Public Finance In Economics

(Econ 3122)
Chapter 2: The rational for Government
Intervention

Addis Ababa University

Department of Economics
Course instructor: Kefyalew Endale (Ph.D.)
April 2021
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 Contents of Chapter 2
Rationales for government intervention
– Macroeconomic intervention
– Incomplete/missing markets and information
assymetry
– Public goods (and club goods-Buchanan model)
– Externalities
– Coase theorem
– Decreasing cost industries (assignment)

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 2. Rational for Gov’t intervention
i. Macroeconomic stabilization
These includes managing
– Inflation (using monetary policy)
– Unemployment (using fiscal policy)
– Balance of payment (using devaluation, export
promotion)
– Trade balance (using devaluation, export
promotion)
– And so on.

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 2. Rational for Gov’t intervention cont’d
ii. Incomplete/missing markets: markets
may be
incomplete or missing due to risks and
uncertainties. For instance, the markets for
insurance and credit in rural areas are either missing
or incomplete
– These imperfections justifies government interventions
iii. Information asymmetry: economic agents don’t have
the same information and the asymmetry leads to market
failures.
Eg1. “The market for lemons” by Akerlof (1970)
• In a used car market, buyers do not know the quality of the
used cars in the market while the sellers do.
– Information asymmetry between buyers and sellers
– Hence, an institution is necessary to support the market system. Eg
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quality control 4
 2. Rational for Gov’t intervention cont’d
Eg 2. Two rival firms A and B
• One of the firm (for instance firm A) can pretend as if a low cost
firm and charges a low price to out way his/her rival from the
market (predatory pricing)
Eg. 3. employer vs employee relationship in hiring
• An employer do not know the skill and commitment of potential
workers during the recruitment.
• This could result in too small employment compared to the
optimal level.
Eg4. Credit rationing (Stiglitz and Weiss, AER, 1980)
• Financial liberalization  rise in interest rate due to
competition by borrowers  banks will be better off.
• However, the above may not actually the case due to adverse
selection.
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 2. Rational for Gov’t intervention cont’d
• Adverse selection low risk borrowers are crowded out
and the bank is selected by high risk borrowers risk of
default increases  increase in the share of bad loans 
decrease in profitability of banks
• Solutions to missing markets/information asymmetry
– Allowing for evaluation in the market for lemons
– Looking at investments in education (for hiring)
– Antitrust law for predatory pricing
– Warranty for goods market
– Collateral requirement for credit market

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 2. Rational for Gov’t intervention cont’d
iv. Public goods: goods where an indvidual’s
consumption/use of the good do not result in reduction
in the quantity of the good for other individuals.
– Suppose two individuals A and B and two goods X
(private good eg. bread) and Y (public good eg. Road)
• Total consumption of X= XA+XB
• Total consumption of Y=YA=YB (the amount is the same for
both users)
– Characteristic of public goods
– Non-rival: some ones consumption of the good doesn’t reduce
the benefit/quantity of the good for other consumers
– Non-excludable: consumers cannot be excluded from
consuming the good

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 2. Rational for Gov’t intervention cont’d
– Non-excludablity of public goods implies that the market
demand of such a good is a vertical summation.
– The equilibrium condition is when the sum of marginal
benefits of consumers equals with the marginal cost
• Suppose two consumers of a public good Y, then the equilibrium is
given by:
MBA+MBB=MCY
• Where the marginal benefit is measured by the respective demand
curves of the consumers.
• Each consumer should be taxed according to her marginal benefit
• Why market system fails to supply public goods?
– Free riding problem (consumers do not reveal their preference for these goods)
DA+DB

PA+PB MCY
PB
PA
4/19/2021 Q 8
 Clubs Goods
• The good is like a public good within the club
• Excludability: club good is restricted to its members
– people can be excluded from membership
– can charge a membership fee
– membership entitles full consumption of the good without
further charge
• Non-Rivalness:
– These goods are non-rival until the optimal club size is
achieved.
– cost of providing the club good may rise with the
membership because large member size requires larger
quantity of the good
– same may also be true of the marginal cost
Eg. Swimming pools and car parking places in a residential
compounds
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 Buchanan’s model of club goods
• Three main assumptions
– A club can costlessly exclude non-members
– Each club member has equal right of using the club good
– Benefits and costs are shared equally
– There is a representative member “i” with the following
utility function
Ui=f(yi, x, s)
Where yi is a private good, X is the club good, and s is the
club size (number of club members)
Analytical problems
i. Determining the optimal quantity of the club good for a
given club member size.
ii. Determining the optimal member size for a given
quantity of the club good.
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 Buchanan’s model cont’d
• Let B(Si) and C(Si) denotes benefits and costs with club size
“si”

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 Buchanan Model Cont’d
• Figure 1 of the previous slide shows the optimizing club good provision
levels for two alternative membership sizes (s1 and s2).
• B(si) and C(si) denotes the total benefit and cost per member si,
respectively.
• The concavity of the benefit curve captures diminishing marginal benefits
to increased provision; while the linearity of the cost line reflects
constant marginal provision cost.
• For membership s1, optimal provision corresponds to X1* where
marginal provision benefit (the slope of the B curve) equals marginal
provision cost (the slope of the C curve).
• If, however, membership size increases to s2, then the benefit curve shifts
down. The reduced slope is due to increased crowding from more
members,
• The cost line pivots down to C(s2) as each member needs to assume a
smaller cost burden because there are more burden sharers.
• The optimal provision, associated with s2 is X2*
• Generally, as membership increases, the optimal provision level increases,
12
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 Buchanan’s model of club goods
• Depicting the optimal club membership choice for two alternative
provision levels
• Let B(Xi) and C(Xi) denotes benefit and cost curves, respectively

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 Buchanan’s model of club goods
• The benefit curve has an inverted U-shape: marginal benefit increases up
to a certain membership size, followed by declining marginal benefit
owing to crowding as membership surpasses this threshold.
• The cost curve is a rectangular hyperbola, as the given cost of providing
X1 is spread over more members.
• The optimal membership s for this provision level is achieved when the
corresponding margins are equated.
• An increase in provision to X2 shifts up the benefit curve, which is now
flatter at any given membership.
• This flattening captures the reduced marginal crowding cost that greater
provision entails—e.g., more highway lanes mean that the same traffic
can flow with less congestion.
• For X2, the cost curve is displaced upward so that the slope has a larger
absolute value at a given membership size. This follows because greater
provision means that each member must assume a greater marginal cost
burden.
• In Fig. 2, the optimal membership for X2 is s2
• Optimal membership increases with augmented provision, whose
relationship is assumed to be linear for simplicity in Fig. 3.
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 Buchanan’s model CONT’D
To the left of S*, the provision is under utilized and to the right of S*, there is congestion
• Hence, S* is the equilibrium condition for the club good
S optimal
X
X optimal

X*

S* S

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 Regional and Global Public goods
• These goods extend across countries boundaries
i. Natural Global commons (Ozone layer)
Use of ozone layer is non-rival but there are problems like
global warming and climate instability when ozone layer is
over utilized.
ii. Human made global commons: these include
• Scientific knowledge from R&D
• Transnational infrastructure like internet
• Privileges and norms like world cultural heritages
iii. Global policy concerns such as
• Peace: it is a universal public good. UN established for this
• Health treatments like TB, malaria, Corona virus
• Financial stability: IMF has been established for global
financial stability
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 Rational for gov’t intervention cont’d
V. Externalities: are called indirect, neighborhood,
spillover, external, third party effects
• They are divergences between social and private
evaluation of costs and benefits
• Consumption externality: arise during
consumption
• Positive consumption externality: marginal benefit
of the society is greater than the private benefit
– Hence, to little of the good (Q) is consumed relative to the
social optimal (Q1) (See next figure for details)
– Eg. Owning a TV in a poor community, vaccination against
flu (herd immunity).
– Solution is to put Pigovian subsidy=MSB-MPB

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 Rational for gov’t intervention cont’d
• Example of positive consumption externality

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 Rational for gov’t intervention cont’d
• Negative consumption externality: arise when the marginal
benefit of society is less than the private benefit. Eg. Consumption of
alcohol and lead to social disaster like traffic accident , Smoking
cigarette, barking dogs of neighbors
• Too much of the good is consumed (Q1) than the social optimal level
(Q2)
• Solution: Pigovian tax=PMB-SMB

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 Rational for gov’t intervention cont’d
• Production externality: arise during a production
activity
• Suppose two products (X & Y) and two inputs (K & L)

• X=f(Lx, Kx)
• Y=F(Ly, Ky, Lx)labor spillover
• Y=F(Ly, Ky, Kx) Capital spillover
• Y=F(Ly, Ky, X) output spillover

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 Rational for gov’t intervention cont’d
• Positive Production externality: arise when the private marginal
cost of production is larger than the social marginal cost
• Too little of the good will be produced compared to the social
optimal level. Eg. Flower garden owner and a neighboring honey
producer.
Solution Pigovian subsidy (equal to BC) (mpc-msc)

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 Rational for gov’t intervention cont’d
• Negative Production externality: arise when the private
marginal cost of production is smaller than the social marginal
cost. Eg. Pollution from a tannery industry which affects
surrounding residents with bad smell and health complications.
• Too much of the good is produced (Q1) over the social optimal
(Q2). Solution: Pivgovian tax of SMC-PMC

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 Rational for gov’t intervention cont’d
• Limitations of pigovian remedy (tax and subsidies)
1. It works only in a competitive market. Under imperfect markets,
Pigovian taxes creates more distortion in the allocation of
resources.
– Xms-quantity under monopoly after tax which is too small
MSC
p
tax MPC

P=AR

Xms Xmp Xcs MR X=quantity

After Befo aft Xcp before tax under
tax re er competitive mkt
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tax tax 23
 Rational for gov’t intervention cont’d
2. Coase theorem (due to Coase 1960):
• Coase (1960) argued that government intervention through taxes
and subsidies is unnecessary to correct externalities if the concerned
parties are willing to negotiate each other for their mutual
advantage.
• The role of the government is to clearly define and offer property
rights.
• Eg Cattle raiser and crop cultivator
• Optimal herd size is ‘C’
i. If the property right is given to the cattle raiser, he /she has the
tendency to increase its herd size to “F”
• In this case the crop cultivator has to compensate the cattle raiser so long as
MD>MB. The cattle raiser will not accept compensation below MB.
ii. If the right is given to the crop cultivator, then the cattle raiser has to
compensate for the damage it caused until size “C”.
• Below “C”, the damaged caused on crops is less than the MB of the cattle
owner. Hence, “C” is the optimal size.
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 Rational for gov’t intervention cont’d
– MB-additional benefit from additional cattle
– MD-the marginal cost of extra animal/cattle on crop
cultivator
MD

MB
MD MB

Net amount of the reduction in

Net amount saved after damage on crop cultivator by
paying compensation paying compensations to cattle
for crop damage raise to reduce the cattle size.

Amount paid by crop cultivator for the

Compensation paid for
crop damage cattle raiser to reduce his cattle size.

F Herd size
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C 25
 Rational for gov’t intervention cont’d
Limitations of Coase theorem
• It doesn’t take equity issue into consideration. For
instance, the crop farmer may be poor but the legal right
could be given to the cattle raiser. In this case the poor
cant compensate the rich
• It assumes that negotiation is costless. In some instances
the cost of negotiation might exceed the benefits
bargaining couldn’t take place
• Negotiation may not be possible in certain circumstances
eg. Smoking cigarettes.

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 Rational for gov’t intervention cont’d
Other remedies of externalities
a. Administrative regulation: it involves the indication of
what economic agents (producers and consumers) can do
and cant do.
– Eg. Prohibiting activities such as smoking in public places
– Restricting cutting trees in certain areas
– Enforcing seat belt during driving
– Restricting drive after taking alcohol
b. Encourage mergery between producers of externality
and the victims
c. Establishing markets for externality. Eg market for
carbon.
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 Limitations of the arguments for government intervention
1. It has pro-state bias: it assumes that the public sector can succeed
whenever the competitive market fails. However, government may also
fail due to:
– Inadequate action as a result of lack of required information and
implementation capacity
– Rent seeking behaviors of implementers
2. Theory of the second best (Lipsey and Lancaster, 1956)
– They argued that removing one market failure in the presence of another
failure does not necessarily improve resource allocation
– Eg 1 competitive industry and trade union. In this case an action which
weakens the trade union will improve resource allocation both in labor market
and goods market.
– Eg 2. monopoly industry and trade union. In this case weakening the trade
union cannot guarantee an improvement in resource allocation.
3. It has anti-state bias
– It assigns those functions which the private sector failed to address
– It compares the public sector with an ideal system (i.e with perfectly
competitive market system)

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 Assignment 2
1. Define decreasing cost industry and give an
example.
2. Why government intervention is necessary in
the case of decreasing cost industries
3. What type of interventions are implemented
by governments in such industries?
Suggested Reference: Brown and Jackson

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