Public Finance II 2022

 Effects of Public Expenditure 

 Production and Price Level 
Increase in public expenditure will lead to increase in aggregate demand by
the amount of the government spending.
 But the final impact of government spending on equilibrium income (GDP)
depends on the state of the economy (the elasticity of the AS) and the
composition of government spending.

 For study analysis purposes, we can classify public expenditures into:

a) Government consumption expenditure (current expenditures)
b) Productive and investment government expenditure (capital expenditures)
c) Transfer payments and subsidies

Third: Transfer payments and subsidies

 We can classify it to:

A-Transfer payments:
It represents transfers of money such as social security payments,
pensions and unemployment grant, financial aid to economic sector
(business).
This payment does not involve transactions of goods and services

B- Subsidies in kind such as medical insurance.

C-Subsidize the prices of certain goods services

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A- The effect of unemployment grant on the work incentives

(working hours)
- Temporary assistance for needy families (TANF) is one of the united states of
American's federal assistance programs. It began in 1997, program providing
cash assistance to indigent American families' ‫األسر األمريكية الفقيرة‬,

- In this section we discuss "how unemployment grant affects recipients

work decisions" ‫كيف تؤثر منحة البطالة على قرارات عمل المستفيدين‬

*** Firstly we can summary and characterize this program in two variables:
 Basic grant (G) that the person receives if he is not working.
 Grant reduction rate (T) which the grant is reduced by (T) rate when the
person earn money

- So the benefit received (B) is related to the basic grant and the level of
earning (E) by:
B = G - TE

It follows that the benefit received is zero (B = zero) when E = G/T.

 Example: Suppose: the basic grant (G) = $300 per month, but that
grant is reduced by (25%) for each $ the person earns
*** Calculate: benefit received (B), if an individual earns:

1- Zero 2-$500 3-$1000 4- $1200

Answer
1- If an individual earns = zero
Benefit received (B) = G – TE = 300 – (0 * 25%) = 300

2-If an individual earns = 500

Benefit received (B) = G – TE = 300 – (500 * 25%) = 175

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3- If an individual earns = 1000

Benefit received (B) = G – TE – 300 – (1000 * 25%) = 50

4- If an individual earns = 1200

Benefit received (B) = G – TE = 300 – (1200 * 25%) = zero

So the benefit reduction (TE) increases as income increases, so the benefit

received decreases as income increases.

At some point the persons' earnings become high enough, so after that point
his benefit received equal zero.

For a given basic grant, the lower grant reduction rate (T), the higher
breakeven level of earnings increases.

 Do it your self

Resolution the previous example, for a same basic grant = 300 per month,
but that grant is reduced by (20%) for each $1 the person earns.

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 The following figure illustrates how the

unemployment grant affects labor supply (working
hours) decisions.
- Indifference curve analysis of the individual's choice between leisure and
income provides a useful way to see how unemployment grant affects working
hours

- Leisure time per month (OT) is measured on the horizontal axis.

Any point on horizontal axis indicates hours of leisure and hours of work

- Income per month (OA) is measured on the vertical axis, which varies with
hours of work.

Point (T): represents zero working hours and zero income

TA line: represents leisure/income combinations.
(I1, I2) indifference curves that represent the preference for leisure and
income.

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 Before the unemployment grant:

Assume this person maximizes utility at point (E) where:
Working hours = L1T leisure hours = OL1 Income = Y1

 After presence of the unemployment grant:

Unemployment grant (TQ) = 300
Grant reduction rate = 25%

- At point (Q) where working hours = zero and this person receives $300 from.
And the grant will reduce by 25% for each dollar the person earns until point (S)

- at point (S) the persons' earnings become high enough that he no longer
receives any benefit at all, thus the budget line is kinked line (ASQ)
- As drawn in figure, this person maximizes utility at point (C) where;
Working hours = L2T leisure hours = OL2 income = Y2

- It is clear this person become works less than he did before grant (L2T
hours, as opposed to L1T) and he receive higher earnings (Y2).

So the government welfare program could

reduce the work incentive

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B- The effect of production subsidy

 A production subsidy (government incentive)
Is a form of financial aid ‫ المساعدات المالية‬or support extended to an economic
sector (institution, business, or individual) generally with the aim of
promoting economic and social policy ‫تهدف إلى تعزيز السياسة االقتصادية واالجتماعية‬

 Subsidies come in various form's including

 Direct subsidies such as cash grants, interest-free loans
 Indirect subsidies such as tax breaks ‫االعفاءات الضريبية‬, insurance, low-interest
loans, accelerated depreciation

- The most common forms of subsidies cash grants to producer.

- Subsidies for producers ensure producers are better off and it commonly
reduces the price of goods and services to the consumer.

 The following figures illustrate "How the unit

subsidy affects the output & price"
Unit Subsidy: is a specific sum per unit produced which is given to the
producer

*** Case (1): Suppose the market is competitive, and its marginal cost is
increasing, and the government decides to give the producer a unit subsidy per
unit, where the supply is elastic

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 Before subsidy:
Competitive equilibrium point is (A), where the demand curve (D) is cutting
the elastic supply curve (S1) at a specified price (P1) and quantity (Q1) &
Consumer surplus ∆ (NAP1)

 After a subsidy:
When the government decides to give the producer a unit subsidy the
marginal cost will decrease therefore, the supply curve will shift in
parallel downwards (from S1 to S2) by the amount of the subsidy.

The new equilibrium point is (B) where the demand curve (D) is cutting the
new elastic supply curve (S2) at a specified price (P2) and quantity (Q2) &
consumer surplus is ∆ (NBP2)

Increase in consumer surplus (welfare gain to consumer) is (ABP1P2)

In the diagram, the subsidy per unit equals the vertical distance between
the two supply curves is (BC).

The total subsidy amount (the overall cost the overall cost of the
government's subsidy) is the area CBP2P3
Total subsidy = Quantity after Gov. Intervention (Q2) x subsidy per unit BC

However, the price the consumer pays doesn't fall by the full amount of
the subsidy, the producer gets some of the benefit in terms of extra
revenue that they can keep

 Hence in this case the benefit of subsidy divided into two parts:
- The benefit to the consumer is (GB) = P1P2 per unit and the whole benefit to the
consumer is the area (P1GBP2)

- The benefit to the producer is (CG) = P3P1 per unit and the total gain to the
producer is (CGP1P3)

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- In this case the benefit to the producer is "smaller than" the benefit to the
consumer because the supply is elastic

*** Case (2):

Suppose the market is competitive, and its marginal cost is constant, and the
government decides to give the producer a unit subsidy per unit

 Before a subsidy:
Competitive equilibrium point is (A), where the demand curve (D) is cutting
the elastic supply curve (S1) at a specified price (P1) and quantity (Q1) &
consumer surplus ∆ (NAP1)

 After a subsidy:
When the government decides to give the producer a unit subsidy the
marginal cost will decrease therefore, the supply curve will shift in
parallel downwards (from S1 to S2) by the amount of the subsidy.

The new equilibrium point is (B), where the demand curve (D) is cutting the
new elastic supply curve (S2) at a specified price (P2) and quantity (Q2)&
consumer surplus is = ∆NBP2

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Increase in consumer surplus (welfare gain to consumer) is ABP1P2

In the diagram, the subsidy per unit equals the vertical distance between
the two supply curves is (BC).
The total subsidy amount (the overall cost the overall cost of the
government's subsidy) is the area BCP1P2
Total subsidy = Quantity after Gov. intervention (Q2) × subsidy per unit BC

In this case, the price the consumer pays decreased by the full amount
of the subsidy from (P1) to (P2), so the benefit to the consumer is (BC) =
(P1P2) per unit and the whole benefit to the consumer is the area (BP1CP2).
And the producer does not get any benefit of subsidy

In this case the consumer gets all benefit of subsidy while the benefit to
the producer equal zero, Because the supply curve is perfectly elastic

The more elasticity of supply, the less the

benefit of subsidy to producer & vice versa

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 To what extent a subsidy will "reduce prices"

for "consumers as demand curve elasticity"
changes?

-
The more inelastic the demand curve the greater the consumer's gain from a
subsidy.

Indeed when demand is perfectly inelastic the consumer gains all the
benefit from the subsidy since all the subsidy is passed to the consumer
through a lower price.
When demand is elastic, the main effect of the subsidy is to increase
the equilibrium quantity rather than lead to a much lower market price.

The more elasticity of demand, the less

benefit of subsidy to consumer

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 Problem (1)
Suppose a commodity is produced in a competitive market, and its marginal cost
is increasing. The supply curve is more elasticity than the demand curve. The
equilibrium price equals L.E 60 per ton and the quantity at this price equals
100 tons

The government decides to give the producer a unit subsidy at L.E 30 per ton;
as a result the quantity of production will increase into 120 tons and the price
will decrease into L.E40. According to this information:

1- Draw a graph to represent this case.

2- Specify the producer price and the consumer price after the government
intervention
3- Calculate the change in the consumer surplus
4- Calculate the overall cost the overall cost of the government's subsidy
5- The benefit of subsidy to the consumer
6- The benefit of subsidy the producer

Answe

2- The producer price after a unit subsidy = 70 the consumer price after a
unit subsidy = 40

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3- The change in the consumer surplus = ABP1P2

= 0.5 (base 1 + base 2) x Height
= 0.5 (100 + 120) x 20 = 2200 → (welfare gain to consumer)

4- The overall cost of the government's subsidy (CBP2P3) =

Quantity after subsidy x the subsidy per unit (BC) = 120 x 30 = 3600

5- The benefit of subsidy to the consumer =

P1GBP2 = 120 x 20 = 2400

6- The benefit of subsidy the producer =

CGP1P3 = 120 X 10 = 1200

 Problem (2)
Suppose a commodity is produced in a competitive market, and its marginal cost
is constant. The equilibrium price equals L.E 80 per ton and the quantity at
this equals 200 tons

The government decides to give the producer a unit subsidy at L.E 20 per ton;
as a result the quantity of production will increase into 300. According to this
information:

1- Draw a graph to represent this case

2- Specify the producer price and the consumer price after the government
intervention
3- Calculate the change in the consumer surplus
4- Calculate the overall cost of the government's subsidy
5- The benefit of subsidy to the consumer

The benefit of subsidy the producer

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