aic public finance 01 the beauty of the market

8/14/2019 AIC Public Finance 01 the Beauty of the Market

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Public Finance: An analysis of market failureChapter 01: The beauty of the market: An introduction

CENTRAL THEME OF PUBLIC FINANCE

When do we give up decisions made in a market setting and decide to rely on decisions made forus by the government or another similar institution? This is the central question asked in

public finance. The analytical framework within which we seek to answer this questionis the market. To appreciate this central question of public finance, we need toappreciate the market. When will we be happy with the market? Economists are happywith the market when the following two hold:

a. Efficiency andb. Equity

If markets fail to achieve the above two objectives, efficiency and/or equity, we mayneed to evaluate replacingprivate individual decisions made in the market withpubliccollective decisions made by the government or a similar institution. This is the central

theme of public finance.

CHARACTERISTICS OF A FREE MARKET TRANSACTION

AMarketis an institutional arrangement where buyers and sellers meet to exchangegoods and services. AMarket Economyis an economic system in which decisions onthe allocation of resources are made by prices generated by voluntary exchange betweeneconomic agents. Production and consumption decisions under such a system aredecentralized. Market forces (demand and supply) determine resource allocation.

The free market can be characterized by the following:

a. Voluntary exchangeb. Excludability andc. Rivalrous consumption

Goods exchanged under the above criteria are termed as private goods.

VOLUNTARY EXCHANGE: Under the free market, economic agents (consumers andproducers) enter into transactions that arent based on compulsion (force, pressure). Theeconomic agent decides whats best for him/her and their objective is optimization, i.e.,to maximize utility or minimize expenditure (consumer) or maximize profit or minimizecost (producer, firm).

EXCLUDABILITY: Voluntary exchange and scarcity implies that one economic agentsconsumption will exclude the consumption of another economic agent.

Asrarul Islam Chowdhury; 01819-219050; 02-9660394; [email protected] Page 1 --


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If X is the total amount of available endowment and there are n individuals, then eachindividual consumes in different quantities.

X1 X2 Xi (1.1)

where, i = 1,2,3, , n, and therefore,

Xi = X1 + X2 + + Xn (1.2)

Equation (1.1) is a strong restriction because there could exist some consumers whoconsume the same amount of X. For example, it could be that most of the n individualsin a set consume different amounts of X (Equation 1.1), but individuals 4 and 7 consume

the same amount, i.e., X4=X7; or X9=X11 etc. To avoid this occurrence, we assume that

the following will not hold at all.

X = X1 = X2 = = Xi (1.3)

for all i, where, i = 1,2,3, , n, and therefore,

Xi = X1 + X2 + + Xn (1.2)

(1.3) implies that all individuals consume X in the same quantity. We rule out thispossibility. Later, in our discussion on public goods well see it wont be possible to ruleout this possibility.

RIVALROUS CONSUMPTION: Scarcity further implies that one individuals

consumption decision will restrict the consumption decision of other individual(s). Ifthere are n units of a good X available and if one individual (say individual 3) consumes2 units of X then there will be (n 2) units of X available for the other individuals. Thisfurther implies that the additional cost of providing an extra individual the good X is anon-zero positive quantity. If MC is the marginal cost of providing an additional unit ofX to an individual, and TC is the total cost, then

MC > 0 (1.4)

Since scarcity implies that no economic good can be free, (1.4) further implies

TC > 0 (1.5)

The above discussion can also be presented in the following diagram.



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Private Good

Voluntary Transaction

Excludability RivalrousConsumption

X1 X2 Xi MC > 0

and andTC > 0 TC > 0

Table 1.1: Characteristics of a market transaction

THE MARKET AND EFFICIENCY

The analysis of private decisions under the free market in economics can be traced backto the writings of Adam Smith1. In numerous writings, Smith talks of an invisible hand2that guides personal self-interest to outcomes that benefit the society. The individual,while trying to improve his/her own welfare, unknowingly, contributes to benefitingthe overall welfare of the society.

Voluntary market decisions are necessarily beneficial for the individual because if a

voluntary transaction doesnt seem beneficial, the economic agent simply chooses not tobuy or sell. Adam Smith argued that the sum-total of individual decisions wouldultimately benefit the entire society. The social benefit provided by the invisible handcan be identified as efficiency. The invisible hand, however, doesnt promise equity.

Efficiency in a competitive market

Smith didnt provide a formal proof of his hypothesis. Nevertheless, we can illustrateSmiths claim with the help of Figure 1.1. In the figure, MB shows the market demandthat expresses the marginal benefit of buyers willingness to pay. MC shows the marketsupply that expresses the marginal cost of sellers.

1Adam Smith (1723-1790), the founder of modern economics, first studied at Glasgow Universityin Scotland and then at Oxford University in England. He then returned to Glasgow to take up aprofessorship in logic. The next year, Smith accepted a professorship in moral philosophy

2The idea of the invisible hand first appears in The Theory of Moral Sentiments (1759), and then inAn Enquiry into the Nature and Causes of the Wealth of Nations (1776). The invisible hand has becomea part of the folklore of economics



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In the presence of perfect competition, economic agents are price-takers. They take themarket price to be given.

The decision to buy depends on the following:

P = MB (1.6)

Similarly, the decision to sell depends on the following:

P = MC (1.7)

where, P is the market price.

Price

A MC (Supply)

P E (P=MC)

BMB (Demand)

O Quantity

Figure 1.1: The efficiency of a competitive market

Point E, the intersection of the supply(MC) and demand (MB) curves,reflects the price and quantity at whichbuyers and sellers are willing to makea transaction.

If it can be shown that the outcome atE is efficient then it can be shown thatthe sum-total of market decisions aresocially beneficial.

An outcome is efficient if net social benefit

W = B C (1.8)

where, W = welfare; B = benefit; and C = cost, is maximised

Efficiency to maximise (1.8) requires that a quantity of output be supplied and sold forwhich, the following will hold

MB = MC (1.9)

Theres no other outcome other than E thats mutually beneficial for both types ofeconomic agents. The outcome at point E is therefore necessarily efficient and the area

AEB is the maximal value of W = B C that the market can offer.

As long as the market is at equilibrium at the intersection of the MB and MC curves atpoint E, the outcome is efficient. But what if the market isnt at equilibrium at theefficient point E? Theres no need to be alarmed. Perfect competition assumes that the



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invisible hand will bring the market to point E through adjustment. Once at point E, themarket will stay there.

Price, P

D

P2 S

E

P*

P1

SD

O S1 D1 Q* D2 S2 Quantity

When theres disequilibrium

(shortage or surplus), perfectcompetitive forces make pricetends towards the equilibrium sothat theres no excess demand orexcess supply, i.e., markets clear

Market allocation will tendtowards the efficient (P*, Q*)combination

Figure 1.2: The competitive market adjustment mechanism

Figure 1.2 shows the market adjustment mechanism under perfect competition. In theabsence of efficiency, achieved at point, E, price will tend towards equilibrium (efficient)to clear the market. Price tends to fall when theres surplus and price tends to rise whentheres a shortage.

The equilibrium of a competitive market is efficient. Both buyers and sellers make self-interested decisions applying P=MB for buyers and P=MC for sellers, and the market

adjusts to the equilibrium efficient outcome at point E if not already at equilibrium.Adam Smiths proposal that the market is guided to efficiency by individual self-interest, as if by an invisible hand, is established provided that the decisions are made in acompetitive market and the social objective is efficiency.

In his original statement, Adam Smith didnt use a demand and supply analysis toestablish the virtue of the market. Alfred Marshall (1842-1924) of economics atCambridge epitomised the demand and supply analysis many years later.

PERFECT COMPETITION ENSURES

OPTIMAL (EFFICIENT) ALLOCATION OF RESOURCES

Competition is an effective way to maximize both economic growth and the welfare ofeconomic agents. Perfect competition maximizes economic welfare by definition,because of the assumptions and objectives upon which this type of market is based. Aperfectly competitive market is characterized by the following assumptions:



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a. Many buyers are sellers who can leave the industry at willb. No economic agent is large enough to influence price, i.e., all economic agents

are price-takers, they arent price settersc. Price-taking behaviour implies the demand curve of the firm is infinitely elastic

d. All benefits and costs accrued to economic agents are accounted for, i.e., there areno externalities ande. Buyers and sellers have full information

Based on the above assumptions, perfect competition implies the following:

A perfectly competitive economy is allocatively efficient, because it produceswhere price is equal to marginal cost (P=MC)

Equating P=MC maximizes consumer and producer surpluses

No rearrangement of production or consumption is possible that will increase economicwelfare of all agents at the same time. This is because all consumers and producers facethe same sets of prices. Any reallocation of resources will reduce allocative efficiency ofindividual firms and/or individual consumers. Markets will clear; there will be noexcess demand or excess supply. Were now in a position to define allocative efficiency.

ALLOCATIVE EFFICIENCY: The production of the best or optimal combination ofoutputs by means of the most efficient combination of inputs. Optimal output is definedas the output combination that would be chosen by individual consumers responding inperfectly competitive markets to prices that reflect true costs of production3.

Allocative efficiency: Partial equilibrium analysis

E: MR=MC E: P = MB E: MB=MC=P=AR=MRE: MR=MC E: P = MB E: MB=MC=P=AR=MRE: MR=MC E: P = MB

(a) (b) (c)

The Firm The Consumer The Market

Figure 1.3: The efficiency case for perfect competitionPartial Equilibrium

3No externality; no excess supply or demand; full employment of resourcesAsrarul Islam Chowdhury; 01819-219050; 02-9660394; [email protected]

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Figure 1.3(a) shows a standard diagram for a perfectly competitive firm producing ahomogeneous product in pursuing profit maximization with the usual marginal cost(MC) and average cost (AC) curves. Price is shown on the vertical axis and quantity onthe horizontal axis.

Being insignificant in relation to market size, the firm is a price-taker, unable to exert any

market power on price. The firm can sell all of its output at p1, thus the horizontal price

line. Price, p1 = AR = MR where, AR and MR are average revenue and marginal revenuerespectively. For levels of production, less than q1, MC>MR, the firm isnt maximizingprofits. For output levels more than q1, MC>MR, the firm wont make profits. It willpay to reduce output. Only at q1, is MR=MC, the profit maximizing level of output.

Figure 1.3(b) shows the consumer. The consumer demands more quantity as the price ofthe commodity falls. The slope of the demand curve gives the marginal benefit (MB).MB>p1 for levels of consumption less than p1; MB


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Allocative efficiency: General equilibrium analysis

Figure 1.4: The efficiency case for perfect competitionGeneral equilibrium

For simplicity and to allow the scope of a graphical analysis, we assume that aneconomy produces only two goods, X and Y. X is shown on the horizontal and Y on thevertical axis. Perfect competition results in the economy operating on the boundary ofits Production possibilities frontier (PPF). This is shown in Figure 1.4. The PPF showsall maximum possible combinations of X and Y the economy can produce with itslimited resources.

If all factors were devoted to the production of only one commodity, the economywould produce either at XMAX (all X and no Y), or at YMAX (all Y and no X). Lets assumethe economy produces at N. This would indicate x1 of X and y1 of Y. The slope of thePPF at a particular point is the Marginal rate of transformation(MRT). It denotes the

transformation from one commodity to another. The slope line is also known as thePrice line, which also denotes the relative prices. MRT of X into Y falls as successiveequal amounts of X is sacrificed to produce more Y. The flatter price line in Figure 1.4(a)shows this.

Consumption is shown by the indifference curves in Figure 1.4(b), which uses the sameaxes as Figure 1.4(a). The indifference curves are convex to the origin. This means thatto keep a consumer at constant level of satisfaction an increasing amount of Y must



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compensate for each successive reduction in the consumption of X. This is also knownas the Marginal rate of substitution (MRS)between the two commodities. MRSgradually increases as more and more of X is sacrificed for each successive unit of Y (notshown in the graph).

Corresponding to x1 of X and y1 of Y in Figure 1.4(a), the consumer achieves equilibriumat point W in Figure 1.4(b) on the indifference curve I2. This is the highest possible levelof satisfaction (welfare) the consumer can achieve given the production situation inFigure 1.4(b).

Figure 1.4(c) combines information from Figures 1.4(a) and 1.4(b). It presents a generalequilibrium where the economy produces two goods, X and Y, with two consumers A

and B, with the set of prices, Px for X and Py for Y. This is also known as a 2X2X2

economy. This mathematical technique allows us to show three dimensions in a twodimensional space.

The indifference curves for individual A is shown by Ia1 to Ia3, and those for individualB are shown by Ib1 to Ib3. The indifference curves for consumer A, are read from theorigin O and those for individual B are read from the origin N (or O in some textbooks).As we move away from Origin O, we have higher levels of utility for individual A. Aswe move away from Origin N (or O) we have higher levels of utility for individual B.

The Box Ox0Ny0 is known as the Edgeworth box diagram after the English economistFrancis Edgeworth8 of the Neo-Classical School. The box diagram allows us to combineproduction efficiency and consumption efficiency in one graph. The box is used as atool to explain various phenomena in economics, especially exchange.

Efficiency in consumption requires that the indifference curves of both individuals aretangent to each other as well as tangent to their respective budget lines. This occurs atpoints 1, 2, and 3. Of these equilibria only one corresponds with efficient production atpoint N. This occurs at point 2 where the budget line at point 2 is parallel to the priceline at point N9.

8Francis Ysidro Edgeworth (1845-1926): Professor of Political Economy at Oxford Universityfrom 1891 to 1922. Edgeworths major contribution to economics isPapers Relating to Political

Economy (1925).Edgeworth introduced Indifference Curves, Contract Curves and the boxDiagram in economic analysis. He was a leading exponent of the Neo-Classical School ofEconomic Thought

9Equilibrium could have occurred at the other points. We are assuming arbitrarily that it occursat Point 2 in the absence of exact equations for consumer and producer equilibrium



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Efficiencies defined

Efficiency in production: This occurs when the economy is operating on the boundaryof its PPF. In our example, this occurs at point N with x1 of X and y1 of Y in Figure

1.4(a). For a fixed supply of inputs, its not possible to produce more of one commoditywithout producing less of another. Conversely, its not possible to reduce the use of oneinput without increasing the use of another to produce a given output. At the boundaryof the PPF the MRT of any two factors of production are equal. The equilibriumcondition will be:

MRT = Y/X = Y1/X1 = Px/Py (1.10)

Efficiency in consumption: This occurs when the indifference curve of two consumersare tangent to each other and also to the same budget line. This occurs at Point 2 in

Figure 1.4(c) in our example. It is not possible to increase welfare by altering thedistribution of commodities between consumers. All consumers have the same MRSand so cant further increase their welfare by trading X and Y with each other. Theequilibrium condition will be:

MRS = Y/X = Y1/X1 = Px/Py (1.11)

Total efficiency: The condition for total efficiency is MRS=MRT. Theres efficiency inboth consumption (MRS) and production (MRT). All consumers and producers face thesame set of perfectly competitive prices, thus MRS=MRT has to hold. The parallel price

lines at points N for production and point 2 for consumption in Figure 1.3 (c) show this.

Total efficiency (MRS=MRT) is also known asAllocative efficiency. It describes an Optimalwelfare situation known as a Pareto optimum after the Italian economist Vilfredo Paretowho introduced the concept of Efficiency in economics10.

For a Total optimum to exist, all marginal conditions must be satisfied simultaneously.Figure 1.4 (c) demonstrates this.

10Vilfredo Pareto (1848-1923): An Italian Economist with extensive training in mathematics,physical sciences, and engineering. Pareto was the successor of Leon Walras to the Chair ineconomics at the University of Lausanne in 1892. His major contribution in economics includes

Manual of Political Economy (1906). The concept of efficiency is synonymously used with his name



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The power of the market

Perfect Competition delivers a Pareto optimum through market forces via theinteraction of the so-called Invisible Hand of Adam Smith or theAuctioneerof

Leon Walras Theres no need for planning. Market forces will lead to a Pareto optimum As long as the assumptions of perfect competition (illustrated above) are valid

and the income distribution is acceptable, the market will generate an efficientoutcome thats also equitable

Philosophical and behavioural implications of Pareto optimum

The welfare of the society is the sum total of the welfare of all individuals Each individual is the best judge of his/her own welfare and pursues to achieve

that welfare in his/her own self-interest Economic agents are rational in the sense that they are optimisers Transactions are based on voluntary exchange

The market may lead to an efficient allocation of resources, but this doesnt necessarilyimply that markets will lead to a just, fair or equitable distribution of resources. ThePareto optimum is developed in isolation from social, moral and political considerationsof justice relating to resource endowments. Nevertheless, it provides a powerfulintellectual rationale for competitive markets in lieu of government planning and controlalso known as laissez faire in the Wealth of Nations of Adam Smith, a term Smith inheritedfrom the Frenchphysiocrats11.

THE MARKET AND EQUITY

There are two precise ways to express the social objective of efficiency. First, throughthe net social benefit criterion W = B C and Second, through Pareto efficiency. Theproblem is how to find a precise definition to what we mean by equity because equity isa normative concept. We should elaborate on equity a bit because of the tension betweenefficiency and equity in the study of public finance.

11A school of economic theory that developed in France in the eighteenth century during thetimer ofAdam Smith. Quesnay and Turgot are the two main exponents of this school. The

physiocrats were very critical of the mercantilist school that advocated exports and discouragedimports. They were proponents of the laissez faire the principal of minimal government. Thenotion of laissez faire was later adopted by Smith and has become a part of the folklore ofeconomics



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Equity through actual compensationOne way to express the objective of equity is to insist on actual compensation wheneversomebody loses from a public policy. Many disagreements that arise in economics and

politics can be traced to different positions on whether social justice through actualcompensation for losers is required before a government can proceed with efficientpublic policies. Consider the following example.

The government has decided to set up a new airport near Savar that will serve as anannex to Zia International Airport in Uttara, Dhaka. The new airport will generatevarious types of employment opportunities for those related to the aviation industry aswell as those not. However, in order to construct the new airport, the government willhave to acquire land in Savar. This will lead to dislocation of many families who willhave to lose their agricultural and residential land. In this situation, does thegovernment compensate the losers? If yes, by how much? One method could be that

the government compensate the losers (whos welfare would be say Y0). If this were possible, then we could say that by definition such a policy would bePareto efficient.

Equity through competitive marketsDo competitive markets provide incomes that are socially just? Personal incomes earned incompetitive markets are consistent with social justice if we make the assumption thatpeople should be rewarded according to the value of their personal contributions to asocietys output. If we make this assumption then competitive markets are both efficientand equitable (socially just). There are, however, problems with this assumption. If

people are rewarded according to their contribution to the social output, it implicitlyimplies that physically disabled people receive less simply because they contribute less;children and the elderly receive less because they contribute less etc.

Efficient markets can generate unequal income distributions12 that arent desirable.

Economies can end up producing at extreme points like XMAX or YMAX in the above

graphs. These situations lead to arguments that market-generated outcomes can beunjust and that a moral obligation for intervention by the government or any otherinstitution is warranted.

Equity as equalityLets assume there are three families in a community in Savar, Families A, B, and C.Each family has an income of Tk 20,000 per month. Now the government decides tobuild a new airport that will be an annex to Zia International Airport. All three familieswill benefit from this public policy because they all decide to open restaurants to cater

12See the Fundamental Theorems of Welfare Economics



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for the passengers and visitors to the airport. However, after one year from theinauguration of the airport, Family A has an income of Tk 22,000 per month; Family B anincome of Tk 25,000 per month; and Family C an income of Tk 30,000 per month.

The change introduced by the public policy satisfies the efficiency condition becauseW = B C > 0. The public policy is also a Pareto improvement in the sense that the welfareof all families increases without having to affect the welfare of any of the other families.However, the initial situation of equal incomes has been violated because Family Cbenefits more than Family A and Family B.

If the three families cant equally share the benefits of the public policy, or if the benefitsarent transferable among the three families, and if its expected that equity throughequality will prevail, then wed require Family B to give up Tk 3000 per month andFamily B to give up Tk 8000 per month. This could be thought of as taxation where thegovernment (or a similar institution) can tax the Families who have benefited more thanthe others to bring equality in the society. Sometimes governments can tax people whomake windfall gains, e.g., one Family has just inherited the money of a deceased parent,or won the lottery. The government can tax such windfall gains.

Equity and envyLets think of two Farmers X and Y who live in two different villages. Neither of thefarmers owns a cow. Now, Farmer Z returns back to his village after working in theMiddle East for ten years. He has saved some money with which he decides to go toSavar Dairy Farm to buy two Australian cows to set up a small dairy project to producecheese. Now, observe the rather contrasting attitude of the other two farmers.

Farmer X makes a visit to Farmer Zs village and looks at Farmer Z and says to himself:I wish I had such cows. Ill work hard and soon Ill be able to afford a cow like that.

Farmer Y also makes a visit to Farmer Zs village and looks at farmer Z and says tohimself: I wish those cows would die!

The response to inequality of Farmer X is efficient. Farmer X wants to improve hiswelfare without affecting the welfare of Farmer Z. This qualifies as a Pareto improvement.

The response to inequality of Farmer Y is Pareto inefficient. His response doesnt add tohis own possessions, but results in a loss of cows of Farmer Z by wishing for Farmer Zs

cows to die.

FUNDAMENTAL THEOREMS OF WELFARE ECONOMICS

The possibility of a market outcome being efficient, but unfairhas lead to many debateson the possibility of intervening into a free market system. The very nature of the freemarket or laissez faire presumes no government involvement or very minimal



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government involvement. In that case, how do proponents of the free market addressefficiency and equity? One answer was given by the French economist, Leon Walras13.These are known as the Fundamental theorems of welfare economics.

The First Fundamental Theorem of Welfare Economics: Every competitive equilibriumwill be Pareto efficient.

The Second Fundamental Theorem of Welfare Economics: If we arent happy with aparticular efficient allocation (First Theorem), we need not abandon market forces. Theinvisible hand (the auctioneer) will lead the society to a desired allocation thats fair,equitable or just.

Y

YMAX

Y1 N

Allocations like point N (x1 of X and y1 of Y) is efficient andequitable at the same time

Allocations like XMAX and YMAX may be efficient, but they arentequitable since theres a full allocation of one commodity and zeroof the other

The Second Fundamental Theorem states that if a society achievesan allocation like XMAX or YMAX market forces will take the societyto an equitable allocation like N without intervention

O X1 XMAX XFigure 1.5: Market efficiencyNot all efficient outcomes are equitable

Implications of the welfare theorems

The First Theorem implies that market forces will generate an efficient outcome

The implication of the Second Theorem is that market forces will take theeconomy to any desired efficient allocation that seems equitable (just or fair)

The implication of the Theorems together is that theres no role for the government inresource allocation. The market will solve both efficiency and equity problems of asociety. The Fundamental Theorems are based on perfectly competitive markets, whichin turn are based on a set of restrictive assumptions. The Theorems are also developedin isolation from common ethical and moral values of societies. In theory, the theoremsare great; in practice, almost impossible to implement if things do go wrong.

13Leon Walras (1834-1910), born in France, Walras was the first holder of the chair in politicaleconomy at the university of Lausanne in Switzerland. Walras is famous for two majorcontributions. First, his independent development of the concept of marginal utility that lead tothe birth of the Neoclassical school, and Second, his greater claim as the original developer of

general equilibrium. Such was the influence of Walras that Joseph Schumpeter, wrote in his Historyof economic analysis in 1954, Walras is in my opinion the greatest of all economists



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PARETO EFFICIENCY REVISITED

A situation is defined as Pareto Efficient,Pareto Optimum or simply Efficient if in order toincrease the welfare of one agent (party) the welfare of at least another agent (party) is

affected. When an economys resources and output are allocated such that a reallocationmakes one agent (party) well off only at the cost of at least another agent (party), then aPareto Optimum is said to exist. The Italian economist Vilfredo Pareto first proposed theconcept. Efficiency and Pareto efficiency are synonymously used in economic literature.The concept is widely used in public finance and public choice. It may therefore pay tolook back on its various dimensions.

In Figure 1.6, we use a PPF to illustrate the notion of Pareto efficiency. Two goods X andY are produced in an economy; X is shown on the horizontal and Y is shown on thevertical axis.

Y

Y1 M

Y2 N

O X1 X2 X

Figure 1.6 (a): Pareto efficiency

XY;YX

Any allocation on the boundary ofthe PPF qualifies as a Paretoefficient allocation because we canincrease the allocation of one good(X or Y) only at the cost ofreducing the allocation of the othergood (Y or X)

This implies that points within theboundary of the PPF are Paretoinefficient

In Figure 1.6 (a), the economy starts off at allocation M with X1 of X and Y1 of Y. Points

on the boundary of the PPF like M are efficient. If the economy wants to move to anotherpoint on the boundary of the PPF like N then this would mean that allocation for X will

increase from X1 to X2, but this happens at the cost of reducing allocation for Y from Y1

to Y2. This phenomenon qualifies are Pareto efficient from the definition above.

If we move the opposite way from allocation N to allocation M (not shown in Figure

1.6(a))on the boundary of the PPF, well see that N is also efficient because in such amove the allocation for Y increases from Y2 to Y1, but at the cost of reducing allocation

for X from X2 to X1.



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THHTH

Y

Y

Y2N

Y1M

O X1 X2 X

Figure 1.6 (b): Pareto inefficiency

XY Y

Y1 M

Y2 N

O X1 X2 X

Figure 1.6 (c): Pareto inefficiency

XY

Figures 1.6 (b) and 1.6 (c) show a Pareto inefficient situation. In Figure 1.6 (b), the

economy initially starts off at allocation M with X1 of X and Y1 of Y. The allocation of Xincreases from X1 to X2 and the economy moves to allocation N with X2 of X and Y2 of Y.

The move from M to N doesnt qualify as a Pareto efficient situation because the welfareof both X and Y can be improved at the same time. This means neither of the two agents(parties) is affected in the move from M to N. This is also known as Pareto improvementas well see in a little while.

The move from M to N in Figure 1.6 (c) is more interesting. It results in a loss for both

sectors from X2 to X1 and from Y2 to Y1. By definition, therefore, this situation cant

qualify as a Pareto efficient situation.

Both situations are Pareto inefficient because theres scope for further improvement inwelfare for both agents (parties). This situation (inefficiency) will continue till theeconomy reaches the boundary of the PPF, which by definition is efficient.

A situation is Pareto inefficient if in a reallocation of resources at least one party is affectedor both parties gain at the same time. The interpretation of this phenomenon is that thereis scope for further improvement. This will continue till the economy reaches anallocation on the boundary of the PPF



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Y

M NY1

O X1 X2 X

Figure 1.6 (d): Pareto improvement

__

X Y Y

Y2 N

Y1 M

O X1 X

Figure 1.6 (e): Pareto improvement

__

Y X

Figures 1.6 (d) and 1.6 (e) illustrate a special type of Pareto inefficient situation known asPareto improvement. A Pareto improvement occurs when its possible to increase theallocation of resources of one agent (party) without affecting the allocation of resourcesof the other agent (party). In Figure 1.6 (d) the economy starts off at allocation M with

X1 of X and Y1 of Y. Keeping the allocation of Y unchanged at Y1, its possible to

increase the allocation of resources of X from X1 to X2. The situation is inefficient in the

sense that theres scope for further improvement as the reader can easily verify. Thissituation will continue until the economy reaches a point on the boundary of the PPF,which by definition is efficient and all further scope for improvement is exhausted.

Figure 1.6 (e) illustrates a Pareto improvement situation for Y from Y1 to Y2 keeping theallocation of X fixed at X1. Similar argument for the movement from M to N.

The situation depicted in Figure 1.6 (b) qualifies as a special Pareto improvement situationbecause by increasing the welfare of one sector (here X) we arent reducing the welfareof the other sector (here Y). Rather, the move from M to N results in an increase inwelfare for both sectors (X and Y).

A situation is a Pareto improvement if the allocation of one agent (party) can be increasedwithout affecting (reducing) the allocation of another agent (party). This Pareto situation is

inefficient because theres scope for further improvement. This continues until when theeconomy reaches a point on the boundary of the PPF when theres no scope for furtherimprovement



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Y

YMAXP

O X

Figure 1.6 (f): Pareto Efficient and Unfair

All Y, No X Y

Q

O XMAX X

Figure 1.6 (g): Pareto Efficient and Unfair

All X, No Y

Efficiency doesnt automatically guaranteean equitable situation. The free market canresult in an unacceptable distribution ofincome (resources) where the economy maybe producing on the boundary of its PPF, butonly one good (Figure 1.6(f) and 1.6(g)), andnone or very little of the other.

A society ventures to be at points like R or S(Figure 1.6(h)) that are efficient and more orless equitable. But the question still remains,which one to choose, R or S?

Y

Y2 S

Y1 R

O X2 X1 X

Figure 1.6 (h): Pareto Efficient and Fair

Both R and S areefficient and fair;which one tochoose finally?

Is efficiency much ado about nothing? Economists are obsessed with efficiency and yet,market outcomes can be efficient and yet not equitable. Look at Figure 1.6 (f) and 1.6 (g).In the first case, the society is on the boundary of its PPF, but producing only Y and noX. The allocation, P, is efficient because any movement along the boundary will result inan increase of X only at the cost of reducing Y. Similar argument holds for Q in Figure1.6 (g) where the economy is again on the boundary of its PPF, but producing only Xand no Y.

Figure 1.6 (h) illustrates a situation that may be acceptable in the efficiency vs equitydebate. Here the economy is on its boundary at point R producing X1 of X and Y1 of Y.

Since the point is on the boundary, it is efficient. Both X and Y are being produced in anacceptable quantity therefore it may qualify as equitable. Unfortunately, the situation isntas easy as it appears on the surface! The question still remains, which efficient andequitable allocation does the society choose? R or S?



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EFFICIENCY AND EQUITYReally, much ado about nothing!

In the beginning, we mentioned the name of Sir Hugh Dalton, who probably gave the

best definition of public financePublic finance lies in the borderline between economics andpolitics. A blend of economics and politics makes the study of public finance and alsopublic choice so much interesting and challenging. And this is where the notions ofefficiency and equity enter and why we have spent so much time on the two concepts.

The definition of efficiency is precise. It doesnt involve a value judgement. A situationis efficient if by increasing the welfare of one agent we have to reduce (affect) the welfareof another agent. The definition of equity isnt that straight forward. Whats equitable(just, fair) to one agent may not be to another. Weve defined the situation in Figure 1.6(h) as an ideal situation societies venture after. But is it that easy and straight forward?

A public policy usually results in a change in the distribution of resources (income). If apublic policy benefits the welfare of one agent (party or sector) its likely to affect thewelfare of another agent. Assume that the government decides to pursue a policy topromote primary education of rural children with special emphasis on girls. Theargument is easy and straightforward. Primary education, especially to girls, willbenefit this generation and also the next because like Napoleon Bonaparte said,give mean educated mother and Ill give you an educated nation! How do you think the exponents ofthe primary health care sector will react? If the health ministry has enoughpolitical cloutit may be able to divert resources from the education sector to benefit itself. Thisresembles the second case in Equity and envy where Farmer Y wished for the death of thecows of Farmer Z.

The final decision of policy makers is usually a political decision. It doesnt necessarily implythat economic analysis will converge with political analysis. In Figure 1.6 (h) both R and S areefficient and equitable, but R indicates more resources for one sector (X) and S indicatesmore resources for the other sector (Y). Which policy will the government or any otherinstitution adopt? Who does the government or another institution benefit at the cost ofthe other? Do the loosers get compensated? This is where economic analysis endsboth R and S and efficient and equitable, therefore desirable. A political analysis isrequired to try to answer why or why not the final decision went in favour of R (or S forthat matter).

The political dimension in public finance and public choice further implies that justbecause a market generates an inefficient or inequitable outcome doesnt necessarily meanthat the government (or a similar institution) will intervene to correct the situation. Thedecision to (or not to) intervene involves politics more than it does economics. Itsbecause of this feature that Public finance lies in the borderline between economics andpolitics.



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THE PRIVATE COST OF PUBLIC FINANCE

Markets and public finance are distinguished by private and public spendingrespectively. Public spending can be financed by taxes, government borrowing or

through the sale of bonds. Governments can also finance public spending throughinflationary finance simply by printing money. In many countries, lotteries providegovernments with revenue. Economics is the science of scarcity. Theres an opportunitycost and trade off to decisions we make. Public finance ultimately places a burden ofpayment on private individuals. Taxes are current obligations to pay money to thegovernment. Government bonds (e.g., savings certificates issued by the post office inBangladesh) will require future taxes to enable the government to repay the pastborrowing and pay for the interest on the loans that people made to the government.Inflationary spending reduces the value of money and other nominal assets privateindividuals hold. Lotteries take advantage of exploiting peoples optimism or their lackof knowledge of understanding expected utility and objective probabilities. Whether we

like it or not, private individuals pay for both private and public spending. In the wordsof Milton Friedman14, there is no free lunch. Its the people who actually and finally payfor all public spending no matter what politicians may make us believe. Governmentsnever give anything to their citizens free. They ensure that a price tag is put on thats tobe paid either today or at some point tomorrow. So much for John Lennonspower to thepeople15!

THE ROAD MAPLOOKING AHEAD

As the course unfolds, youll gradually appreciate whypublic finance lies in between

economics and politics. For the time being, even if you dont understand anything thatfollows, it will still help to give you an idea of the long and winding road16 that lies ahead.

The beast of the marketMarket failurePerfect competition is great if it works. Unfortunately, they dont work in reality. Infact, perfect competition has remained a textbook case against which the performance ofother markets is evaluated. If markets fail to do what theyre supposed to, i.e., achieve

14Milton Friedman, the 1976 Nobel Prize winner in economics. A leading exponent of theChicago School, Friedman was instrumental in developing the notion of human capital. Hisanalysis on the consumption function lead to the formulation of the permanent income

hypothesis. Friedman was also instrumental in formulating the natural rate of unemployment.He also contributed to the development of the quantity theory of money, the Fisher equation andother aspects that later laid the foundation to the monetarist literature in macroeconomics

15Power to the People is a John Lennon song that inspired and was inspired by the civil rightsmovement in the USA during the 1960s

16The Long and Winding Road was written by Paul McCartney and features in the last BeatlesAlbum, Let It Be published in 1970 just before the group disbanded



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efficiency and/or equity its still not a matter of worry if the good is something that thesociety doesnt value highly. But what happens if were dealing with primaryeducation, primary health care, roads and highways, or a good thats a necessity forsurvival like drinking water or a necessity for economic activity like electricity and gas?

What happens if the marketfails to produce the amount that the society desires? Underwhat conditions may such a situation of market failure arise? What economicconsequences does market failure inflict on the citizens of a nation?

Now think about other alternative situations. What happens if we find out that marketsfail to provide certain insurance or health care to the poor simply because they cant payfor the costs? How can we stop people from smoking in public places or ensure thatdrivers wear seatbelts or dont talk on their mobile phones when driving?

When markets fail to achieve efficiency and/or equity, an institution has to intervene tocorrect the market failure. Historically, this institution has been the government. Thistopic introduces the basics of market failure and why and where governments intervene.It will also provide an introduction to market failure in the presence of public goods,externalities, natural monopolies and merit goods.

Let there be lightProperty rightsA simple analysis of competitive markets assumes thatproperty rights are given. Propertyrights determine ownership and create the institutional infrastructure for economicagents to make voluntary transactions. Property rights are also known as the Rule of Law.The functioning of a market economy presupposes that the government will oversee therule of law, but doesnt determine the rule of law. In this way, the government acts asAdam Smiths invisible hand or as the auctioneerof Leon Walras. In discussing the above,

this section will briefly try to establish that in the absence of the rule of law, economicagents find an incentive to be appropriative rather than beproductive. How can suchinefficiencies be resolved? This section presents a brief answer to this question.

Market failure and public goodsPrivate goods exhibit excludability and rivalry in their consumption. In 1954, a younggraduate from Chicago, Paul Aaron Samuelson17, who later went on to win the 1970Nobel Prize in economics, observed that there are some goods, which arent free, butonce theyre produced they can be provided to more consumers at no additional cost.Samuelson termed such goods aspublic goods. Markets fail in the case of public goods

because public goods violate the excludability and rivalry properties of a private good.

17Paul A Samuelson (1915- ), professor at the MIT, USA and the 1970 winner of the Nobel Prizein economics for raising the general analytical and methodological level of economic science withthe aid of mathematical tools. Samuelsons contribution to economics is vast. In public finance,Samuelson introduced and coined the now widely used notion of public goods and determinethe optimal allocation of resources in the presence of both private and public goods



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Violation of rivalry implies that P=MC=0 for public goods! Some consumers cantherefore afford the luxury of consuming public goods without having to pay for them,therefore, bypass the price mechanism. If this can be the case, then how do we or howcan we providepure public goods? This question will be addressed in this section.

Not all goods arepure public goods. Most goods exhibit mixed characteristics of pureprivate goods and pure public goods. These goods are known as impure public goods.One of these impure public goods is known as club goods. The name of another NobelPrize winning economist, and one of the finest brains in economics, is associated withthe development and formulation of club goods, James M Buchanan18. This section willalso look into features of club goods in detail.

Market failure and externalitiesA crucial assumption of perfect competition is that all benefits and costs are accountedfor. In reality, this is a very strong assumption because the economic decisions of agentsusually spill overto the neighbourhood of other agents. For instance, consider a situationwhere a smoker smokes in a non-smoking zone; I dont receive any compensation frommy neighbour, not even 100gm of honey from his beehive because his bees collect pollenfrom the roses in my garden; a steel firm doesnt have to worry about the waterpollution it creates that results in a loss of agricultural output for farmers livingdownstream etc. In all these examples, economic agents arent accounting for all thebenefits and costs that are being spilled overto the neighbourhood of other economicagents.

External effects can be either positive or negative. They arise because imperfectlycompetitive markets fail to account for all costs and benefits. Depending on the scale of

the external effect, various economists have proposed various solutions to solve thisspecial type of market failure. In discussing externalities well come across the works ofeconomists like Arthur Pigou19, Ronald Coase20, and Roger Hardin21 and whatinstitutional market intervention they proposed.

18James M Buchanan (1919- ), professor at the George Mason University, USA and winner of the1986 Nobel Prize in economics. In the 1960s, Buchanan got disenchanted with traditionaleconomic theory because there was no satisfactory explanation of how economic decisions aremade in the public sector. Influenced by Knut Wicksells voluntary exchange model, Buchananviews the political process as a means of co-operation to achieve reciprocal advantages. Theoutcome of this process depends on the rules of the game where these constitutional rules lead to

predictable and predetermined outcomes. Buchanan is one of the Nobel among the Nobels becausehe almost single-handedly established a new branch in economics now known aspublic choice

19Arthur Cecil Pigou (1877-1959), English economist from Cambridge, UK. Pigou extended thework of another Cambridge economist, Alfred Marshall (1842-1924). Pigous contribution inpublic finance lies in his distinction between private and social costs that arise due to thepresence of externalities. Pigou suggested taxes as a corrective measure, which is known as thePigovian Tax



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Market failure and natural monopoliesCompetitive pricing requires that P=MC condition will hold. The neoclassical theory of

the firm further assumes that the Long Run Average Cost (LRAC) Curve is U-shaped.However, in certain industries, P=MC cant hold unless a loss is incurred (puremonopoly). Elsewhere, the LRAC falls over a certain range of output. In suchindustries, its more efficient to have a single producer rather than numerous producers.John S Mill22 first made this observation. Such industries are known as naturalmonopolies. This type of market failure can be a major problem because the utilityindustry (water, gas, electricity) usually exhibits characteristics of natural monopoly.One way to solve the market failure is for the government to become a direct producerand absorb losses because water, gas, electricity and the like generate positive externaleffects elsewhere in the economy. Another way is to develop pricing strategies thatcontribute to cost recovery. A final strategy would be to involve the private sector toparticipate in service delivery. This section discusses the economics of naturalmonopolies and touches on the political economy of privatisation and nationalisation ofnatural monopolies, especially in the utility industry.

Market failure and taxationTaxes are involuntary payments made to the government or a similar institution with noexpectation of anything in return. This very definition contradicts the voluntary natureof a market transaction and points to one kind of market failure. At the same time, taxesare an unavoidable aspect of government activity because governments require funds(revenue) to finance their expenditures. In this backdrop, what economic features do

20Ronald H Coase (1910 -), British born economist who was educated at the London School ofEconomics (LSE), but worked for most of his life at Chicago, USA. Coase won the 1991 NobelPrize in economics for his seminal work in the theory of the firm in the economics of externalities.Coase proposed a hypothesis that externalities do not give rise to market failure if transactionscosts andproperty rights are well defined and well enforceable. In such an instance, a market-likesolution can be found where the involved parties would have an incentive to internalise theexternality

21Roger Hardin was instrumental in formulating the notion that communal property like naturalresources can be subject to market failure. It is difficult to exclude because of the club goodnature of communal property. But then, such goods are prone to congestion that can lead to

market failure. Hardins efforts have been coined as the tragedy of the commons

22John Stuart Mill (1806-1873), an English philosopher and economist. His major contributionlies in synthesising Ricardian economics to present a systematic and complete elaboration ofclassical economics that formed a foundation for the neoclassical school. Mills Principles of PoliticalEconomy (1848) became the standard textbook of economics before it was replaced by AlfredMarshalls Principles of Economics during the end of the nineteenth century only to be laterreplaced by Samuelsons economics



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taxes impose on economic agents? This is the central question that will be addressed inthis section.

Dalton revisitedTextbooks on public finance and public choice usually start with an introduction to theirnature, scope and limitations. I, personally, think that one can only appreciate publicfinance and public choice after studying its core features first. Therefore, thisconcluding section is an appreciation of Daltons definition thatpublic finance lies in theborderline between economics and politics.

FAMOUS LAST WORDS

To finish this introductory piece, public finance can be defined as follows:

Public finance is essentially a study of market failure. Governments orsimilar institutions intervene when markets fail to generate an efficientand/or equitable outcome. Efficiency has a precise definition, but equityis a normative concept that relies on value judgements. Value judgements change from one society to another as well as within thesame society from one time period to another, although similarities canbe traced. Its this normative aspect of public finance that makesgovernments intervene in some cases where and when markets fail toachieve efficiency and/or equity, while turn a blind eye in others. Itsbecause of this feature that the study of public finance lies in the borderlinebetween economics and politics.

This course is designed to make you challenge yourself beyond the narrow boundariesof the classroom. If youve enjoyed and have been inspired by this introductory piece,then a whole world of joy lies ahead not only in the discipline of public finance andpublic choice, but also with benefits spilled overelsewhere in economics!

Bon Voyage!

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