Individuals and Government

Chapter 1 (cont.)

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 .
The Allocation of Resources Between Government and Private Use
(Cont.)
The Production Possibility Curve:

 The trade-off between government goods and services (not sold in the market)
and private goods and services (like food, clothing sold in the market) is
illustrated with the familiar production-possibility curve.

 This curve gives the alternative combinations of government goods and

services and private goods and services that can be produced in an economy,
given its productive resources and technology and assuming that resources are
fully employed.

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 .
The Allocation of Resources Between Government and Private Use
(Cont.)

The production-possibility curve shows alternative combinations of government goods and services and
private goods and services that can be produced in an economy. The curve assumes that productive
resources and technology are given. An increase in government goods from 0G1 to 0G2 requires a
sacrifice of X1X2 units of private goods per year.
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 How Government Goods and Services are Distributed
 Government goods and services are distributed to groups of individuals
through the use of non-market rationing.

 This means that government goods and services are not made available to
persons according to their willingness to pay and their use is not rationed by
prices:
 In some cases, the services are available to all, with no direct charge and no eligibility
requirements (national defense services; police services).

 In other cases, criteria such as income, age, family status, residence, or the payment
of certain taxes, fees, or charges are used to determine eligibility to receive benefits.
• social security pensions (age/ disability/ paying taxes)
• public transportation facilities (fare/ charges)
• elementary schooling in a given school district (residence/ fees)
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 Mixed Economy, Markets, and Politics
A Mixed Economy
 Government supplies many goods and services.
 Government regulates private economic activity.
 Government expenditures range between 25% to 50% of
GDP, and taxes represent at least 25% of GDP.
 Provision takes place through political institutions not
markets:
 This involves interaction among all individuals of the
community (through voting and elections), rather than just
buyers and sellers.
 Political decisions can thus force citizens to finance government
services regardless of their personal preferences.
 Examples: The USA and most other nations today have mixed
economies. 5
A Pure-Market Economy
 All goods and services would be supplied by
private firms for profit.
 All exchanges would take place through markets
(interaction between buyers and sellers only),
with prices determined by free interplay of
supply and demand.
 Individuals would be able to purchase goods
and services freely, according to their tastes and
economic capacity (their income and wealth),
given the market-determined prices.
 In a market, buyers are not forced to purchase
something they do not want.
 Mixed Economy, Markets, and Politics: Circular Flow in the Mixed Economy

The upper and lower loops represent transactions between households and business firms in markets. Households use the income they earn from
the sale of productive services to purchase the outputs of business firms. The inner loop represents transactions between households and
government and between business firms and government. Governments purchase productive services from households and outputs of business
firms. These purchases are financed with taxes, fees, and charges levied on persons and firms, and the inputs acquired are used to provide
government services and transfers. 6
 Summary of Diagram
 The upper loop is the output market, where outputs are offered for sale to
households, which, in turn, pay for them with the money earned from the sale of their
productive resources.
In output market, firms represent the supply side, while households represent the demand side.

 The lower loop of the diagram represents the input markets, where households sell
their resources to firms for market-determined prices.
 In input market, households represent the supply side, while firms represent the demand side.

 The lower and upper loops represent the case in a pure market economy where there
is no government (all goods and services would be produced by private business firms).

 In a perfectly competitive market economy, no seller can influence prices; prices are
determined by supply and demand. Given market prices:
households decide which resources to sell and which outputs to buy.
firms decide which inputs to buy and what outputs to produce.
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 Summary of Diagram (cont.)

 In a mixed economy, government activities can be represented in the central

part of the circular flow:

1. Governments purchase inputs (resources) from households. They also purchase outputs
of business firms such as steel, cars, guns, stationary, computers, drugs, etc.
 To pay for these purchases, the government imposes taxes, charges, and fees levied on persons and
firms.

2. Governments use the inputs and resources they acquired to provide government
services (national defense, roads, public schooling, police) and transfers.

 In other words, the government participates in markets first as a buyer of goods,

services, and resources; then as: (i) a provider of other goods and services, (ii) a
provider of subsidies and transfer payments, and iii) an imposer of taxes and
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charges.
 Aging Populations: Implications for Public Finance
 The world is getting older:
 The average age of the population is rising: economic development, access to health care and
increased life-expectancy at birth.
• Egypt’s life expectancy at birth in 2018 reached 71.8, and was 69.4 in 2005

 Percentage of elderly to total population is increasing: as national income (development level)

rises:
• fertility rates (number of births per woman) decline….denominator decreases
-Example: China’s one child policy and the impact of this on having an aging population (check the following table).
• improved access to health care increases life expectancy……numerator increases .

In short, over the next 50 years we can expect to see more old people around, living longer, and higher
percentages of the elderly as a share of total population.

 Does this phenomenon have any effect on public finance?

Yes. Check next slides.
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Aging Populations: Implications for Public Finance (cont.)

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 Aging Populations: Implications for Public Finance (cont.)
 Old-age dependency ratio is the percentage of the population 65 years of age and
older to the population ages 15–64.
 this is an indicator of the proportion of retired workers to active workers in a nation.

 Because young people (under the age of 65) are likely to be in the labor force and
their income generates taxes to pay for government programs (Social Security
pensions, healthcare), a rise in the old-age dependency ratio means that a smaller
percentage of the population is productive which imposes a fiscal burden on the
government.
 For example, an old-age dependency ratio of 50 percent indicates that on average, there are 2
people of working age for each retiree.

 What is the fiscal Impact of a high dependency ratio?

 Significant increases of Social Security Pensions and government-funded health care expenditures.
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Aging Populations: Implications for Public Finance (cont.)

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 Aging Populations: Implications for Public Finance (cont.)
How can the government face the fiscal burden of a high dependency ratio?
 On the Revenue side:
 Increase tax rates on working population.
• If the government decided to increase taxes, this will affect incentives to work and produce with negative implications
for growth.

 Borrow to finance the deficit.

• If the government decided to borrow, this could result in soaring interest rates and declines in private investment (recall
the “crowding out” effect) that would adversely affect economic growth.

 On the Expenditure side:

 If taxes remained the same, and if the government did not increase borrowing, this will result in little funds available
to spend on other government programs such as defense and highways, causing low economic growth.
• Here the government has to consider the private sector for replacing it in providing these goods (PPP, BOT, are
alternative partnership programs).

 Otherwise, the government can decide to keep its spending on health care and social security pension programs
constant with the growing number of the elderly, which will result in deterioration of the service (decline of the
benefit per recipient).

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