FM-AA-CIA-15 Rev.

0 10-July-2020

Study Guide in FM Elec102: Public Finance Module No. 1

STUDY GUIDE FOR MODULE NO. _1_

Module 1: Introduction and Background of Public Finance

MODULE OVERVIEW

Public Finance is the management of a country’s revenue, expenditures, and debt

load through various government and quasi-government institutions. This guide provides an
overview of how public finances are managed and what the various components of public
finance are.

MODULE LEARNING OBJECTIVES

At the end of this module, you should be able to:

- Identify how the government intervene in the economy;
- Determine the size and growth of government;
- Identify how revenues are allocated and expenditures are spent
LEARNING CONTENTS

Topic 1: The Four Questions to Public Finance

In the simplest terms, public finance is the study of the role of the government in the
economy. This is a very broad definition. This study involves answering the four questions
of public finance:

■ When should the government intervene in the economy?

■ How might the government intervene?
■ What is the effect of those interventions on economic outcomes?
■ Why do governments choose to intervene in the way that they do?

When should the government intervene in the economy?

To understand the reason for government intervention, think of the economy as a series of
trades between producers (firms) and consumers. A trade is efficient if it makes at least one
party better off without making the other party worse off. The total efficiency of the economy
is maximized when as many efficient trades as possible are made.

There are two reasons governments may want to intervene in market economies:
 Market failures – problems that causes the market economy to deliver an outcome
that does not maximize efficiency (example: health insurance)
 Redistribution – the shifting of resources from some groups in society to others;
resource allocations provided by the market economy are unfair.

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How might the government intervene?

There are several different general approaches that the government can take to
intervention.
 Tax or subsidized private sale or purchase called price mechanism whereby
government policy is used to change the price of a good in one of two ways: (1)
Through taxes, which raise the price for private sales or purchases of goods that are
overproduced, or (2) Through subsidies, which lower the price for private sales or
purchases of goods that are underproduced.
 Restrict or mandate private sale or repurchase. Restrict private sale for goods that
are overproduced and mandate private purchase of goods that are underproduced.
 Public Provision. Another alternative is to have the government provide the good
directly in order to potentially attain the level of consumption that maximizes social
welfare.
 Public Financing of Private Provision. Governments may want to influence the level
of consumption but may not want to involve themselves directly in the provision of a
good.

What is the effect of those interventions on economic outcomes?

In assessing the effects of government interventions, policy makers must keep in mind that
any policy has direct and indirect effects.
 The direct effects of government interventions are those effects that would be
predicted if individuals did not change their behavior in response to the interventions.
 The indirect effects of government intervention are effects that arise only because
individuals change their behavior in response to the interventions.

Why do governments choose to intervene in the way that they do?

Political economy is the theory of how the political process produces decisions that affect
individuals and the economy.

Governments face enormous challenges in figuring out what the public wants and how to
choose policies that match those wants. In addition, governments may be motivated by
much more than simply correcting market failures or redistributing income. Just as there are
a host of market failures that can interfere with the welfare-maximizing outcome from the
private market, there are a host of government failures that can lead to inappropriate
government interventions. Politicians must consider a wide variety of viewpoints and
pressures, only two of which are the desire to design policies that maximize economic
efficiency and redistribute resources in a socially preferred manner.

Topic 2: Why Study Public Finance? Facts on Government in the US and Around the World

In this section, we detail that role by walking you through the key facts about government in
the United States and other developed nations. In addition, to motivate the study of public
finance, we propose some interesting questions that arise from these facts.

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a. The size and growth of government

- government spending expanded during The Great Depression and grew even more
dramatically during World War II (grows during recession)

 Gross domestic product is the monetary value of all finished goods and services
made within a country during a specific period.
 GDP provides an economic snapshot of a country, used to estimate the size of an
economy and its growth rate.

b. Decentralization
- A key feature of governments is the degree of centralization across local and national
government units—that is, the extent to which spending is concentrated at higher (federal)
levels or lower (state and local) levels.

c. Spending, taxes, deficits and debts

- When you run a household, you live on a budget. Outflows of cash for groceries, rent,
clothing, entertainment, and other uses must be financed by inflows of cash from work or
other sources. Any excess of income over spending is a cash flow surplus that can be
saved to finance your own spending in future periods or, by way of an inheritance (also
referred to as a bequest), your children’s spending after you die. Any shortfall of income
below spending is a cash flow deficit and must be financed by past savings or by borrowing
from others. Any borrowing results in the buildup of some household debt, which must
ultimately be repaid from future inflows of cash.

d. Distribution of spending
- The composition of federal government spending has changed dramatically over time. It is
spent on national defense or military expenditures which is an example of public good
(goods for which the investment of any one individual benefits a larger group of individuals);
Social Security programs (government provision of insurance against adverse events to
address failures in the private insurance market); health care programs and health.

e. Distribution of revenue sources

- In the US, the major source of revenue are from income tax, sales tax and property taxes.

f. Regulatory role of the government

- (1) exerts influence through its powers of taxation and spending and (2) regulating
economic and social activities

Why Study Public Finance Now?

Three major policy issues facing US and the rest of the world:
1. Social security
2. Health care
3. Education

It is clear from the facts presented in this chapter that the government plays a central role in
the lives of all Americans. It is also clear that there is ongoing disagreement about whether
that role should expand, stay the same, or contract. The facts and arguments raised in this

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chapter provide a backdrop for thinking about the set of public finance issues that we
explore in the remainder of this course.

LEARNING ACTIVITY 1

Reflection on Learning:
 What is the importance of public finance?
 How does the country solve the issues and challenges our country is facing from
time to time?

Learning Activity:
 During face-to-face discussion, prepare for a recitation.
 Prepare for a quiz after discussion.
SUMMARY

 There are four key questions to consider in the study of public finance. The first is:
When should the government intervene in the economy? Our baseline presumption is
that the competitive equilibrium leads to the outcome that maximizes social efficiency.
So government intervention can be justified only on the grounds of market failure
(increasing the size of the pie) or redistribution (changing the allocation of the pie).

 Government, which consists of both national(federal) and local units (states, counties,
cities, and towns), is large and growing in the United States and throughout the world.
The nature of government spending and revenue sources is also evolving over time as
governments move away from being providers of traditional public goods(such as
defense) to being providers of social insurance (such as Social Security and health
insurance).Governments also affect our lives through regulatory functions in a wide
variety of arenas.

 Public finance is central to many of the policy debates that are active in the United
States today, such as those over the Social Security program, health care, and
education.
REFERENCES
What Is Market Failure?
Market failure, in economics, is a situation defined by an inefficient distribution of goods and
services in the free market. In an ideally functioning market, the forces of supply and demand
balance each other out, with a change in one side of the equation leading to a change in price that
maintains the market’s equilibrium. In a market failure, however, something interferes with this
balance.

 Market failure refers to the inefficient allocation of resources that occurs when individuals
acting in rational self-interest produce a less-than-optimal outcome.
 Market failure can occur in explicit markets where goods and services are bought and sold
outright, or in implicit markets such as elections or the legislative process.
 It may be possible to correct market failures using private market solutions, government-
imposed solutions, or voluntary collective actions.
A market failure refers to the inefficient distribution of resources that occurs when the individuals in

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a group end up worse off than if they had not acted in rational self-interest. In the case of a market
failure, the overall group incurs too many costs or receives too few benefits. The economic
outcomes under market failure deviate from what economists usually consider optimal and are
usually not economically efficient

Causes of Market Failure

There are many types of imbalances that can affect the equilibrium of the markets. The following list
provides an overview of some common causes of market failure

Externalities: Externalities occur when the consumption of a good or service benefits or harms a
third party. Pollution resulting from the production of certain goods is an example of a
negative externality that can hurt individuals and communities. The collateral damage
caused by negative externalities may lead to market failure.
Information failure: When there is insufficient information available to certain participants in the
market, this can also be the source of market failure. If the buyer or seller in a transaction lacks
access to the information on which the price is based, they may be willing to overpay or
undercharge for a good or service, disrupting the market’s equilibrium.
Market control: When one party has too much control over a market, this can also create
imbalanced pricing and lead to market failure. In the case of a monopoly or oligopoly, a single seller
or a small group of sellers can manipulate pricing. In other situations, known
as monopsony or oligopsony, it is the buyers that have the advantage. In either case, the disrupted
balance of supply and demand could cause market failure.
Public goods: Public goods are another example of market failure because they defy the tenets of
supply and demand that drive the free markets. Public goods and services are nonexcludable—
once something like a street light is produced, it is accessible to everyone, and the producer
cannot limit consumption only to paying customers. Public goods are also nonrival, as use by one
individual does not limit consumption by others.

Solutions to Market Failure

There are many potential solutions for market failure. These can take the form of private market
solutions, government-imposed solutions, or voluntary collective action solutions.
Private market solutions: In some instances, the solution to a market failure may emerge within the
private market itself. For example, asymmetrical information  could be solved by intermediaries
or ratings agencies such as Moody's and Standard & Poor's informing market participants about
securities risk. Underwriters Laboratories LLC performs the same task for electronics. Negative
externalities such as pollution may be solved with tort lawsuits that increase opportunity costs for the
polluter. Radio broadcasts elegantly solved the nonexcludable problem by packaging periodic paid
advertisements with the free broadcast.
Government-imposed solutions: When the solution does not come from the market itself,
governments can enact legislation and take other measures as a response to a market failure. For
example, if businesses hire too few low-skilled workers after a minimum wage increase, the
government can create exceptions for less-skilled workers. Governments can also impose taxes
and subsidies as possible solutions. Subsidies can help encourage behavior that can result in
positive externalities. Meanwhile, taxation can help cut down negative behavior.
Collective action solutions: While the government may have the upper hand in developing
legislative, tax, or regulatory solutions, private collective action can also help solve market failure.
Parties can privately agree to limit consumption and enforce rules among themselves to overcome
the market failure of the tragedy of the commons.3 Consumers and producers can band together to
form co-ops to provide services that otherwise might be underprovided in a pure market, such as a
utility co-op for electric service to rural homes or a co-operatively held refrigerated storage facility
for a group of dairy farmers to chill their milk at an efficient scale.

Types of market failures include negative externalities, monopolies, inefficiencies in production and
allocation, incomplete information, and inequality.

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