Lecture Six: Public Finance

PART ONE: THE ECONOMIC BASIS

FOR GOVERNMENT ACTIVITY

Chapter 5: Public Choice and Political

Process

Dr. Yara El-Sehaimy

Ya b d e l k h a l e k @ e c u . e d u . e g
 Chapter 5 Outline
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 Government and politics.

 Allocation of recourses between public and private sectors.
 How much government is enough.
 Positive and normative economics.
 Marginal condition for efficiency.
 Market failure.
 Externalities and internalization.
 Types of goods.
 Free-rider problem.
 How are they all interconnected?
 Median voter theory.
 Governments and Politics
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 Public Finance: is the field of economics that studies government

activities and the alternative means of financing government
expenditures.

 In order to understand and analyze the role of government we need first

to understand the following:
 Government expenditures.
 Regulations.
 Taxes
 Investment.
 Consumption.
 Borrowings.

 Government is an organization formed to exercise authority over the

actions of people who live together in a society and to provide and finance
essential services.
Allocation of Resources between Government
and Private Sector
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 Government supply goods and services, right?

 To make such goods and services, government requires labor,

equipment, buildings, and land, which are the factors of production
that the private sector needs too.

 So, the question now is, how we are going to allocate the factors of
production between public and private sector?

 This trade off could be illustrated by the Production Possibility Frontier

PPF.
Allocation of Resources between Government
and Private Sector
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 Government Goods and services
such as roads, schooling, and fire
protection, usually are not sold in
markets.

Government Goods
 Private goods and services such as
A D
food and clothing, usually made
available for sale in markets.
B

 Recourses are either used in public

or private sector. C

 A &B Efficient points. Private Goods

 C inefficient
 D unattainable
Allocation of Resources between Government
and Private Sector
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 As long as the economy is on the
PPF line; therefore, the economy is
at equilibrium.

 In which, scarce recourses are

Government Goods
A
efficiently allocated based on the
market benefits and preference.
B
 If the economy moves from A to B,
it will still be efficient but with
more recourses allocated to the
private sector than the public one.
Private Goods
How Much Government is Enough?
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 One reason we demand government services is that in many cases it provide us

with items that can’t easily make available for ourselves or purchase from
others in markets.

 Government power is extracted through establishing rules that regulates the

social interactions among individuals and to settle disputes among citizens.

 Government use their power to redistribute income and economic

opportunities among citizens through tax brackets, income support,
unemployment transfers, stabilize economic performance, regulate production
and consumption.

 Government provide goods and services that the market/private sector fails to
supply.

 Therefore, government should interfere as long as there is a market failure.

How Much Government is Enough?
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 In order to analyze the role of the government, we need to set a ground

based on which our analysis could take place.

Economics

Positive “is” Normative “should”

 Marginal Condition for Efficiency
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Efficiency = Marginal Social Benefit (MSB) - Marginal Social Cost (MSC)

Producing a • Extra benefit obtained by • The minimum sum of money
desired making one more person satisfies required to compensate the
result with a by using one extra produced unit. producers for making one extra
minimum unit.
of effort or • MSB = ∆TSB/ ∆Q
expense • MSC = ∆TSC/ ∆Q

 So, what is the condition for efficiency?

 Efficiency attained when:

MSB = MSC

 What happened when MSB>MSC or MSC>MSB?

 MarketMarket
Failure
Failure Types
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Concentrate Asymmetric
Externalities Public Goods
Market Power Information
 Externalities Types
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Externalities
Positive
 Are benefits to 3rd parties other
than the buyers or the sellers of a good
or service not reflected in prices.
Buyers and sellers of goods that
results in +ve externality do not
consider the fact that each unit
produced provided benefits to others.
Negative
 Are costs to 3rd parties other than
the buyers or the sellers of a good or
service not reflected in prices.
Buyers and sellers of goods that
results in -ve externality do not
consider the fact that each unit
produced provided damage/ cost to
others.
Internalization of Negative Externality
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Private + Social Cost

Price
Private Cost

P’*
P*

Demand

Q’* Q* Quantity

Taxes
Give me 1 example of negative Externality?
Internalization of Positive Externality
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Price
Supply

P’*
P*

Private + Social Benefit

Private Benefit

Q* Q’* Quantity

Subsidies
Give me 1 example of Positive Externality?
 How Goods are Classified?
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 In order to understand public goods market failure, we need to

understand first how goods are classified.

 We classify goods based on many factors such as:

 Based on income.
 Based on relative goods.
 Based on benefit.
 Based on social gain.
 Rivalry and excludability.

 Let’s understand each type!

How Goods are Classified? –Rivalry & Excludability-
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Characteristic
Rival Non-Rival

Excludable Common Resource

Private Goods
Goods

Non-Excludable
Club Goods Public Goods
 Free-Rider Problem
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 A free-rider is a person who seeks to enjoy the benefits of a public good

without contributing anything to the cost of it.

 The free-rider problem evolved from the incentive people have to enjoy
the external benefits financed by others, with no additional cost applied
to them.

 There aren’t penalties of free-riding behavior, so why not doing it.

 What makes free-rider strategy succeed is that few people apply it; but
if it turned to be a collective action, all the society will be worse off.
 How are they all interconnected?
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 Democracy  Voting  Constitution  Political Parties  Politics 

Government and Presidency  Affect Everything!!

 Choice of taxes, subsidies, expenditures, laws, public goods,

externalities, interfering in the market, etc.

 Who controls it all? CITIZENS through voting!

 Citizens always choose the candidate that decreases their total cost.

 The main voting mechanism used is majority role (50%+1).

 Median Voter Theory
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 Under the majority voting role.

 Median voter is the one whose most preferred outcome is the

median/average of the most preferred outcomes of all those voting.

 Within majority-rule voting systems, the results of the voting will

depend on the preferences of the median voter.
 15 Minutes
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 Let’s talk economics 

 Could you identify a +ve and –ve externalities in the Egyptian

economy?

 Identify 5 public goods in the Egyptian economy.

 Do you think Egyptian policy makers follow positive or normative

economics in decision making?

 Do you think efficiency condition is achieved in the Egyptian economy?

 Thank You!
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!SIX LECTURE DOWN SIX TO GO!