Public finance (Sem-IV)

Assignment
Name – Anuradha kumari
Roll no. - 19COM8036

Question .1 - Briefly examine

three major functions of
government in a mixed
economy.

Ans. A mixed economic system is a system that

combines aspects of both capitalism and socialism.
A mixed economic system protects private property
and allows a level of economic freedom in the use
of capital, but also allows for governments to
interfere in economic activities in order to achieve
social aims.

Three Main functions of government: -

• Raising taxes: To provide public goods and public
services, the government needs to raise tax.
They can do this in a variety of ways – taxes on
goods (customs duties), taxes on income, taxes
on people (poll tax) and tax on property and
land. The government has to consider the best
way of raising taxes. If the government run a
budget deficit, they will need to raise the
shortfall through borrowing and selling
government bonds.
• Providing public services: Public goods tend to be
not provided in a free market because of the
free rider problem. Therefore, these goods and
services need to be provided by the government.
Examples of public goods include street
lighting, roads and law and order. There are
also public services which are provided
piecemeal in a free market, like education and
healthcare. However, the government may feel
that these merit goods are important for
equality and improving labor productivity.
Therefore, most governments provide some
form of state provided education and health
care.
• Regulation of markets: Adam Smith in ‘Wealth of
Nations ‘noted that in a free market, firms were
often able to create monopoly power. This
enables them to charge excessive prices to
consumers. The government may need to
regulate monopoly power, e.g., prohibiting
mergers or setting price
 limits in natural monopolies (industries like tap
water and railways).
Also, firms may develop monopsony power,
where they are able to pay low wages and
provide poor working conditions for workers. In
this case, the government may need certain
regulations on labor markets, such as minimum
wages, minimum age of working and provide
basic levels of health and safety.

• Reducing inequality/poverty: This can be due to

inherited wealth and opportunity. It can also be
due to monopoly power. The government may
feel the need to ensure everyone has an equal
opportunity, for example providing education so
even those from poor family have the
opportunity to get qualifications. It may also
involve redistributing income from high earners
to low-income earners, progressive taxes such
as higher rate of income tax and providing
means-tested benefits such as income
support/housing benefit and state pensions.

Question 2 ; (a) Write and explain

Second Fundamental Theorem of
Welfare Economics.

Ans.
Compare the two allocations ps (at the lower left-
hand comer of the box) and g (located near the
center). Because ps Ties on the contract curve. by
definition it is Parelo efficient. On the other hand, g
is inefficient. Is allocation ps therefore belter? That
depends on what is meant by better. To the extent
that society prefers a relatively equal distribution of
real income, q might be preferred to ps. even though
q is not Pareto efficient. On the other hand, society
might not care about distribution at all, or perhaps
care more about Eve than Adam. I this case, ps
would be preferred to q.
The key point is that the criterion of Pareto
efficiency by itself is no
enough to rank alternative allocations of resources.
Rather, explicit value
judgments are required on the fairness of the
distribution of utility. To formalize this notion, note
that the contract curve implicitly defines a
relationship between the maximum amount of utility
that Adam can attain for each level of Eve's utility. In
Figure 3.10, Eve's utility is plotted on the horizontal
axis, and Adam's utility is recorded on the vertical
axis. Curve UU is the utility possibilities curve
derived from the contract curve. It shows the
maximum amount of one person's utility given the
other individual's utility level. Point p~s corresponds
to point ps on the contract curve in Figure 3.9. Here,
Eve's utility is relatively high compared to Adam’s.
Point Py in Figure 3.10, which corresponds to pa in
Figure 3.9, is just the opposite. Point corresponds to
point q in Figure 3.9. Because q is off the contract
curve, must be inside the
utility possibilities curve, reflecting the fact that it

is possible to increase one person's utility without

decreasing the others.
All points on or below the utility possibilities curve
are attainable by society; all points above it are not
attainable. By definition, all points on UU are Pareto
efficient, but they represent very different
distributions of real income between Adam and Eve.
Which point is bes1? The conventional way to
answer this question is to postulate a social welfare
function, which embodies society’s views on the
relative deservedness of Adam and Eve. A social
welfare function is simply a statement of how
society's well-being relates to the well-being of is
members. Think of it this way: Just as an
individual's welfare depends on the quantities of
commodities she consumes; society's welfare
depends on the utilities of each of its members.
Algebraically, social welfare (W) is some function
F() of each individual's utility:

We assume the value of social welfare increases as

either U
ADAM
Eve
or U
increases-society is belter off when any of its
members becomes better off.
Note that we have said nothing about how society
manifests these preferences. Under some
conditions, members of society may not be able to
agree on how to rank each other's utilities, and the
social welfare function does not even exist. For the
moment, we simply assume it does exist.
Just as an individual's utility function for
commodities leads to a set of indifference curves
for those commodities, so does a social welfare
function lead to a set of indifference curves
between people's utilities. Figure 3.11 depicts a
typical set of social indifference curves, their
downward slope indicates that if Eve's utility
decreases, the only way to maintain a given level of
social welfare is to increase Adam s utility, and vice
versa.

though point i is Pareto efficient and point ii is not.

Here, society's value judgments, embodied in the
social welfare function, favor a more equal
distribution of real income, inefficient though it may
be. Of course, point ii is preferred to either of these.
It is both efficient and "fair".
Now, the First Welfare Theorem indicates that a
properly working competitive system leads to some
allocation on the utility possibilities curve. There is
no reason, however, that it is the particular point
that maximizes social welfare. We conclude that,
even if the economy generates a Pareto efficient
allocation of resources, government intervention
may be necessary to achieve a "fair" distribution of
utility.
 Q2(b).
Explain in brief the
Samuelson model for attaining
Pareto optimality conditions for
provision of public and private
goods in a general equilibrium
framework, using diagrams.

Ans. Samuelson Rule: -

1.Private Goods: social efficiency is
maximized when the marginal costs are set
equal to the marginal rate of substitution for
each individual
2.Public Goods: social efficiency is maximized when
the marginal costs are set equal to the sum of the
marginal rates of substitution (rather than each
individual’s MRS).
Two goods P
and G Two

individuals A&B

To A: The marginal public good is worth

To B:

Now = Marginal benefit derived from consumption of G.

The social marginal benefit from the next unit of public

good G is
The social MC is the same as before: derived from
the production function of G. .
Efficiency requires

Samuelson Rule (1954)} as opposed

To private good case
This is because the good is nonrival:
 Q 3 . Short notes on reasons for market
failure.

Ans. Reasons for market failure ,

• Market power,
• Externalities,
• Public goods, and
• Incomplete information

Market Power: Market power or monopoly power is

the ability of a firm to profitably raise the market
price of a good or service over its marginal cost.
Firms that have market power are price makers and
therefore, can charge a price that gives them
positive economic profits. Excessive market power
causes the single producer or a small number of
producers to produce and sell less output than would
be produced in a competitive market. Market power
can cause markets to be inefficient because it
keeps price higher and output lower than the
outcome of equilibrium of supply and demand..

Externalities: Anything that one individual does, may have,

at the margin, some effect on others. The price system
works efficiently because market prices convey
information to both producers and consumers. The
actions of either consumers or producers result
in costs or benefits that do not reflect as part of the
market price. Such costs or benefits which are not
accounted for by the market price are called
externalities because they are “external” to the
market. In other words, there is an externality when
a consumption or production activity has an indirect
effect on other’s consumption or production
activities and such effects are not reflected directly
in market prices. The unique feature of an
externality is that it is initiated and experienced not
through the operation of the price system, but
outside the market. Since it occurs outside the price
mechanism, it has not been compensated for, or in
other words it is uninternalized or the cost (benefit)
of it is not borne (paid) by the parties.
Externalities are also referred to as 'spillover
effects', 'neighborhood effects' 'third-party effects'
or 'side-effects', as the originator of the externality
imposes costs or benefits on others who are not
responsible for initiating the effect. Externalities
may be unidirectional or reciprocal.
Externalities can be positive or negative. Negative
externalities occur when the action of one party
imposes costs on another party. Positive
externalities occur when the action of one party
confers benefits on another party. The four possible
types of externalities are:
Negative production externalities
Positive production externalities
Negative consumption externalities, and
Positive consumption externalities

Public Goods: Paul A. Samuelson who introduced the

concept of ‘collective consumption good’ in his path-
breaking 1954 paper ‘The Pure Theory of Public
Expenditure’ is usually recognized as the first
economist to develop the theory of public goods. A
public good (also referred to as collective
consumption good or social good) is defined as one
which all enjoy in common in the sense that each
individual’s consumption of such a good lead to no
subtraction from any other individuals’ consumption
of that good. Once a public good is provided, the
additional resource cost of another person
consuming the goods is ‘zero’. Public
goods are generally divided into two categories
namely, public consumption goods and public
factors of production.

Incomplete Information: . Perfect information

implies that both buyers and sellers have complete
information about anything that may influence their
decision making. However, this assumption is not
fully satisfied in real markets due to the
following reasons.
1.Often, the nature of products and services
tends to be highly complex
2.In many cases consumers are unable to quickly
/ cheaply find sufficient information on the best
prices as well as quality for different products.
Sometimes they misunderstand the true costs or
benefits of a product or are uncertain about the
true costs and benefits.
3.People are ignorant or not aware of many
matters in the market. Generally, they have
inaccurate or incomplete data and consequently
make potentially ‘wrong’ choices / decisions.
Information failure is widespread in numerous
market exchanges. When this happens misallocation
of scarce resources takes place and equilibrium
price and quantity is not established through price
mechanism. This results in market failure.

Question-4
Externalities cause market price to
diverge from social cost bringing about an
inefficient allocation of resources. How
 can we solve this problem with government
interventions?

Ans.

To promote the overall welfare of all members

of society, social returns should be
maximized and social costs minimized.
Otherwise, market outcomes involve
underproduction of goods or services that entail
positive externalities or overproduction in the
case of negative externalities. Governments
have numerous methods to reduce the effects of
negative externalities and to promote positive
externalities.

Government initiatives towards negative

externalities;

1.Direct controls or regulations that

openly regulate the actions of those
involved in generating negative
externalities, and

2.Market-based policies that would provide

economic incentives so that the self-
interest of the market participants would
achieve the socially optimal solution.

Direct controls, also known as command

solutions, prohibit specific activities that
explicitly create negative externalities or require
that the negative externality be limited to a
certain level.

The market-based approaches–environmental

taxes and cap-and-trade – operate through price
mechanism to create an incentive for change. In
other words, they rely on economic incentives
to accomplish environmental goals at lesser
costs.
 The size of the tax depends on the amount of
pollution a firm produces. These taxes are
named Pigouvian taxes after
A.C. Pigou who argued that an externality
cannot be alleviated by contractual negotiation
between the affected parties and therefore
taxation should be resorted to. These taxes, by
‘making the polluter pay’, seek to internalize the
external costs into the price of a product or
activity. More precisely, the tax is placed on the
externality itself (the amount of pollution
emissions) rather than on output (say, amount of
steel). For each unit of pollution, the polluter
must choose either to pay the tax or to reduce
pollution through any means at its disposal. Tax
increases the private cost of production or
consumption as the case may be, and would
decrease the quantity demanded and therefore
the output of the good which creates negative
externality. The proceeds from the tax, some
argue, can be specifically earmarked for
projects that protect or enhance environment.

A tradable permit is a license that allows a

company to release a unit of pollution into the
environment over some period of time.
Each firm has permits specifying the number of
units of emissions that the firm is allowed to
generate. A firm that generates emissions above
what is allowed by the permit is penalized with
substantial monetary sanctions. By allocating
fewer permits than the free pollution level, the
regulatory agency creates a shortage of permits
which then leads to a positive price for
pollution, just as in the tax case. India is
experimenting with cap-and-trade in the form of
Perform, Achieve & Trade (PAT) scheme and
carbon tax in the form of a cess on coal.

A government subsidy is a market-based

approach that changes the price of the product
and allows individual consumers to respond to
those prices and make their own decisions.
Subsidies to consumers of a good with positive
externality will increase the marginal private
benefit of consumption (since individuals now
get paid to buy a good) and increase the
demand for the good.
 gives the same revenue.

Ans. A product tax may be imposed per unit of

product, in which case it is, referred to as a "unit
tax” the product tax may be imposed as a price, in
which case it is referred to as an “ad valorem tax”.
General product or "sales taxes" are necessarily of
the ad valorem form, with a uniform rate applied to a
wide range of products.

Unit Tax -With respect to case l, a tax of u per unit is

imposed, the tax enters as a wedge between the
market price which sellers get and the net price which
they. keep. Since sellers are interested
the net price, they must å higher market price to-
cover their cost. The supply schedule-which
confronts buyers there— fore rises- from SS to S'S',
the vertical distance between the two schedules
being equal to u. Buyers purchase less and quantity
falls to OE, given by the intersection of DD with S'S'.
Market price rises to OF and the net sellers falls to
OK. Since in this example product is produced under
conditions of increasing cost, the net price falls
as quantity declines. Because of this, the market
price rises by less than the tax. Thus, at the new
quantity OE, the market price has risen by BF
whereas the tax per unit of output equals KF. Note
that the introduction of the tax in case I of Figure
15-1 was depicted as a parallel upward shift in the
supply schedule from SS to S'S', which is in line
with the usual practice of imposing the tax on the
seller, who adds tax to net price and keeps only part
of the gross price which he collects. The same
result would be obtained, however, if the tax was
imposed on the buyer, with only part of his payment
going to the seller and the rest to the Treasury. In
this case, the tax may be depicted by a downward
shift in the net demand schedule to the left. With
the supply. schedule now unchanged, the new
equilibrium is set by the
intersection of SS and D TD' at L. The new output again
equals OE
it must now be shown as a change in the demand
schedule. Moreover, since the tax is determined as
a percentage of price, the adjustment is reflected in
a swivel rather than a shift of the schedule. The
demand schedule thus swivels from DD to D'D', with
the amount of tax per unit falling as the quantity
sold rises.
The rate of ad valorem tax commonly expressed- as
the ratio of tax to net price kept by the seller, equals
GL/EL. The new equilibrium at the intersection of SS
and D'D', the price paid by the buyer equals GE, and
the net price received by the seller is LE. The
amount of tax per unit is GL and revenue equals
KFGL.
Note that the ad valorem rate in case Il is chosen so
as to give the same yield as a unit tax of GL. For a
given unit tax u, there is
always an ad valorem rate t such that both give the
same revenue. The relationship between the two rates,
as may be seen from the diagram, depends on the
supply and demand schedules.