FACULTY OF COMMERCE

BA IN LAW AND PUBLIC ADMINISTRATION

PUBLIC ECONOMICS ASSIGNMENT 1

Name; Ednah David

Student ID; 01192100712

Lecture; Ms Oshinka
 1. Discuss function of Public Economics
a. Protection of private property / national security.  The role of the government is to ensure
basic law and order, through ensuring the rule of law. This involves protecting the rights to
private property. In a free market, there is an incentive to free ride on the provision of law
and order, therefore it tends to be under-provided. A government can pay for policing
through general taxation. A similar function of the government is to provide for national
defence – paying for an army. It is military spending which often was the primary cause of
the first taxes.Policing and courts are an example of a public good – which usually require
government provision.
b. Raising taxes. To provide public goods and public services, the government needs to raise
tax. They can do this in a variety of ways – taxes on goods (customs duties), taxes on income,
taxes on people (poll tax) and tax on property and land. The government has to consider the
best way of raising taxes. A good tax is efficient (doesn’t distort economic activity); easy to
collect (hard to avoid); fair (may involve taking a higher proportion of high earners). If the
government run a budget deficit, they will need to raise the shortfall through borrowing and
selling government bonds.
c. Providing public services. Public goods tend to be not provided in a free market because of
the free rider problem. Therefore, these goods and services need to be provided by the
government. Examples of public goods include street lighting, roads and law and order.
There are also public services which are provided in a free market, like education and
healthcare. However, the government may feel that these merit goods are important for
equality and improving labour productivity. Therefore, most governments provide some
form of state provided education and health care.
d. Regulation of markets. Adam Smith in ‘Wealth of Nations‘ noted that in a free market, firms
were often able to create monopoly power. This enables them to charge excessive prices to
consumers. The government may need to regulate monopoly power, e.g. prohibiting
mergers or setting price limits in natural monopolies (industries like tap water and
railways).Also, firms may develop monopsony power, where they are able to pay low wages
and provide poor working conditions for workers. In this case, the government may need
certain regulations on labour markets, such as minimum wages, minimum age of working
and provide basic levels of health and safety.
e. Reducing inequality/poverty. In a capitalist economy, we may see a growth in inequality
and poverty. This can be due to inherited wealth and opportunity. It can also be due to
monopoly power. The government may feel the need to ensure everyone has an equal
opportunity, for example providing education so even those from poor family have the
opportunity to get qualifications. It may also involve redistributing income from high earners
to low-income earners, e.g. progressive taxes such as higher rate of income tax and
providing means-tested benefits such as income support/housing benefit and state
pensions.

2. Explain the benefit pricing with a practical example from your society.

The rule for Lindahl pricing can be written mathematically as P 1 z [Z, M1] + P 2 z [Z, M2] = c where P
1 z [Z, M1] is person 1’s inverse demand function, expressing her willingness to pay for the public
good as a function of the quantity Z of the public good, and her income M1 ( and perhaps on some
other factors as well ). Since P i z is the height of person i’s demand curve for the public good, it is a
price that applies only to person i. As long as people’s tastes differ, then one person’s demand curve
will look different from another’s. Even with everyone consuming the same quantity Z of the public
good, the willingness to pay will differ among people. Advantages of Lindahl Pricing The Lindahl
solution involves both the level of public good provision, and the method by which it is financed. The
method of finance is that each person’s tax bill equals the quantity of public goods consumed, times
the price per unit. But each person’s price will be different. This solution is sometimes called “benefit
taxation”, since each person’s Lindahl price is the marginal benefit she derives from the good being
financed. The Lindahl solution covers the cost of the public sector ( and more than covers it if the
marginal cost of the public good is increasing ). It yields an efficient allocation. It also charges people
proportionately to some measure of the benefit 23 they derive from the public good being financed.
If one person’s demand curve is above another person’s — indicating the first person has a higher
demand for the public good — then this first person will pay more taxes to finance the public good.
Another attractive feature of the Lindahl solution is that it leaves everyone

A bigger problem with Lindahl pricing is the availability of the relevant information. The great
advantage of competitive markets for private goods is that no firm needs to know anything about
the tastes of individual consumers. ( And consumers do not have to know anything about the
production technology of firms. ) The only thing a competitive firm has to know — other than its
own production technology — is the price at which it can sell the good. The only things a consumer
has to know — other than her own tastes — are the prices of the goods and services available. This
is an enormous advantage of competitive private markets

a. Lindahl equilibrium is a theoretical state of an economy where the optimal quantity of public
goods is produced and the cost of public goods is fairly shared among everyone.

b. Achieving Lindahl equilibrium require the implementation of a Lindahl tax, which charges
each individual an amount proportionate to the benefit they receive.

c. Lindahl equilibrium is a theoretical construct because various theoretical and practical issues
prevent an effective Lindahl tax from ever actually being implemented.

3. Compare maximum socialadv antage to paretto efficiency

Social advantage is maximised at the point where marginal social sacrifice cuts the marginal social
benefits curve. This is at the point P. At this point, the marginal disutility or social sacrifice is equal to
the marginal utility or social benefit. Beyond this point, the marginal disutility or social sacrifice will
be higher, and the marginal utility or social benefit will be lower. Before this point, the marginal
utility or social benefit is more than marginal disutility or marginal sacrifice. The Point of Maximum
Social Advantage- 9 Maximum Social Advantage is achieved at the point where the marginal social
benefit of public expenditure and the marginal social sacrifice of taxation are equated, i.e. where
MSB = MSS. This is the optimum limit of the states’ public finance activity. Thus, public expenditure
should be incurred up to the point where the marginal utility due to public expenditure us just equal
to the marginal disutility due to taxation of public income. Department of Economics .
Maximum Social Advantage is achieved at the point where the marginal social benefit of public
expenditure and the marginal social sacrifice of taxation are equated, i.e. where MSB = MSS. This is
the optimum limit of the states’ public finance activity. Thus, public expenditure should be incurred
upto the point where the marginal utility due to public expenditure us just equal to the marginal
disutility due to taxation of public income.

Social efficiency

Definition of social efficiency. This is the optimal distribution of resources in society, taking into
account all external costs and benefits as well as the internal costs and benefits. Social efficiency
occurs at an output where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).

Social efficiency is closely related to the concept of Pareto efficiency – A point where it is impossible
to make anyone better off without making someone worse off

Note:

 Social benefit = private benefit + external benefit

 Social cost = private cost + external cost

Social efficiency and negative externality

We say social efficiency occurs at an output where Marginal Social Benefit (MSB) = Marginal Social
Cost (MSC)

If a good has a negative externality – ignored by individuals, then in a free market, we tend to get
over-consumption and social inefficiency.
In a free market, consumers ignore the external costs of consumption (e.g. you drive a car but don’t
factor in the congestion you cause to other people). Therefore, the free market equilibrium is at Q1
(where S=D).

However, at Q1 the Marginal Social Cost is greater than the Marginal Social Benefit. Therefore by
consuming at this point, the cost to society is greater than benefit (e.g. think of traffic jams and
pollution because too many people drive at once). We say there is a deadweight welfare loss –
indicated by the red triangle.

If the output is reduced from Q1 to Q2, society is in a better position. At Q2, the marginal social cost
= the marginal social benefit. This is said to be socially efficient

Social efficiency and positive externality

With a positive externality, we ignore the benefits to third parties.

The free market equilibrium (Q1) is less than the socially efficient level (Q2) where SMC = SMB.
At Q1,  the Marginal Social Benefit (MSB) is greater than the Marginal Social Cost (MSC). Therefore,
in this situation, if we increase output from Q1 to Q2, the addition to social welfare (MSB) is greater
than the marginal social cost, therefore net social welfare increases until we get to point Q1 where
SMB = SMC.

Implications of Social efficiency

It is important to take into account externalities. (both positive and negative) It can be difficult to
measure externalities, but we need to make an effort. Government intervention – taxes and
subsidies can attempt to influence production and consumption to achieve social efficiency.

Usefulness of Pareto efficiency

If we were building a new airport – let us assume there are winners and losers

 The private and external benefits are estimated at £20bn

 The cost of building airport is £13bn

 Residents living nearby see a loss in personal welfare of £1bn

 The net benefit to society is £20bn- £14bn. A clear gain of £6bn

  However, using principles of Pareto efficiency – this is not a Pareto improvement because
those living nearby lose out.

What should we do? The scheme has a net welfare gain – but some lose out.

 One option is to make the airport company compensate local residents for the
inconvenience of losing out.

 In this way, the airport goes ahead, and the company make a profit, but local residents are
compensated for losing out.

Example of giving to charity

Firstly it depends on how you define utility. If a billionaire gives money away to charity – he has less
money – so from one perspective, he is financially worse off.

If Bill Gates gives money to Rwanda, his wealth declines and Rwanda becomes wealthier.
However, if Bill Gates has wealth of $10 billion, he may be unable to spend it. If we measure by
consumption, if he gives to Rwanda; his consumption remains unchanged, but Rwanda gains
increase in consumption. If we measure by consumption, there is a Pareto improvement

Giving wealth to Rwanda doesn’t reduce consumption of Bill Gates, but does increase consumption
of Rwanda.

Utility

Another factor is maybe Bill Gates gets joy from giving to charity – certainly more joy than having
money in a bank account. So, if Bill Gates gives money to developing economies, it can be definitely
a Pareto improvement

 Bill Gates gets joy from giving money

 Bill Gates worries less about having $50 billion in bank account

 Developing economies gain from capital investment to alleviate poverty.

Limitations of Pareto Improvement

Pareto efficiency can have its uses and may form part of the decision making process. But also it has
its limitations.

 It makes no judgement about the equality of distribution or overall welfare.

 A distribution of income could be Pareto efficient, but not maximise overall social welfare.

 It could involve some resources being wasted – as long as no one feels worse off.

 From a utilitarian perspective, we should consider the utility that income gives. If we transfer
money from the rich to the poor, it is not a Pareto improvement in terms of wealth – the
rich are worse off. But, such a decision may increase overall utility in society because
of diminishing the marginal utility of money. A billionaire wouldn’t really notice not having
less income, but the developing economy or individual living in poverty would see a
significant increase in well-being from a small increase in income.

What Is Pareto Efficiency?

Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated
to make one individual better off without making at least one individual worse off. Pareto efficiency
implies that resources are allocated in the most economically efficient manner, but does not imply
equality or fairness. An economy is said to be in a Pareto optimum state when no economic changes
can make one individual better off without making at least one other individual worse off.

Pareto efficiency, named after the Italian economist and political scientist Vilfredo Pareto (1848-
1923), is a major pillar of welfare economics. Neoclassical economics, alongside the theoretical
construct of perfect competition, is used as a benchmark to judge the efficiency of real markets—
though neither perfectly efficient nor perfectly competitive markets occur outside of economic
theory.

 Pareto efficiency is when an economy has its resources and goods allocated to the maximum
level of efficiency, and no change can be made without making someone worse off.

 Pure Pareto efficiency exists only in theory, though the economy can move toward Pareto
efficiency.

 Alternative criteria for economic efficiency based on Pareto efficiency are often used to
make economic policy, as it is very difficult to make any change that will not make any one
individual worse off.

Pareto Efficiency

Understanding Pareto Efficiency

Hypothetically, if there were perfect competition and resources were used to maximum efficient
capacity, then everyone would be at their highest standard of living, or Pareto efficiency. Economists
Kenneth Arrow and Gerard Debreu demonstrated, theoretically, that under the assumption of
perfect competition and where all goods and services are tradeable in competitive markets with
zero transaction costs, an economy will tend toward Pareto efficiency.
In any situation other than Pareto efficiency, some changes to the allocation of resources in an
economy can be made, such that at least one individual gains and no individuals lose from the
change. Only changes in allocation of resources that meet this condition are considered moves
toward Pareto efficiency. Such a change is called a Pareto improvement.

A Pareto improvement occurs when a change in allocation harms no one and helps at least one
person, given an initial allocation of goods for a set of persons. The theory suggests that Pareto
improvements will keep enhancing value to an economy until it achieves a Pareto equilibrium,
where no more Pareto improvements can be made. Conversely, when an economy is at Pareto
efficiency, any change to the allocation of resources will make at least one individual worse off.

Pareto Efficiency in Practice

In practice, it is almost impossible to take any social action, such as a change in economic policy,
without making at least one person worse off, which is why other criteria of economic efficiency
have found a wider use in economics.

These include the following:

 Buchanan unanimity criterion: under which a change is efficient if all members of society
unanimously consent to it.

 Kaldor-Hicks efficiency: under which a change is efficient if the gains to the winners of any
change in allocation outweigh the damage to the losers.

 Coase Theorem: which states that individuals can bargain over the gains and losses to reach
an economically efficient outcome under competitive markets with no transaction cost.

4. Critically evaluate the second best theory.

The theory of the second best provides the theoretical underpinning to explain many of the reasons
that trade policy can be shown to be welfare enhancing for an economy. In most of the cases in
which a trade policy is shown to improve national welfare, the economy begins at an equilibrium
that can be characterized as second best. Second-best equilibria arise whenever the market has
distortions or imperfections present. In these cases, it is relatively conceive of a trade policy that
corrects the distortion or imperfection sufficiently to outweigh the detrimental effects of the policy
itself. In other words, whenever market imperfections or distortions are present, it is always
theoretically or conceptually possible to design a trade policy that would improve national welfare.
As such, the theory of the second best provides a rationale for many different types of protection in
an economy.

The main criticism suggested by the theory is that rarely is a trade policy the first-best policy choice
to correct a market imperfection or distortion. Instead, a trade policy is second best. The first-best
policy, generally, would be a purely domestic policy targeted directly at the market imperfection or
distortion.
We use the theory of the second best to explain many of the justifications commonly given for
protection or for government intervention with some form of trade policy. In each case, we also
discuss the likely first-best policies.

KEY TAKEAWAYS

 A second-best policy is one whose best national welfare effect is inferior to a first-best policy
when beginning in a second-best equilibrium.

 As a general rule of thumb, beginning in a second-best equilibrium, the first-best policy will
be a policy that attacks the market imperfection or distortion as directly as possible.

 As a general rule of thumb, domestic policies are usually first-best policies, whereas trade
policies are usually second-best policies.

 One exception to the previous rule of thumb is that a trade policy is the first-best policy
choice to correct the imperfection of a large country in international markets.

5. Discuss the issue recognised from your society, the role government in market in your economy.

Preserve Order

Recall Thomas Hobbes' grim view of humans when ungoverned by a central authority. Maintaining
social peace is perhaps the fundamental purpose of government. The US Constitution's preamble
refers to this function specifically when it declares its intent to "ensure domestic tranquility," an
elegant phrase to describe the government's role as society's policeman.

Defend Against External Enemies

While anthropologists continue to debate whether or not humans are an inherently warlike species,
war has been a constant in the human condition since the dawn of recorded civilization. In fact, a
growing body of scholarship suggests that the state evolved into its present, modern form because
of its superior capacity for waging war vis-à-vis competing forms of political organization. While the
development of nuclear weapons in the mid-20th century makes outright conflict between powerful
states less likely but more dangerous, one of government's chief functions is still the protection of
societies against outside aggression.

Manage Economic Conditions

Modern governments are expected to create the conditions for economic growth and material
prosperity. While not all governments do this successfully, it is a function assumed in modern
democracies. In the United States, economic policy leaves most decisions to the private markets
where individual choice, competition and exchange are presumed to lead to a growing economy. But
even free markets need government regulation in the form of enforceable property rights, consumer
protection, enforcement of contracts, and health and safety laws to work fairly and efficiently.

Redistribute Income and Resources

Governments in economically developed countries are expected to not only make the economic pie
grow larger but to distribute the fruits of prosperity. Governments tax wealthier citizens and transfer
income and services to certain categories of individuals who are thought to need them. Thus all
modern governments can be characterized as welfare states. Welfare states don't just redistribute
money from wealthier individuals to poorer ones, they redistribute resources from the young to the
old, the disabled, and the socially challenged. Wealthier governments provide subsidized housing,
food, and health care to the poor, as well as providing pensions for the elderly.

Provide Collective (Public) Goods

Public goods are resources that governments play a crucial role in providing. These are usually
services that typically private markets cannot provide, or they can provide but only in a way that is
inefficient or unfair. National security is a good example. Can private markets provide military
security? Sure, military security can be outsourced. Wealthy individuals and governments could hire
private mercenaries. But history proves that reliance on mercenaries is a risky strategy for protecting
populations because mercenaries may turn on the governments that hired them. They may threaten
the very people they are hired to protect. For this reason effective governments tend to monopolize
national security. Once provided, everyone shares in its benefits. The same is true of clean air, the
postal service, and the interstate highway system. Certain goods are best provided by government,
though individuals often disagree over what those are.

Prevent Externalities

Externalities are indirect costs or benefits produced by an activity which impacts society.

Externalities affect those who are not direct participants or beneficiaries in the activity, and they
may be negative or positive. Factories can produce air pollution that individuals living nearby must
breathe, or they may contaminate a city's water supply. Obviously, these are negative externalities.
Those suffering from pollution do not share in the profits the polluting factory earns by its activity.
Education is an example of a positive externality when members of society other than students
benefit from a more educated population. Governments regulate activities that impose harmful or
undesirable externalities. Externalities are not always physical, as in the case of pollution. They may
also be psychological or aesthetic. A pornographic book store located next to a church or a liquor
store located next to a school would both be examples of externalities that city governments
prevent through zoning.

Functions of Government

Public Goods, from the Concise Encyclopedia of Economics

Public goods have two distinct aspects: nonexcludability and nonrivalrous consumption.
“Nonexcludability” means that nonpayers cannot be excluded from the benefits of the good or
service. If an entrepreneur stages a fireworks show, for example, people can watch the show from
their windows or backyards. Because the entrepreneur cannot charge a fee for consumption, the
fireworks show may go unproduced, even if demand for the show is strong….

Externalities, from the Concise Encyclopedia of Economics

Externalities are probably the argument for government intervention that economists most respect.
Externalities are frequently used to justify the government’s ownership of industries with positive
externalities and prohibition of products with negative externalities. Economically speaking,
however, this is overkill.

Government Spending, from the Concise Encyclopedia of Economics

In the past, government spending increased during wars and then typically took some time to fall
back to its previous level. Because the effects of World War I were not totally gone by 1929, the line
for the United States from 1790 to 1929 has a very slight upward slant. But in the second quarter of
the twentieth century, government spending began a rapid and steady increase. While economists
and political scientists have offered many theories about what determines the level of government
spending, there really is no known explanation for either part of this historical record….

Distribution of Income, from the Concise Encyclopedia of Economics

The distribution of income is central to one of the most enduring issues in political economics. On
one extreme are those who argue that all incomes should be the same, or as nearly so as possible,
and that a principal function of government should be to redistribute income from the haves to the
have-nots. On the other extreme are those who argue that any income redistribution by government
is bad….

Redistribution, from the Concise Encyclopedia of Economics

The federal government has increasingly assumed responsibility for reducing poverty in America. Its
primary approach is to expand programs that transfer wealth, supposedly from the better off to the
poor. In 1962, federal transfers to individuals (not counting payments for goods and services
provided or interest for money loaned) amounted to 5.2 percent of gross domestic product, or 27
percent of federal spending (Stein and Foss 1995, p. 212). By 2000, federal transfers had increased
to 10.9 percent of GDP, or approximately 60 percent of federal spending; GDP was $9.82 trillion and
federal spending was $1.79 trillion. These transfers are commonly referred to as government
redistribution programs, presumably from the wealthy to the poor. The unstated implication is that
income was originally distributed by someone. But no one distributes income. Rather, incomes are
determined in the marketplace by millions of people providing and purchasing services through
voluntary exchanges, and government transfers necessarily limit these exchanges….

… Such an examination yields a striking fact: most government transfers are not from the rich to the
poor. Instead, government takes from the relatively unorganized (e.g., consumers and general
taxpayers) and gives to the relatively organized (groups politically organized around common
interests, such as the elderly, sugar farmers, and steel producers).

Federal Budget, from the Concise Encyclopedia of Economics

Deficit spending has been a way of life for the federal government for most years since World War II.
A whole generation of elected federal officials has come and gone without ever balancing the
budget. The last time that federal budget expenditures were brought into balance with revenues
was in 1969, and prior to that the last time was in 1960….
Taxation, from the Concise Encyclopedia of Economics

Economists specializing in public finance have long enumerated four objectives of tax policy:
simplicity, efficiency, fairness, and revenue sufficiency. While these objectives are widely accepted,
they often conflict, and different economists have different views of the appropriate balance among
them….

In the News and Examples

Should government help people make better choices? Richard Thaler on Libertarian Paternalism.
EconTalk podcast episode, November 2011.

Richard Thaler of the University of Chicago Graduate School of Business defends the idea of
libertarian paternalism–how government might use the insights of behavioral economics to help
citizens make better choices. Host Russ Roberts accepts the premise that individuals make imperfect
choices but challenges Thaler on the likelihood that government, in practice, will improve matters.
Along the way they discuss the design of Sweden’s social security system, organ donations and
whether professors at Cornell University are more or less like you and me….

Can taxes correct externalities? Greg Mankiw on Gasoline Taxes, Keynes and Macroeconomics.
EconTalk podcast episode, January 2007.

Greg Mankiw of Harvard University and Greg Mankiw’s Blog talks about the state of modern
macroeconomics and Keynes vs. the Chicago School. He defends his proposal to raise gasoline taxes
and discusses the politics of tax policy….

Social Security, from the Concise Encyclopedia of Economics

The Social Security system, including old-age and survivors insurance, disability insurance, and
hospital insurance (Medicare), poses a staggering liability in the years ahead. Benefits in the year
2025, when the retirement of the baby-boom generation is in full swing, are projected to cost 23
percent of taxable payroll in the economy, up from 14 percent today….

A Little History: Primary Sources and References

What is a flat tax? What are the economic implications? Rabushka on the Flat Tax. EconTalk podcast
episode, April 2007.

Alvin Rabushka of Stanford University’s Hoover Institution lays out the case for the flat tax, a reform
of the current system that would replace the 66,000 page U.S. tax code with a single rate and no
deductions other than personal exemptions. An individual tax return would fit on a simple postcard.
Rabushka discusses the economic changes that would come with such a reform and the adoption of
the flat tax around the world since Rabushka and Robert Hall proposed the idea in 1981….

Advanced Resources

Externalities, from the Concise Encyclopedia of Economics

Positive externalities are benefits that are infeasible to charge to provide; negative externalities are
costs that are infeasible to charge to not provide.
Protect and provide

The concept of government as provider comes next: government as provider of goods and services
that individuals cannot provide individually for themselves. Government in this conception is the
solution to collective action problems, the medium through which citizens create public goods that
benefit everyone, but that are also subject to free-rider problems without some collective
compulsion.

The basic economic infrastructure of human connectivity falls into this category: the means of

ociety wants.