State Budget & Macro Analysis

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prepared by: Pro. Said Ossman
 Chapter Three
Economic Effects of
Public spending

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 contents:
 Introduction.
 Economic effects of transfer payments.
- Economical Transfer Payments.
- Social Transfer Payments.
 Economic effects of exhaustive expenditures.

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 Introduction
 Based on the new concept of public spending, any public spending
(Current / capital, real Expenditures / transfer payments) will cause some
economic, social and political effects in the society.
 In our analysis in this chapter, we will depend on the classification of
public expenditures which are: A- Transfer payments.
B- Exhaustive Expenditures

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 Economic effects of Transfer payments
 Transfer payments are grants and subsidies that the government
provides to individuals or private sector (firms) or institutions, inside or
outside the country without getting any thing in return.
 We can classify transfer payments into two types which are:

Economical Social Transfer

Transfer Payments Payments

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 Economical Transfer Payments
 It includes these grants and subsidies that the government provides to
the private sector aiming at achieving many objectives such as:
 Encouraging the private sector to increase production of certain
necessary goods & services.
 Encouraging the private sector to decrease the cost of production and so
increase production from exported goods.
 Protecting small farmers from decreasing their income by guaranteeing
a minimum price for their production.
 Encouraging the free market to achieve efficiency in allocating resources
in the market of semi-public goods (Positive Externalities).
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 Economical Transfer Payments
 Based on the objective of the economical transfer payments, we can
analyze the economic effects of this type of expenditures as follows:
 Case 1: If the objective of the subsidy is decreasing cost of production,
increasing production of some basic and necessary goods and services,
and decreasing their market prices, especially if the produced goods are
considered inputs for agriculture production to encourage farmers, and
may be the subsidy for final products to decrease its market prices.
 To analyze the economic effects in this case, we can assume the
followings:
 A product is sold in a perfect competition market and produced under
increasing cost of production.
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 Government aims at encouraging production by providing a fixed subsidy

 Economical Transfer Payments
 Based on the objective of the economical transfer payments, we can
analyze the economic effects of this type of expenditure as follows:
 Per unit.
 The elasticity of the supply curve is higher than the elasticity of the
demand curve.
 Determine the expected economic results on consumption, production,
market prices, and consumer welfare.
 From the previous graph, the initial equilibrium is determined at point A,
where equilibrium quantity is at Q1 and the initial equilibrium price is at
p1 60 (this price is considered the price paid by the consumer and
received by the producer).
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 Economical Transfer Payments

Price S1
MC 1
S2
C
65 = p3
A
P1
B

P2 D
z
Quantity

Q1 Q2
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 Economical Transfer Payments
 When the government provides a fixed subsidy per unit for the producer,
this will lead to decreasing cost of production at all production levels, so
the supply curve will shift from S1 to S2. and so, the equilibrium will
move to point B.
 So, after providing the subsidy:
 The equilibrium quantity increases from q1 to q2.
 The equilibrium price decreases from p1 to p2.
 The consumer welfare increases as they consume more and pay less
(increase in consumer welfare = ABP1P2).
 The subsidy per unit = CB.
 Total subsidy = CBP2P3 = 15 * 120 = 1800
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 Economical Transfer Payments
 So, after providing the subsidy:
 The benefit of the consumer from the subsidy = 10 * 120 = 1200
 The benefit of the producer from the subsidy = 5 * 120 = 600

As the elasticity of supply is higher than the elasticity

of demand, so the benefit of the producer will be less
than the benefit of the consumer from the subsidy,
keeping other factors constant.
 When the benefit of the consumer reaches its maximum level and no
benefit for the producer???
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 Economical Transfer Payments
 Based on the previous analysis, we can note that:
 The subsidy will encourage the producer to increase its production, and
as a result, increase the job opportunities.
 Consumers' welfare increases, as they consume more and pay less,
especially if the subsidized good is a necessary one, so this will increase
the real income of consumers. This reflects that the economic transfer
payment has a social dimension.
 On the other hand, if the subsidized product is an exported one, this
subsidy will increase the ability to export sector for competing abroad in
the external markets, which will enhance the balance of payment.

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 Economical Transfer Payments
 Case 2: if we suppose the previous example, but the subsidized product is
sold in a monopolistic market or (monopolistic competition market), and
the marginal cost of production is increasing, so we can expect the
following results:
 Before government subsidy:
 The equilibrium is achieved where, MR = MC, at q1 and the initial
equilibrium price, will be at p1
 After government unit subsidy:
 The marginal cost of production will decrease, and MC curve will shift
right.
 The new equilibrium point will be achieved where MR intersects with
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MC2, at q2 and the new equilibrium price will be at p2.

 Economical Transfer Payments
Price

P1 MC1
p2
MC2
N

G AR (Average Revenue)

Quantity

Q1 Q2
Marginal Revenue (MR)
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 Economical Transfer Payments
 Based on the previous graph, we can conclude that:
 After the government subsidy, the consumed quantity in the market
increases and at a lower equilibrium price, so the consumers` welfare
will increase.
 The benefit of the consumer equal the decrease in the equilibrium price.
 Subsidy per unit = the vertical distance between the initial MC curve and
the shifted one MC2 = NG

The total subsidy = NG * Q2

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  Suppose that education is produced in the competitive market and
its marginal cost is constant at LE 200 per credit hour.
 Before GOV intervention the NO. of enrollment students in a rural
or slums area in Egypt was 2000 students.
 The Egyptian GOV decides to cover 70% of the tuition fees of
education for the household sector, as a result, the number of
enrolled students will increase to 2800.
 According to this data and information answer the following:
 1- Explain graphically and numerically the effects of this subsidy
on citizen welfare (consumer surplus).
 2-Calculate:-A- the change in Students’ welfare.
 B- Total subsidy (the effect on the budget).
 C-The excess burden of this subsidy

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 

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 Economical Transfer Payments
 Case 3: If the target of the government subsidy is protecting the income
of farmers from decreasing lower than a certain level through the idea
of (Guaranteed price).
 So here, the government will pay the difference between the two prices
(The guaranteed price and the equilibrium price in the market), then the
government will interfere in the market and purchase the excess
production that resulted from this subsidy.
 based on the following graph, we can say that:
 The market is a perfect competition market, and the equilibrium point is
determined where S = D, so the equilibrium quantity will be at q1, and
the equilibrium price will be at P1.
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 The guaranteed price that the government set is at P2, so at any price
 Economical Transfer Payments

S1
A D D2
P2
E1
P1 B
P3 Z

D1

Q1 Q2 Quantity
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 Economical Transfer Payments
 That is higher than P2, the government will not interfere in the market,
but if the equilibrium price decrease less than that price, so the
government should interfere by paying the difference.
 Before government subsidy: The demand of the market is D1, the initial
equilibrium price is at p1 and quantity is at q1.
 After government intervention by guaranteed price, so the demand will
be downward sloping until p2, and then the demand will be transferred
to a perfectly elastic demand D2.
 At p2 (that is higher than p1), there will be excess supply in the market
that equals ( AD ), as the quantity supplied will be higher than quantity
demanded.
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 Economical Transfer Payments
 The market after government subsidy:
 The new equilibrium point will be determined where the new demand D2
intersects with the s1 at point D.
 The equilibrium quantity produced in the market will increase to q2,
price paid by consumer will be at p3, but price received by producer is p2,
which means that the government paid the difference as subsidy per unit
which is DZ (p2 – p3).
 So, from the previous graph, we can conclude that:
 As a result of the subsidy, the price received by the producer increases
from p1 to p2, and this encourages producers to increase their
production from q1 to q2, so farmers income increases and so producers
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welfare.
 Economical Transfer Payments
 The market after government subsidy:
 So, from the previous graph, we can conclude that:
 As a result of the subsidy, the price paid by consumers decreases from p1
to p3, this encourages them to increase their consumption from q1 to q2,
which means that they consume more at less price, so consumers`
welfare increases.
 Consumer benefit from the subsidy = BZ (i.e, the decrease in price)
 Producer benefit from the subsidy = BD (i.e, the increase in price)
As a result of this subsidy, producers will be in a better situations, as
they produce and sell more at higher price, so their profit will increase,
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or their loss will decrease
 Economical Transfer Payments

The government subsidy here could

prevent competitive markets from
achieving efficiency of resource use

 Distorting of efficiency where efficiency conditions do not satisfy (MSC >

MSB at q2 )
 The society achieves losses in efficiency that estimated by triangle area
E1DZ .These losses generate as a result of distorting in the resource use
in the agriculture sector.
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 Economical Transfer Payments
 Case 4: If we suppose the same previous example, but the market of the
subsidized product is a monopolistic market (or Monopolistic
competition market).

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 Economical Transfer Payments

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 Economical Transfer Payments
 ** Before subsidy(GOV intervention) :
 The equilibrium point is (E1) where MR=MC, Eq. Q is Q1 =1000 and price
P1= 100.
 ** After subsidy(GOV intervention) :
 The GOV will give the producer subsidies as a guaranteed price=150.
 The New AR is: KZN and the new MR is: KXZN
 The Eq. point will be E2 where MR=MC, and Eq. Q is Q2 =1800 and price
P2= 150.
 ** Subsidy: is the difference between guarantee price (P2) and consumer
price (p3)
 = E2M(70).
 **Benefit from the subsidy:
 1) Producer benefit (Profit) = TR(0P2E2Q2) –TC(0CYQ2)=AREA E2YCP2
 2) Consumer benefit (P) = area YMP3C
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 Economical Transfer Payments
 Case 5: If the target of the government is achieving efficient allocation
od resources in the market of goods that generate positive externalities.
Here the free-market system fails in achieving efficiency, so the
government interferes using “Corrective Subsidy” to achieve
Economic Efficiency in the market (Efficiency Gain).
 Example: we already analyze this case in chapter one (Goods with
positive Externalities), you can study it from chapter one.

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