Public Finance: An analysis of market failure Chapter 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 for us 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 question is the market. To appreciate this central question of public finance, we need to appreciate the market. When will we be happy with the market? Economists are happy with the market when the following two hold: a. Efficiency and b. Equity If markets fail to achieve the above two objectives, efficiency and/or equity, we may need to evaluate replacing private individual decisions made in the market with public collective decisions made by the government or a similar institution. This is the central theme of public finance.

CHARACTERISTICS OF A FREE MARKET TRANSACTION
A Market is an institutional arrangement where buyers and sellers meet to exchange goods and services. A Market Economy is an economic system in which decisions on the allocation of resources are made by prices generated by voluntary exchange between economic agents. Production and consumption decisions under such a system are decentralized. Market forces (demand and supply) determine resource allocation. The free market can be characterized by the following: a. Voluntary exchange b. Excludability and c. Rivalrous consumption Goods exchanged under the above criteria are termed as private goods. VOLUNTARY EXCHANGE: Under the free market, economic agents (consumers and producers) enter into transactions that aren’t based on compulsion (force, pressure). The economic agent decides what’s best for him/her and their objective is optimization, i.e., to maximize utility or minimize expenditure (consumer) or maximize profit or minimize cost (producer, firm). EXCLUDABILITY: Voluntary exchange and scarcity implies that one economic agent’s consumption will exclude the consumption of another economic agent.

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction If X is the total amount of available endowment and there are n individuals, then each individual consumes in different quantities. X1 ≠ X2 ≠ … ≠ Xi … … … (1.1)

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

ΣXi = X1 + X2 + …

+ Xn

(1.2)

Equation (1.1) is a strong restriction because there could exist some consumers who consume the same amount of X. For example, it could be that most of the n individuals in 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,

ΣXi = X1 + X2 + …

+ Xn

(1.2)

(1.3) implies that all individuals consume X in the same quantity. We rule out this possibility. Later, in our discussion on public goods we’ll see it won’t be possible to rule out this possibility. RIVALROUS CONSUMPTION: Scarcity further implies that one individual’s consumption decision will restrict the consumption decision of other individual(s). If there are n units of a good X available and if one individual (say individual 3) consumes 2 units of X then there will be (n – 2) units of X available for the other individuals. This further implies that the additional cost of providing an extra individual the good X is a non-zero positive quantity. If MC is the marginal cost of providing an additional unit of X 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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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction

Private Good Voluntary Transaction

Excludability X1 ≠ X2 ≠ … ≠ Xi and TC > 0 Table 1.1: Characteristics of a market transaction

Rivalrous Consumption MC > 0 and TC > 0

THE MARKET AND EFFICIENCY
The analysis of private decisions under the free market in economics can be traced back to the writings of Adam Smith1. In numerous writings, Smith talks of an invisible hand2 that guides personal self-interest to outcomes that benefit the society. The individual, while trying to improve his/her own welfare, unknowingly, contributes to benefiting the overall welfare of the society. Voluntary market decisions are necessarily beneficial for the individual because if a voluntary transaction doesn’t seem beneficial, the economic agent simply chooses not to buy or sell. Adam Smith argued that the sum-total of individual decisions would ultimately benefit the entire society. The social benefit provided by the invisible hand can be identified as efficiency. The invisible hand, however, doesn’t promise equity. Efficiency in a competitive market Smith didn’t provide a formal proof of his hypothesis. Nevertheless, we can illustrate Smith’s claim with the help of Figure 1.1. In the figure, MB shows the market demand that expresses the marginal benefit of buyers’ willingness to pay. MC shows the market supply that expresses the marginal cost of sellers.
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Adam Smith (1723-1790), the founder of modern economics, first studied at Glasgow University in Scotland and then at Oxford University in England. He then returned to Glasgow to take up a professorship in logic. The next year, Smith accepted a professorship in moral philosophy

The idea of the invisible hand first appears in The Theory of Moral Sentiments (1759), and then in An Enquiry into the Nature and Causes of the Wealth of Nations (1776). The invisible hand has become a part of the folklore of economics Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 3 --

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

In the presence of perfect competition, economic agents are price-takers. They take the market 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 where, P is the market price. … … … (1.7)

Price A MC (Supply)

P B

E (P=MC)

Point E, the intersection of the supply (MC) and demand (MB) curves, reflects the price and quantity at which buyers and sellers are willing to make a transaction. If it can be shown that the outcome at E is efficient then it can be shown that the sum-total of market decisions are socially beneficial.

MB (Demand) O Quantity

Figure 1.1: The efficiency of a competitive market

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 for which, the following will hold MB = MC … … … (1.9)

There’s no other outcome other than E that’s mutually beneficial for both types of economic 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 at point E, the outcome is efficient. But what if the market isn’t at equilibrium at the efficient point E? There’s no need to be alarmed. Perfect competition assumes that the
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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction invisible hand will bring the market to point E through adjustment. Once at point E, the market will stay there.
When there’s disequilibrium (shortage or surplus), perfect competitive forces make price tends towards the equilibrium so that there’s no excess demand or excess supply, i.e., markets clear Market allocation will tend towards the efficient (P*, Q*) combination

Price, P D P2 E P* P1 S D O S1 D1 Q* D2 S2 Quantity

S

Figure 1.2: The competitive market adjustment mechanism Figure 1.2 shows the market adjustment mechanism under perfect competition. In the absence of efficiency, achieved at point, E, price will tend towards equilibrium (efficient) to clear the market. Price tends to fall when there’s surplus and price tends to rise when there’s a shortage. The equilibrium of a competitive market is efficient. Both buyers and sellers make selfinterested 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 Smith’s proposal that the market is guided to efficiency by individual selfinterest, as if by an invisible hand, is established provided that the decisions are made in a competitive market and the social objective is efficiency. In his original statement, Adam Smith didn’t use a demand and supply analysis to establish the virtue of the market. Alfred Marshall (1842-1924) of economics at Cambridge 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 of economic agents. Perfect competition maximizes economic welfare by definition, because of the assumptions and objectives upon which this type of market is based. A perfectly competitive market is characterized by the following assumptions:

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction a. Many buyers are sellers who can leave the industry at will b. No economic agent is large enough to influence price, i.e., all economic agents are price-takers, they aren’t price setters c. 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 are no externalities and e. 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 produces where 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 economic welfare of all agents at the same time. This is because all consumers and producers face the same sets of prices. Any reallocation of resources will reduce allocative efficiency of individual firms and/or individual consumers. Markets will clear; there will be no excess demand or excess supply. We’re now in a position to define allocative efficiency. ALLOCATIVE EFFICIENCY: The production of the best or optimal combination of outputs by means of the most efficient combination of inputs. ‘Optimal output’ is defined as the output combination that would be chosen by individual consumers responding in perfectly competitive markets to prices that reflect true costs of production3. Allocative efficiency: Partial equilibrium analysis
E: MR=MC E: MR=MC E: P = MB E: MB=MC=P=AR=MR

(a) The Firm

(b) The Consumer

(c) The Market

Figure 1.3: The efficiency case for perfect competition—Partial Equilibrium

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No externality; no excess supply or demand; full employment of resources Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 6 --

Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction Figure 1.3(a) shows a standard diagram for a perfectly competitive firm producing a homogeneous 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 on the 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 revenue respectively. For levels of production, less than q1, MC>MR, the firm isn’t maximizing profits. For output levels more than q1, MC>MR, the firm won’t make profits. It will pay 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 of the commodity falls. The slope of the demand curve gives the marginal benefit (MB). MB>p1 for levels of consumption less than p1; MB<p1 for levels of consumption above q1. Only at price, p1, will p1=MB hold. Figure 1.3(c) shows the horizontal sum of demand and supply schedules of all consumers and producers respectively in the industry4. Equilibrium quantity is Q1 where the market demand5 of all consumers equals market supply6 at p1 prices. The market clears at this price-quantity combination, i.e., there’s no scope for excess demand to push prices up, or excess supply to pull prices down from the equilibrium level. At this price-quantity relationship both consumer and producer surpluses7 are maximized. The above is a Partial equilibrium analysis for a single industry. If perfect competition exists everywhere then economy wide production and consumption will both be maximized and it won’t be possible to increase the welfare of one group without reallocating resources. Let’s now move to a General equilibrium analysis that is shown in Figure 1.4.

Horizontal summation: sum total of how much each consumer is demanding at a particular price; or how much a producer is willing to supply at a particular price. Since we sum across the horizon, the variable on the vertical axis is assumed fixed
5 6 7

4

Horizontal sum of all individual demand Horizontal sum of all individual supply

Consumer surplus: area under the demand curve, but above price line; Producer surplus: area above the supply curve, but below price line Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 7 --

Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction Allocative efficiency: General equilibrium analysis

Figure 1.4: The efficiency case for perfect competition—General equilibrium For simplicity and to allow the scope of a graphical analysis, we assume that an economy produces only two goods, X and Y. X is shown on the horizontal and Y on the vertical axis. Perfect competition results in the economy operating on the boundary of its Production possibilities frontier (PPF). This is shown in Figure 1.4. The PPF shows all maximum possible combinations of X and Y the economy can produce with its limited resources. If all factors were devoted to the production of only one commodity, the economy would produce either at XMAX (all X and no Y), or at YMAX (all Y and no X). Let’s assume the economy produces at N. This would indicate x1 of X and y1 of Y. The slope of the PPF 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 the Price line, which also denotes the relative prices. MRT of X into Y falls as successive equal 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 same axes as Figure 1.4(a). The indifference curves are convex to the origin. This means that to keep a consumer at constant level of satisfaction an increasing amount of Y must
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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction compensate for each successive reduction in the consumption of X. This is also known as the Marginal rate of substitution (MRS) between the two commodities. MRS gradually increases as more and more of X is sacrificed for each successive unit of Y (not shown in the graph). Corresponding to x1 of X and y1 of Y in Figure 1.4(a), the consumer achieves equilibrium at point W in Figure 1.4(b) on the indifference curve I2. This is the highest possible level of satisfaction (welfare) the consumer can achieve given the production situation in Figure 1.4(b). Figure 1.4(c) combines information from Figures 1.4(a) and 1.4(b). It presents a general equilibrium 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 two dimensional space. The indifference curves for individual A is shown by Ia1 to Ia3, and those for individual B are shown by Ib1 to Ib3. The indifference curves for consumer A, are read from the origin 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. As we 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 economist Francis Edgeworth8 of the Neo-Classical School. The box diagram allows us to combine production efficiency and consumption efficiency in one graph. The box is used as a tool to explain various phenomena in economics, especially exchange. Efficiency in consumption requires that the indifference curves of both individuals are tangent to each other as well as tangent to their respective budget lines. This occurs at points 1, 2, and 3. Of these equilibria only one corresponds with efficient production at point N. This occurs at point 2 where the budget line at point 2 is parallel to the price line at point N9.

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Francis Ysidro Edgeworth (1845-1926): Professor of Political Economy at Oxford University from 1891 to 1922. Edgeworth’s major contribution to economics is Papers Relating to Political Economy (1925). Edgeworth introduced Indifference Curves, Contract Curves and the box Diagram in economic analysis. He was a leading exponent of the Neo-Classical School of Economic Thought

Equilibrium could have occurred at the other points. We are assuming arbitrarily that it occurs at Point 2 in the absence of exact equations for consumer and producer equilibrium Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 9 --

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction Efficiencies defined Efficiency in production: This occurs when the economy is operating on the boundary of 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, it’s not possible to produce more of one commodity without producing less of another. Conversely, it’s not possible to reduce the use of one input without increasing the use of another to produce a given output. At the boundary of the PPF the MRT of any two factors of production are equal. The equilibrium condition will be: MRT = ∆Y/∆X = ∆Y1/∆X1 = Px/Py … … … (1.10)

Efficiency in consumption: This occurs when the indifference curve of two consumers are 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 the distribution of commodities between consumers. All consumers have the same MRS and so can’t further increase their welfare by trading X and Y with each other. The equilibrium condition will be: MRS = ∆Y/∆X = ∆Y1/∆X1 = Px/Py … … … (1.11)

Total efficiency: The condition for total efficiency is MRS=MRT. There’s efficiency in both consumption (MRS) and production (MRT). All consumers and producers face the same 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 as Allocative efficiency. It describes an ‘Optimal welfare’ situation known as a ‘Pareto optimum’ after the Italian economist Vilfredo Pareto who 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.

Vilfredo 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 in economics 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 Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 10 --

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction The power of the market Perfect Competition delivers a Pareto optimum through market forces via the interaction of the so-called Invisible Hand of Adam Smith or the Auctioneer of Leon Walras There’s 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 efficient outcome that’s 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 doesn’t necessarily imply that markets will lead to a just, fair or equitable distribution of resources. The Pareto optimum is developed in isolation from social, moral and political considerations of justice relating to resource endowments. Nevertheless, it provides a powerful intellectual rationale for competitive markets in lieu of government planning and control also known as laissez faire in the Wealth of Nations of Adam Smith, a term Smith inherited from the French physiocrats11.

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

A school of economic theory that developed in France in the eighteenth century during the timer of Adam 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 discouraged imports. They were proponents of the laissez faire the principal of minimal government. The notion of laissez faire was later adopted by Smith and has become a part of the folklore of economics Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 11 --

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

Equity through actual compensation One way to express the objective of equity is to insist on actual compensation whenever somebody loses from a public policy. Many disagreements that arise in economics and politics can be traced to different positions on whether social justice through actual compensation for losers is required before a government can proceed with efficient public policies. Consider the following example. The government has decided to set up a new airport near Savar that will serve as an annex to Zia International Airport in Uttara, Dhaka. The new airport will generate various types of employment opportunities for those related to the aviation industry as well as those not. However, in order to construct the new airport, the government will have to acquire land in Savar. This will lead to dislocation of many families who will have to lose their agricultural and residential land. In this situation, does the government compensate the losers? If yes, by how much? One method could be that the government compensate the losers (who’s welfare would be say ∆Y<0) by the amount that the winners of this public policy will gain (who’s welfare would be say ∆X>0). If this were possible, then we could say that by definition such a policy would be Pareto efficient. Equity through competitive markets Do competitive markets provide incomes that are socially just? Personal incomes earned in competitive markets are consistent with social justice if we make the assumption that people should be rewarded according to the value of their personal contributions to a society’s output. If we make this assumption then competitive markets are both efficient and equitable (socially just). There are, however, problems with this assumption. If people are rewarded according to their contribution to the social output, it implicitly implies 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 aren’t 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 be unjust and that a moral obligation for intervention by the government or any other institution is warranted. Equity as equality Let’s 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 to build a new airport that will be an annex to Zia International Airport. All three families will benefit from this public policy because they all decide to open restaurants to cater
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See the Fundamental Theorems of Welfare Economics Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 12 --

Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction for the passengers and visitors to the airport. However, after one year from the inauguration of the airport, Family A has an income of Tk 22,000 per month; Family B an income 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 because W = B – C > 0. The public policy is also a Pareto improvement in the sense that the welfare of 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 C benefits more than Family A and Family B. If the three families can’t equally share the benefits of the public policy, or if the benefits aren’t transferable among the three families, and if it’s expected that equity through equality will prevail, then we’d require Family B to give up Tk 3000 per month and Family B to give up Tk 8000 per month. This could be thought of as taxation where the government (or a similar institution) can tax the Families who have benefited more than the others to bring ‘equality’ in the society. Sometimes governments can tax people who make 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 envy Let’s think of two Farmers X and Y who live in two different villages. Neither of the farmers owns a cow. Now, Farmer Z returns back to his village after working in the Middle East for ten years. He has saved some money with which he decides to go to Savar Dairy Farm to buy two Australian cows to set up a small dairy project to produce cheese. Now, observe the rather contrasting attitude of the other two farmers. Farmer X makes a visit to Farmer Z’s village and looks at Farmer Z and says to himself: “I wish I had such cows. I’ll work hard and soon I’ll be able to afford a cow like that”. Farmer Y also makes a visit to Farmer Z’s village and looks at farmer Z and says to himself: “I wish those cows would die”! The response to inequality of Farmer X is efficient. Farmer X wants to improve his welfare 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 doesn’t add to his own possessions, but results in a loss of cows of Farmer Z by wishing for Farmer Z’s cows to die.

FUNDAMENTAL THEOREMS OF WELFARE ECONOMICS
The possibility of a market outcome being efficient, but unfair has lead to many debates on the possibility of intervening into a free market system. The very nature of the free market or laissez faire presumes no government involvement or very minimal
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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction government involvement. In that case, how do proponents of the free market address efficiency 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 equilibrium will be Pareto efficient. The Second Fundamental Theorem of Welfare Economics: If we aren’t happy with a particular efficient allocation (First Theorem), we need not abandon market forces. The invisible hand (the auctioneer) will lead the society to a desired allocation that’s fair, equitable or just. Y YMAX Y1 N
Allocations like point N (x1 of X and y1 of Y) is efficient and equitable at the same time

Allocations like XMAX and YMAX may be efficient, but they aren’t equitable since there’s a full allocation of one commodity and zero of the other The Second Fundamental Theorem states that if a society achieves an allocation like XMAX or YMAX market forces will take the society to an equitable allocation like N without intervention

O

X1 XMAX X Figure 1.5: Market efficiency—Not 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 the economy to any desired efficient allocation that seems equitable (just or fair)

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

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Leon Walras (1834-1910), born in France, Walras was the first holder of the chair in political economy at the university of Lausanne in Switzerland. Walras is famous for two major contributions. First, his independent development of the concept of marginal utility that lead to the 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 History of economic analysis in 1954, “Walras is in my opinion the greatest of all economists” Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 14 --

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

PARETO EFFICIENCY REVISITED
A situation is defined as Pareto Efficient, Pareto Optimum or simply Efficient if in order to increase the welfare of one agent (party) the welfare of at least another agent (party) is affected. When an economy’s resources and output are allocated such that a reallocation makes one agent (party) well off only at the cost of at least another agent (party), then a Pareto Optimum is said to exist. The Italian economist Vilfredo Pareto first proposed the concept. 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 to look back on its various dimensions. In Figure 1.6, we use a PPF to illustrate the notion of Pareto efficiency. Two goods X and Y are produced in an economy; X is shown on the horizontal and Y is shown on the vertical axis.
∆X↑ ⇒ ∆Y↓; ∆Y↑ ⇒ ∆X↓ Y1 Y2 M N Any allocation on the boundary of the PPF qualifies as a Pareto efficient allocation because we can increase the allocation of one good (X or Y) only at the cost of reducing the allocation of the other good (Y or X) This implies that points within the boundary of the PPF are Pareto inefficient

Y

O

X1

X2

X

Figure 1.6 (a): Pareto efficiency

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 another point 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, we’ll see that N is also efficient because in such a move 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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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction

THHTH
Y2 Y Y1 M N

Y

∆X↑ ⇒ ∆Y↑

Y Y1 Y2 N M

∆X↓ ⇒ ∆Y↓

O

X1

X2

X

O

X1

X2

X

Figure 1.6 (b): Pareto inefficiency

Figure 1.6 (c): Pareto inefficiency

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 X increases 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 doesn’t qualify as a Pareto efficient situation because the welfare of 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 improvement as we’ll 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 can’t qualify as a Pareto efficient situation. Both situations are Pareto inefficient because there’s scope for further improvement in welfare for both agents (parties). This situation (inefficiency) will continue till the economy 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 affected or both parties gain at the same time. The interpretation of this phenomenon is that there is scope for further improvement. This will continue till the economy reaches an allocation on the boundary of the PPF

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

Y

__ ∆X↑ ⇒ Y

Y Y2 Y1 N M

__ ∆Y↑ ⇒ X

Y1

M

N

O

X1

X2

X

O

X1

X

Figure 1.6 (d): Pareto improvement

Figure 1.6 (e): Pareto improvement

Figures 1.6 (d) and 1.6 (e) illustrate a special type of Pareto inefficient situation known as Pareto improvement. A Pareto improvement occurs when it’s possible to increase the allocation of resources of one agent (party) without affecting the allocation of resources of 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, it’s possible to increase the allocation of resources of X from X1 to X2. The situation is inefficient in the sense that there’s scope for further improvement as the reader can easily verify. This situation 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 the allocation 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 situation because by increasing the welfare of one sector (here X) we aren’t reducing the welfare of the other sector (here Y). Rather, the move from M to N results in an increase in welfare for both sectors (X and Y).

A situation is a Pareto improvement if the allocation of one agent (party) can be increased without affecting (reducing) the allocation of another agent (party). This Pareto situation is inefficient because there’s scope for further improvement. This continues until when the economy reaches a point on the boundary of the PPF when there’s no scope for further improvement

Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 17 --

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

Y YMAX P

All Y, No X

Y

All X, No Y

Q O X O XMAX X

Figure 1.6 (f): Pareto Efficient and Unfair

Figure 1.6 (g): Pareto Efficient and Unfair Efficiency doesn’t automatically guarantee an equitable situation. The free market can result in an unacceptable distribution of income (resources) where the economy may be producing on the boundary of its PPF, but only one good (Figure 1.6(f) and 1.6(g)), and none 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 or less equitable. But the question still remains, which one to choose, R or S?

Y Y2 Y1 S

Both R and S are efficient and fair; which one to choose finally? R

O

X2

X1

X

Figure 1.6 (h): Pareto Efficient and Fair

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 no X. The allocation, P, is efficient because any movement along the boundary will result in an increase of X only at the cost of reducing Y. Similar argument holds for Q in Figure 1.6 (g) where the economy is again on the boundary of its PPF, but producing only X and no Y. Figure 1.6 (h) illustrates a situation that may be acceptable in the efficiency vs equity debate. 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 an acceptable quantity therefore it may qualify as equitable. Unfortunately, the situation isn’t as easy as it appears on the surface! The question still remains, which efficient and equitable allocation does the society choose? R or S?

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

EFFICIENCY AND EQUITY Really, much ado about nothing!
In the beginning, we mentioned the name of Sir Hugh Dalton, who probably gave the best definition of public finance—Public finance lies in the borderline between economics and politics. A blend of economics and politics makes the study of public finance and also public choice so much interesting and challenging. And this is where the notions of efficiency and equity enter and why we have spent so much time on the two concepts. The definition of efficiency is precise. It doesn’t involve a value judgement. A situation is efficient if by increasing the welfare of one agent we have to reduce (affect) the welfare of another agent. The definition of equity isn’t that straight forward. What’s equitable (just, fair) to one agent may not be to another. We’ve 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 a public policy benefits the welfare of one agent (party or sector) it’s likely to affect the welfare of another agent. Assume that the government decides to pursue a policy to promote primary education of rural children with special emphasis on girls. The argument is easy and straightforward. Primary education, especially to girls, will benefit this generation and also the next because like Napoleon Bonaparte said, give me an educated mother and I’ll give you an educated nation! How do you think the exponents of the primary health care sector will react? If the health ministry has enough political clout it may be able to divert resources from the education sector to benefit itself. This resembles the second case in Equity and envy where Farmer Y wished for the death of the cows of Farmer Z. The final decision of policy makers is usually a political decision. It doesn’t necessarily imply that economic analysis will converge with political analysis. In Figure 1.6 (h) both R and S are efficient and equitable, but R indicates more resources for one sector (X) and S indicates more resources for the other sector (Y). Which policy will the government or any other institution adopt? Who does the government or another institution benefit at the cost of the other? Do the loosers get compensated? This is where economic analysis ends— both R and S and efficient and equitable, therefore desirable. A political analysis is required to try to answer why or why not the final decision went in favour of R (or S for that matter). The political dimension in public finance and public choice further implies that just because a market generates an inefficient or inequitable outcome doesn’t necessarily mean that the government (or a similar institution) will intervene to correct the situation. The decision to (or not to) intervene involves politics more than it does economics. It’s because of this feature that Public finance lies in the borderline between economics and politics.

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

THE PRIVATE COST OF PUBLIC FINANCE
Markets and public finance are distinguished by private and public spending respectively. Public spending can be financed by taxes, government borrowing or through the sale of bonds. Governments can also finance public spending through inflationary finance simply by printing money. In many countries, lotteries provide governments with revenue. Economics is the science of scarcity. There’s an opportunity cost and trade off to decisions we make. Public finance ultimately places a burden of payment on private individuals. Taxes are current obligations to pay money to the government. Government bonds (e.g., savings certificates issued by the post office in Bangladesh) will require future taxes to enable the government to repay the past borrowing 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 private individuals hold. Lotteries take advantage of exploiting people’s optimism or their lack of 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 words of Milton Friedman14, “there is no free lunch”. It’s the people who actually and finally pay for all public spending no matter what politicians may make us believe. Governments never give anything to their citizens free. They ensure that a price tag is put on that’s to be paid either today or at some point tomorrow. So much for John Lennon’s power to the people15!

THE ROAD MAP—LOOKING AHEAD
As the course unfolds, you’ll gradually appreciate why public finance lies in between economics and politics. For the time being, even if you don’t understand anything that follows, it will still help to give you an idea of the long and winding road16 that lies ahead. The beast of the market—Market failure Perfect competition is great if it works. Unfortunately, they don’t work in reality. In fact, perfect competition has remained a textbook case against which the performance of other markets is evaluated. If markets fail to do what they’re supposed to, i.e., achieve
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Milton Friedman, the 1976 Nobel Prize winner in economics. A leading exponent of the Chicago School, Friedman was instrumental in developing the notion of human capital. His analysis 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 and other aspects that later laid the foundation to the monetarist literature in macroeconomics

Power to the People is a John Lennon song that inspired and was inspired by the civil rights movement in the USA during the 1960s The Long and Winding Road was written by Paul McCartney and features in the last Beatles Album, Let It Be published in 1970 just before the group disbanded Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 20 -16

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction efficiency and/or equity it’s still not a matter of worry if the good is something that the society doesn’t value highly. But what happens if we’re dealing with primary education, primary health care, roads and highways, or a good that’s a necessity for survival like drinking water or a necessity for economic activity like electricity and gas? What happens if the market fails to produce the amount that the society desires? Under what conditions may such a situation of market failure arise? What economic consequences does market failure inflict on the citizens of a nation? Now think about other alternative situations. What happens if we find out that markets fail to provide certain insurance or health care to the poor simply because they can’t pay for the costs? How can we stop people from smoking in public places or ensure that drivers wear seatbelts or don’t talk on their mobile phones when driving? When markets fail to achieve efficiency and/or equity, an institution has to intervene to correct the market failure. Historically, this institution has been the government. This topic 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 light—Property rights A simple analysis of competitive markets assumes that property rights are given. Property rights determine ownership and create the institutional infrastructure for economic agents 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 the rule of law, but doesn’t determine the rule of law. In this way, the government acts as Adam Smith’s invisible hand or as the auctioneer of Leon Walras. In discussing the above, this section will briefly try to establish that in the absence of the rule of law, economic agents find an incentive to be appropriative rather than be productive. How can such inefficiencies be resolved? This section presents a brief answer to this question.

Market failure and public goods Private goods exhibit excludability and rivalry in their consumption. In 1954, a young graduate from Chicago, Paul Aaron Samuelson17, who later went on to win the 1970 Nobel Prize in economics, observed that there are some goods, which aren’t free, but once they’re produced they can be provided to more consumers at no additional cost. Samuelson termed such goods as public goods. Markets fail in the case of public goods because public goods violate the excludability and rivalry properties of a private good.
Paul A Samuelson (1915- ), professor at the MIT, USA and the 1970 winner of the Nobel Prize in economics for raising the general analytical and methodological level of economic science with the aid of mathematical tools. Samuelson’s contribution to economics is vast. In public finance, Samuelson introduced and coined the now widely used notion of public goods and determine the optimal allocation of resources in the presence of both private and public goods Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 21 -17

Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction Violation of rivalry implies that P=MC=0 for public goods! Some consumers can therefore 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 how can we provide pure public goods? This question will be addressed in this section. Not all goods are pure public goods. Most goods exhibit mixed characteristics of pure private 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 Nobel Prize winning economist, and one of the finest brains in economics, is associated with the development and formulation of club goods, James M Buchanan18. This section will also look into features of club goods in detail.

Market failure and externalities A crucial assumption of perfect competition is that all benefits and costs are accounted for. In reality, this is a very strong assumption because the economic decisions of agents usually spill over to the neighbourhood of other agents. For instance, consider a situation where a smoker smokes in a non-smoking zone; I don’t receive any compensation from my neighbour, not even 100gm of honey from his beehive because his bees collect pollen from the roses in my garden; a steel firm doesn’t have to worry about the water pollution it creates that results in a loss of agricultural output for farmers living downstream etc. In all these examples, economic agents aren’t accounting for all the benefits and costs that are being spilled over to the neighbourhood of other economic agents. External effects can be either positive or negative. They arise because imperfectly competitive 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 this special type of market failure. In discussing externalities we’ll come across the works of economists like Arthur Pigou19, Ronald Coase20, and Roger Hardin21 and what institutional market intervention they proposed.
James M Buchanan (1919- ), professor at the George Mason University, USA and winner of the 1986 Nobel Prize in economics. In the 1960s, Buchanan got disenchanted with traditional economic theory because there was no satisfactory explanation of how economic decisions are made in the public sector. Influenced by Knut Wicksell’s voluntary exchange model, Buchanan views the political process as a means of co-operation to achieve reciprocal advantages. The outcome 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 because he almost single-handedly established a new branch in economics now known as public choice
19 18

Arthur Cecil Pigou (1877-1959), English economist from Cambridge, UK. Pigou extended the work of another Cambridge economist, Alfred Marshall (1842-1924). Pigou’s contribution in public finance lies in his distinction between private and social costs that arise due to the presence of externalities. Pigou suggested taxes as a corrective measure, which is known as the Pigovian Tax Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 22 --

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

Market failure and natural monopolies Competitive 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 can’t hold unless a loss is incurred (pure monopoly). Elsewhere, the LRAC falls over a certain range of output. In such industries, it’s more efficient to have a single producer rather than numerous producers. John S Mill22 first made this observation. Such industries are known as natural monopolies. This type of market failure can be a major problem because the utility industry (water, gas, electricity) usually exhibits characteristics of natural monopoly. One way to solve the market failure is for the government to become a direct producer and absorb losses because water, gas, electricity and the like generate positive external effects elsewhere in the economy. Another way is to develop pricing strategies that contribute to cost recovery. A final strategy would be to involve the private sector to participate in service delivery. This section discusses the economics of natural monopolies and touches on the political economy of privatisation and nationalisation of natural monopolies, especially in the utility industry.

Market failure and taxation Taxes are involuntary payments made to the government or a similar institution with no expectation of anything in return. This very definition contradicts the voluntary nature of a market transaction and points to one kind of market failure. At the same time, taxes are an unavoidable aspect of government activity because governments require funds (revenue) to finance their expenditures. In this backdrop, what economic features do
Ronald H Coase (1910 -), British born economist who was educated at the London School of Economics (LSE), but worked for most of his life at Chicago, USA. Coase won the 1991 Nobel Prize 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 transactions costs and property rights are well defined and well enforceable. In such an instance, a market-like solution can be found where the involved parties would have an incentive to internalise the externality
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Roger Hardin was instrumental in formulating the notion that communal property like natural resources can be subject to market failure. It is difficult to exclude because of the club good nature of communal property. But then, such goods are prone to congestion that can lead to market failure. Hardin’s efforts have been coined as the tragedy of the commons

John Stuart Mill (1806-1873), an English philosopher and economist. His major contribution lies in synthesising Ricardian economics to present a systematic and complete elaboration of classical economics that formed a foundation for the neoclassical school. Mill’s Principles of Political Economy (1848) became the standard textbook of economics before it was replaced by Alfred Marshall’s Principles of Economics during the end of the nineteenth century only to be later replaced by Samuelson’s economics Asrarul Islam Chowdhury; 01819-219050; 02-9660394; asrarul@gmail.com -- Page 23 --

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Public Finance: An analysis of market failure Chapter 01: The beauty of the market: An introduction taxes impose on economic agents? This is the central question that will be addressed in this section.

Dalton revisited Textbooks on public finance and public choice usually start with an introduction to their nature, scope and limitations. I, personally, think that one can only appreciate public finance and public choice after studying its core features first. Therefore, this concluding section is an appreciation of Dalton’s definition that public finance lies in the borderline 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 or similar institutions intervene when markets fail to generate an efficient and/or equitable outcome. Efficiency has a precise definition, but equity is a normative concept that relies on value judgements. Value judgements change from one society to another as well as within the same society from one time period to another, although similarities can be traced. It’s this normative aspect of public finance that makes governments intervene in some cases where and when markets fail to achieve efficiency and/or equity, while turn a blind eye in others. It’s because of this feature that the study of public finance lies in the borderline between economics and politics. This course is designed to make you challenge yourself beyond the narrow boundaries of the classroom. If you’ve 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 and public choice, but also with benefits spilled over elsewhere in economics! Bon Voyage!

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