of war on governmental spending, and it stresses a long term
trend of public economic activity, which tend to overlook the significant ‘time pattern’ or
process of public expenditure growth.
7.1) Peacock and Wiseman Hypothesis:
Another hypothesis regarding the growth of public expenditure was put forth by Peacock and
Wiseman, in their empirical study of public expenditure in U.K. for the period 1890-1955.
Peacock and Wiseman emphasize the time pattern of public spending trends rather than striving
for a genuine positive theory of public sector growth. The main thesis of the authors is that
public expenditure does not increase in a smooth and continuous manner, but in jumps and jerks
or step like fashion. Their analysis involves three related elements: 1) Displacement effect. 2)
Inspection effect. 3) Concentration effect.
At times, some social or other disturbance takes place, creating a need for increased public
expenditure which the existing public revenue cannot meet. In absence of dire needs and
sufficient pressure earlier, the revenue constraints were dominating, guiding and restraining the
growth of public expenditure. Now under changed requirements due to social, economic or other
disturbances, such constraints are done away with. Fiscal activities of the government rise step
by step to successive new higher level during the span of decades to meet successive social and
other disturbances. The Public expenditure increases and makes the inadequacy of the present
revenue quite clear to everyone.
1) Displacement effect: When a social disturbance occurs, the government raises taxes to
increase revenue and increases public expenditure to meet the social disturbances. This creates a
displacement effect by which low taxes and expenditures are replaced by higher tax and
expenditure levels. The movement from the older level of expenditure and taxation to a new and
higher level is the displacement effect. However, after the disturbance ends, the people get used
to the newly emerged level of tax tolerance and makes the people willing to support higher level
of public expenditure. As a result, the new level of public expenditure and public revenue
stabilize but are soon destabilized by another new disturbance which causes another
displacement effect.
2) Inspection effect: The inadequacy of the revenue as compared with the required public
expenditure creates an inspection effect. The government and the people review the revenue
position and need to find a solution of the important problems that have come up and agree to the
required adjustment to finance and thus increases expenditure. They attain a new level of tax-
tolerance. They are now ready to tolerate a greater burden of taxation and as result the general
level of expenditure and revenue goes up. In this way the public expenditure and revenue get
stabilized at a new level till another disturbance occurs to cause a displacement effect.
3) Concentration effect: When an economy is experiencing economic growth there is a tendency
of central government`s economic activities to grow at a faster rate than that of state and local
government`s activities. This is known as concentration effect. It is related to the political set up
of the country. Thus, each major disturbance leads to the government assuming a larger
proportion of the gross national activity. The concentration effect also refers to the apparent
activity to grow faster than that of those state and local level governments.
