Chapter 7

Discuss and contrast the various macro and micro models of public sector growth & critically argue
which model best applies to the growth of the public sector in South Africa.

Macro Models

 Explain broad patterns of government expenditure with regard to aggregate variables such
as GDP.
 These models are:
1. Wagner and the stages of development
2. Peacock and Wiseman’s displacement effect
3. Melzer-Richard hypothesis.

The stages of growth models of Wagner

 Structural change during development from a subsistence to an industrialised economy

influences the extent of public spending.
 Public spending priorities in three stages of development:
- Nature of government expenditure in the initial stage of development: Legal and
administrative institutions that have been established to reduce the cost of business.
Expenditure to initiate capital formation in the economy. Basic infrastructure is most
important.
- Nature of government expenditure in the middle stage of development: Capital
expenditure through infrastructure continues. State involvement in solving cases of
market failure which will occur now.
- Nature of government expenditure in the last stage of development: Capital expenditure
on economic infrastructure declines, but social spending begins to grow in relative
significance e.g. education, health and social security.

Peacock and Wiseman displacement effect

 Social upheavals or disturbances change established conceptions about acceptable tax

burdens and public spending levels.
 In times of crisis, the crisis demands higher state expenditure and thus higher taxes
 Make large increases in government spending possible
 Once the crisis is over, government spending remains high when upheavals end. This is
because taxpayers got used to high taxes and government direct such revenue to new
applications.

Meltzer Richard Hypothesis

 Median voter is the decisive voter in a democracy whose preference determines the winning
party elections.
 Pressure for redistributing income via the national budget would increase if extension of the
franchise changes the median voter to someone whose income lies below the average.
– Median voter then prefers a high tax burden and more redistributive government
expenditure.
 Reductions in labour supply and saving by heavily taxed persons can constrain such
spending.
 Micro Models
Focus on the decision-making behaviour of individuals and institutions in the public sector
1. Baumol’s unbalance productivity growth
2. Brown and Jackson’s microeconomic model
3. Role of politicians, bureaucrats and interest groups

Baumol’s unbalanced productivity growth can be exposed as follows:

 Distinction is drawn between:

 A progressive sector of the economy, characterised by technological improvements which
boost labour productivity, and
 A non-progressive sector with less opportunities for labour-enhancing technological
progress
 Non-progressive sector has to keep wage levels on par with progressive sector, therefore
wage bill rises.
 Non-progressive sector often the services sector rendered by government, non-progressive
because of inherent labour-intensity.

Brown and Jackson’s theory unfolds as follows:

 The variable in their model is the level of publicly provided goods and services, a measure of
the magnitude of the state’s role in the economy
 The explanatory variables are

- Preferences

- Income

- Tax rate of the median voter

- Cost of goods and services

 The amount of publicly provided services rendered, and therefore the magnitude of state
expenditure on such services is related to:
- The service environment
- The extent to which greater expenditure is necessary simply to keep up the levels of
service, not necessarily lifting the level
- Size, density and age structure of the population

- Quality of services demanded by the median voter.

- Higher quality demanded demands more inputs and thus greater government expenditure.
Distinguish between the notions of ‘crowding in’ and ‘crowding out’ (of private
investment).
 Solow-type aggregate production function
- Y = f(Kp ,Kg , eN)
- Kp and Kg represents the levels of capital owned by the private and public sectors
respectively, e is a measure of labour productivity and N is the quantity of labour (with eN
being Solow’s éffective’’ labour)
- Y = f(Kp (Kg ),Kg , e(Kg )N)
- where the relationship Kp (Kg) is either positive or negative, depending on whether there is
a net crowding-in p Kg or crowding-out effect, and where the first derivative of e (Kg ) is
positive.
 Capital goods provided by government would boost aggregate supply, output of
the economy provided that:
o It crowds in private capital formation in the form of supporting such capital
formation by for instance the infrastructure needed to successfully operate
factories or service industries
o It does not crowd out private capital formation by funding government
capital formation through borrowing which drives interest rates up.
 Crowding in thus refers to the extent to which the government’s expenditures on
capital formation, in the sense in which the NGT interprets capital formation,
supports capital formation by the private sector.
 Crowding out refers to the extent to which the government’s capital formation
discourages private capital formation, inter alia, through public sector borrowing
that drives up interest rates.

Consider the implication of new growth theory for the role of government in the economy.
Chapter 9

Q1

Conditional cash transfer programmes + diagram/graph best suited to answer – income tax
financed cash transfers programmes can reduce the reward for working - wages

Definition, discuss, example

 Programmes with livelihood protection and livelihood promotion effects.

 Aim to combat two types of poverty:
Current – Income support for consumption smoothing
Future – Human capital accumulation to break intergenerational poverty cycles.
 Nature: Provide cash to households that meet requirements – Increasing human capital of
children e.g., school attendance or health check-ups.
 Two sets of considerations justify behavioural conditions:
Efficiency-related market failures:
1. Positive external benefits of investments in education and healthcare of children.
2. Mismatches between parental preferences and children’s interests e.g., child labour vs
school attendance.

Equity-related market failure:

1. Conditions can be useful self-targeting mechanisms.

 Empirical findings regarding ccts:
Positive effects on household consumption, reduction in child labour increases in household
savings and investment.
Boosts school enrolment and use of healthcare facilities.
(But effects on education and health outcomes depends on quality of government provided
services)
Q2

Choice related argument on superiority of cash transfers over in-kind transfers

Core theoretical argument for cash transfers – Recipients who are allowed to choose how to use
social assistance benefits can attain higher levels of utility than those who are given goods selected
by government officials.

Budget line: Shows combination of two goods/services that a consumer can afford given prices and
their income. Its slope is the negative of the price ratio of goods & services.

Indifference curve: Combination of two goods/services that yield the same utility to consumer.

MRS: slope of indifference curve

Initial equilibrium: E1 Consumers budget line, AB, is tangent to indifference curve I1.

Government introduces new social assistance programme that provides at 0QF2 to low income
individuals. Consumer satisfies the income means test that determines eligibility.

The in-kind benefit enables individual to consume more = income increase = outward shift of budget
line. Individuals cash income remains the same.

ACD: budget constraint after intro of food parcel scheme.

New equilibrium: E2. In kind transfers increased individual’s consumption, now the indifference
curve represents higher utility.

Unlike cash transfers, in-kind transfers do not allow selection of combination along hypothetical line
EC.

Preferred combination: 0QF3 and 0QO3.

I3 is higher than I2, which means individual attains higher utility if given cash instead of food parcel.
Q3

Social service assistance should come in the form of goods and services not money. Agree or
disagree? Explain.

Choice, advantage of choice, disadvantage of other

Choice: cash form

Advantages of choice: allows beneficiary a choice of what to use the funds.

Disadvantage of other option:

Q4

Differentiate between social insurance programme and social assistance programme

Define, discuss, example

Social insurance programme:

Funded from mandatory contributions by workers and firms.

Contributions are known as social security taxes.

Benefits are limited to those who have made contributions.

Social assistance programme:

Cash transfer programmes funded from general tax revenues.

Eligibility for assistance not restricted to contributors to dedicated funds from which benefits are
paid.

Livelihood protection ( ability to maintain standards of living when experiencing loss of income) and
livelihood promotion (sustainable poverty reduction vis improvements in standard of living). These
depend on the use of money.

Two sets of risks:

1. Squandering money on luxuries & sin consumption

2. Using all money on consumption smoothing.
Q5

Outline economic rationale for social insurance programme

Efficiency and equity-related market failures justify government intervention via insurance schemes.

Efficiency – Private insurers cannot determine actuarily fair premiums for cover against some income
losses.

- Requirements: insurer must be able to know/reliably estimate probability of loss &

potential size of loss.

Information problems – prevent determination/actuarially fair premiums for cover against some
income losses. Example unemployment.

- Types of information problems: Both parties to a transaction lack information

- Asymmetric information ― One party to a transaction has more or better information
than the other party has

Adverse selection ― Persons who face high probabilities of suffering losses can hide their high-risk
status from insurers

- Problem of hidden characteristics ― Arises before insurance contracts are signed when
potential clients hide information about their probabilities of suffering losses from
insurers

Moral hazard ― Insured persons can behave in ways that increase the size of an insured loss without
the knowledge of the insurer

- Problem of hidden actions ― Occurs after insurance contracts were signed when clients
engage in hidden actions that affect the size of the loss or the likelihood of its
occurrence

• Social insurance and efficiency-related insurance market failures:

• Can overcome some adverse selection problems by making insurance compulsory

• Also potential cost savings and merit-good considerations

• Information problems prevent resolution of other adverse selection problems (e.g.

loss probabilities)

• Social insurance cannot overcome major moral hazard issues

• Social insurance and equity-related insurance market failures:

• Make consumption smoothing possible for those cannot afford any or full insurance
(including retirement insurance)