Public Finance

Lecture 2

Economic Systems and Allocation of Resources

 Main Points

• Types of Economic Systems

• The allocation of Resources between Government and
Private Use
• How Government Goods and Services are Distributed?
• How much Government is Enough?

2
1. Types of Economic Systems
1. Traditional Economy:

} Is the ancient type of economy in the world. They produce products and
services that are a direct result of their beliefs, customs, traditions,
religions, etc.
} Vast portions of the world still function under a traditional economic
system. These areas tend to be rural, second- or third-world, and closely
tied to the land, usually through farming.

3
2. Planned (Command) Economy:

} Here, a large part of the economic system is controlled by a centralized

power; often the government.
} This kind of economy tends to develop when a country finds itself in
possession of a very large amount of valuable resource(s).
} The government then steps in and regulates the resource(s).
} Often the government owns everything involved in the industrial process,
from the equipments to the facilities.

4
3. Market Economy (Capitalism):

} In a pure market economy, all goods and services would be supplied by

private firms for profit and all exchanges of goods and services would
take place through markets, with prices determined by free interplay of
supply and demand.

} Individuals would be able to purchase goods and services freely, according

to their tastes and economic capacity (their income and wealth), given
the market-determined prices.

5
4. Mixed (Dual) Economy:

} Refers to a mixture of both; market and command economies.

} Here, government supplies a considerable amount of goods and services
and regulates private economic activity.
} The provision of goods and services takes place through political
institutions. This involves interaction among all individuals of the
community, rather than just buyers and sellers—as is the case in market
economy.

6
 Economic What to Produce? How to Produce? For whome to Examples

System produce?

Determined by tradition Determined by traditions For family and tribes. Native Americans who

Traditional from generation to another. and customs. relied on hunting and

fishing before
immigration of
Europeans in 1492.

Determined by government Determined by Determined by  Cuba

Planned officials. government officials. government officials.  North Korea

 China
Determined by individuals Determined by Determined by  Saudi Arabia

Mixed and governments. individuals and individuals and  Egypt

governments. governments.

Market Determined by individuals. Determined by Determined by  USA

7 individuals. individuals.  Canada
 2. The allocation of Resources between Government
and Private Use

} Government provision of goods and services requires labor, capital and land.
Thus, the cost of government goods and services is the value of private
goods and services that must be sacrificed when resources are transferred to
government use.

} When individuals pay taxes, their ability to purchase goods and services for
their own use is reduced. Thereby taxes have indirect costs because they
distort choices.

8
} Taxes also affect prices of goods and services and the incentive to work,
save, and allocate expenditures among goods and services.
} The resources governments obtain are used to provide citizens with
goods and services, such as roads, police and fire protection, and national
defense.These goods and services are shared by all.
} There are also other goods and services provided by government are
limited to certain groups, such as Social Security pensions and public
primary and secondary schooling.

9
The trade-off between
government and private
goods and services can
be illustrated with the
production-possibility
curve (PPC).

10
} The production-possibility curve shows alternative combinations
of government goods and services and private goods and services
that can be produced in an economy.
} The curve assumes that productive resources and technology are
given.
} An increase in government goods from 0G1 to 0G2 (moving
from point A → B along the PPC) requires a sacrifice of X1X2
units of private goods per year.

11
Circular Flow of
Income

12
} The upper and lower loops represent transactions between households and
business firms in markets.
} Households use the income they earn from selling their factors of production
to purchase the outputs of business firms.
} The inner loop represents transactions between households and business firms
with the government.
} Governments purchase productive services from households and outputs of
business firms.
} These purchases are financed with taxes, fees, and charges levied on households
and firms.
13
Examples

Egypt in 2018

14
Examples

USA in 2021

15
Examples

Australia in 2021

16
3. How Government Goods and Services are
Distributed?
} The government (public) goods and services are distributed to
individuals through the use of nonmarket rationing.

} This means that government goods and services are not made
available to persons according to their willingness to pay and
their use is not rationed by prices.

17
} In some cases, the services are available to all, with no direct charge or
any requirements such as the provision of national defense services which
is available to all and not rationed by prices.

} In other cases, criteria such as income, age, family status, residence are
used to determine eligibility to receive benefits.
 For example, Social Security pensions.

18
4. How much Government is Enough?

Government goods and services are demanded for the following

reasons:

1. The government can provide us with items that we cannot easily make
available for ourselves or purchase from others in markets.
 Example; establishing property rights to the use of resources and enforce
contracts.
2. Government power is exerted to establish rules that regulate the social
interaction among individuals and to settle disputes among citizens.
 Example; providing a system of law enforcement and courts.

19
3. Governments also use their power to redistribute income and economic
opportunity among citizens.
 Example, the government uses tax revenues to provide income support for
elderly,unemployed,and poor citizens.

4. Governments stabilize economic fluctuations (the ups and downs of economic

performance through the business cycle) to prevent the waste and unemployment
of productive resources and the undesirable consequences of inflation.

5. Governments regulate production and consumption to achieve such goals as

improved health and the elimination of monopolistic control over prices.
20
 Public Finance

Lecture 3

Efficiency and Markets

1
Main Points

1. The Concept of Economic Efficiency.

2. Positive and Normative Approaches.
3. Pareto Optimality and Efficiency Criterion.
4. Allocative and Productive Efficiency.
5. Equity versus Efficiency.

2
1. The Concept of Economic Efficiency

 Economic efficiency is the benchmark by which both market outcomes and

government intervention are judged.
 Economic efficiency requires all actions to be generating more social benefits than
social costs.
 If this condition is met, then we will have a free market economy with no government
intervention.
 The unobservable market force that helps the demand and supply of goods in a free
market to reach equilibrium automatically is the invisible hand.
 The concept of efficiency is considered to be one of the topics studied under
normative economics.

3
2. Positive and Normative Approaches
Positive Analysis Normative Analysis
 Explains “What is?” without making  Designed to formulate recommendations on
judgments. “what should be?”
 Objective and fact based.  Is subjective and value based (i.e value
 Are able to be tested and proved or judgment).
disproved.  Are opinion based, so they cannot be
 Cause and effect relationship. proved or disproved.
For example, the impact of a widening a  Efficiency is a normative criterion for
road on individuals by reducing the time evaluating the effects of resource use on the
and money costs involved in getting well-being of individuals. (Pareto optimality).
between two locations.
4
3. Pareto Optimality and the Efficiency Criterion

The efficiency criterion is satisfied when resources are used

over any given period of time in such a way as to make it
impossible to increase the well being of any one person without
reducing the well-being of any other person.

5
 The economy will be Pareto Optimal when markets are
perfectly competitive and the economy is in a state of general
equilibrium.
 This also happens when prices reflect economic values.
 When this price system is in equilibrium, the marginal revenue
product, the opportunity cost, and the price of a resource or asset
will all be equal.
 Therefore, each unit of every good and service is in its most
productive use or best consumption use. No transfer of resources
could result in greater output or satisfaction.
6
 Market Conditions for Pareto Optimality
1. All productive resources are privately owned.
2. All transactions take place in markets and in each separate market
many competing sellers offer a standardized product to many
competing buyers.
3. Economic Power is dispersed so that no single buyer or seller can
influence prices.
4. All relevant information is freely available to buyers and sellers.
5. Resources are mobile and may be freely employed in any
enterprise.
7
4. Allocative and Productive Efficiency

a. The Allocative Efficiency:

 Allocative efficiency happens when consumers

maximize their satisfaction and producers maximize
their profits.
 Allocative efficiency requires two different types of
efficiency →

8
 1. Efficiency in consumption:
 Allocative efficiency happens when consumers get the maximum possible
satisfaction from the current combination of goods and services produced and
sold.
 In other words, the level of satisfaction that consumers receive will not increase
even if the consumers change their pattern of consumption and buy different
quantities of goods and services.
2. Efficiency in specialization and exchange:
 Allocative efficiency requires efficient markets where firms specialize in producing
and selling the products that they can produce with minimum cost to maximize
their profits.
9
• The consumer surplus is the net
benefit (satisfaction) that
consumers obtain from a good.

• This is represented graphically by

the triangular area BCD.

• Producer surplus measures the difference between the market price and the
minimum amount of money that producer would accept for the product.

• This is represented graphically through the triangular area ABD.

10
 The combination of both these types of efficiency results in allocative
efficiency.
 Allocative efficiency will be increased as long as doing more of something
results in a greater marginal benefit to society than marginal cost.
 As long as this process continues, allocative efficiency will increase.

The optimum level of allocative efficiency is determined when:

marginal benefit = marginal cost.

11
b. The Productive Efficiency:

 Productive efficiency occurs when the available factors of production are

allocated between products in such a way that it is not possible to reallocate
the production factors to raise the output of one product without reducing
the output of another product.

12
 There are many situations in which it is possible to raise the total
output in an economy by simply reallocating factors of production
at no additional cost (i.e. if the factors of production were
misallocated).
 This is because factors of production are more productive in some
uses than they are in others.
 In a perfectly competitive economy, producers continue reallocating
factors of production until they are reach their most productive
use.
 Example: reallocating labor from agricultural to industrial sector.
13
5. Equity versus Efficiency

 The socially efficient level of production or consumption occurs when social

marginal benefit is equal to social marginal cost.

 “Equity” concerns the distribution of resources and is inevitably linked with

concepts of fairness and social justice.

 In the case of efficient market equilibrium, the reallocation of productive

resources to produce goods or services will inevitably hurt someone.

14
 We must distinguish between horizontal and vertical
equity;

 Horizontal equity is achieved when equal people are treated equally.

 Vertical equity is achieved when people are treated fairly along a socio-
economic continuum.

The problem involved with applying criteria of equity is that persons differ in
their ideas about fairness.

15
 Public Finance

Lecture 1

Introduction to Public Finance

 Main Points

1. Defining Public Finance.

2. The Process of Public Finance
3. Components of Public Finance
4. Why public finance is needed?

2
 1. Defining Public Finance
Public finance is the field of economics that studies government
activities and the alternative means of financing government
expenditures. As you study public finance, you will learn about the
economic basis for government activities and the impact of
government expenditures, regulations, taxes, and borrowing on
incentives to work, invest, and spend income.

Public finance = the revenues and expenditures of the government

3
} Governments:
Are organizations formed to exercise authority over the actions of people who live together in a
society and to provide and finance essential services. Many citizens and resources are employed in the
production of government services.
} Individuals:
They pay taxes and are also recipients of income financed by those taxes.
o For example, Social Security pensions, unemployment insurance compensation, and subsidies to
the poor are financed by taxes.
o The extent to which individuals have the right to participate in decisions that determine what
governments do varies from society to society according to the political interaction of citizens.
} Political institutions:
o These constitute the rules and generally accepted procedures that evolve in a community for
determining the role of the government and how to finance its activities.
o Through these democratic mediums, individual desires are translated (through voting and
elections ) into binding decisions by the governments.

4
2- The Process of Public Finance

In the narrow sense, public finance is defined only as the

study of income and expenditure of the government.

But the broader view is that public finance also includes the
sources of income and the way of expenditure of various
government corporations, public companies, and quasi
governmental ventures.

5
6
3- Components of Public Finance

1. Public Expenditure
2. Public Revenue
3. Public Debt
4. Public financial administration
5. Public Policy

7
Components of Public Finance
1. Public Expenditure:
It means the spending of the public authorities – central, state and local
governments – either for protecting the citizens or for promoting their social
and economic welfare.

This involves; wages and salaries; subsidies and transfers; expenditure on goods
and services such as infrastructures like road, electricity, telecom, and human
capital accumulation like health and education; interest expenditure etc.

The volume of public expenditure has been growing in all countries because of
the continuous increase in the activities of the state and other public bodies.

8
2- Public Revenue:
} This includes sources of government income.
} Governments generate revenues from:
1. Taxes, such as income taxes, capital taxes, and sales taxes.
2. Commercial revenues as the prices of goods and services supplied
by public enterprises;
3. Adminstrative revenues from tolls, fees and fines.
4. Gifts and grants.

9
3- Public Debt:
} These are obligations of governments to be paid at some future time.
} These debts arise when public revenue falls short of expenditure and government has to
borrow from internal and external sources.
} Public debts can be classified according to;
} (1)Maturity Period: as short-term (less than five years) or long-term (more than five
years).
} (2)The issuer: as direct obligations (issued and backed by the government), contingent
obligations (issued by a governmental corporation or other quasi-governmental body
but guaranteed by the government), or revenue obligation (backed by
anticipated revenues from government-owned commercial enterprises such
as toll highways or public utilities and not by taxes).
} (3)The location: either internal (domestically) or external (held by a foreign jurisdiction).
} (4)The marketability, as negotiable securities (marketable) or nonnegotiable securities.

10
} To accelerate economic development many governments choose to raise funds
through borrowing (debt financing) rather than taxation.
} Debt financing is appropriate when “Tax” financing is practically or politically
infeasible.
} National governments can’t use taxation during war time.
} Local governments can’t use taxation to finance large capital projects such as
highways and schools.
} The level of public debt varies from country to country, from less than 10 % of
the GNP to more than double the GNP.
} Debt financing is believed to have an inflationary effect on the economy and
thus it is often used during economic recessions to stimulate consumption,
investment, and employment.

11
4. Public Financial Administration:

} This includes central and regional public institutions

responsible for; accounting; auditing and budgeting;
supervising local government finances; tax administration;
tax collection; administration of employee – retirement
systems; debt and investment administration; and the like.

} All these require an efficient, energetic and scientific

management to look after the public expenditure, public
revenue and public debt.

12
5. Public Policy:

The main goal of this policy is economic stabilization and economic

growth.
Two main policies:
a. Fiscal policy:
Tools: Government taxation and expenditures.
} Expansionary fiscal policy: Increases in government spending and/or cuts in
taxes; these results in an increase in output.(+ve multiplier effect).
} Contractionary fiscal policy: Cuts in government spending and/or increases
in taxes. (-ve multiplier effect).
13
b. Monetary Policy:
Tools: Money supply and Interest rate.

} Expansionary monetary policy:

↑Ms ↓i
} Contractionary monetary policy:
↓Ms ↑i

14
4- Why public finance is needed?

1. Public Finance determines governments provision of public

goods. Such as roads, military forces,etc.

2. Citizens would not voluntarily pay for these services, and

therefore businesses have no incentive to produce them, that’s
why they are produced by governmnets.

15
3. Public finance enables governments to correct for the effect of
externalities (undesirable effects).
Ex: the effect of pollution.

4. It determines the government transfers to financially disadvantaged

people. Such as social security and pensions.

16