INTRODUCTION: Major Reason for Systemic Failure of the

Government:
Mercantilism ● Limited Information
● Wealth by trade restriction. ● Limited Control over private market response
● Trade Surplus and Protectionism, Increase ● Limited Control over bureaucracy
supply of Gold and Silver, More People ○ Legislation not equal to
(Labor), Colony = Wealth Implementation
● Limitations imposed by Political Process
Laissez-Faire
● Government should leave the market alone.
○ Free Market Capitalism- economy Three Economic Branches of the Government:
fails when the government is involved. (Musgrave's)
○ Libertarian View (Police Force, Private ● Stabilization (price and growth stability)
Rights, Public Goods) ● Allocation (budgeting)
● Distribution (Public goods and how to
Keynesian Economics distribute it)
● Government intervention leads to economic ●
growth. Pillar of Capitalism:
● Government prevents economic recession. ● Private Property
Fiscal and Monetary policy tools. ● Self-Interest
● Competition
Mixed Economy ● Market Mechanism
● Different from market-based and ● Freedom to Choose
Command-based economy ● Limited role of the government
● Both public and private sectors play an
important role in the economy Public Sector Economics
Characteristics: 1. What is to be produced?
● Private property still exists ● Private goods or Public goods?
● Government interferes in some economic 2. How is it to be produced?
activities ● By Public sector or Private sector?
3. For whom is to be produced?
GOVERNMENT FAILURES ● About distribution: Taxation and
welfare program vary
Market Failure 4. How are these decisions made?
● Inefficient distribution of goods and services ● Collective decision-making

Public Goods GOVERNMENT ACTIVITY

● Non Rival and Non Excludable
○ Non Rival Goods -can be consumed
by multiple users simultaneously
○ Non Excludable Good - impossible
to exclude other people from
consuming.
Government Vs. Private
Providing a legal system - required if a market
economy is to function
1. Producing Goods - defense, education,
healthcare (sometimes)
2. Affecting what the private sector produces,
through subsidies, taxes, credit, and
regulation.
3. Purchasing goods and services from the
private sector, which are the supplied by the
government to firms and household
4. Redistributing Income
 ● Transfer Payments - transfer money BUDGET CONCEPTS
from someone to another.
● Social Insurance - a universal Budget
insurance or safety net for everyone. ● The budget is the government’s financial plan
for a year. It is a table/schedule of
Types of Government Activity: expenditures based on either obligations or
1. The production of goods and services cash concepts and the corresponding
● Nationalization - from sources of financing, either from revenues,
privately-owned corporations to borrowings, or cash drawdown. Ultimately, it
state-owned enterprises. is a tool that enables the government to
2. The regulation and subsidization of achieve its development agenda.
private production Budget Deficit
● Taxes (Tax credit, Fiscal ● A situation where government spending
Incentives:PEZA) exceeds revenues.
● Subsidies (Not illegal, but ● Deficit = Revenue < Expenditures.
anti-competitive, Credit: Low-interest ● A deficit is financed by borrowing.
loan) Fiscal Policy
● Regulation (BSP for Financial ● The part of government policy which is
Institutions, DOLE hiring employees, concerned with raising of resources through
DTI and SEC for business) taxation and borrowing and deciding on the
3. The purchase of goods and services level and pattern of expenditure.
(C+I+G) Debt Service
● Infrastructure (DPWH) ● The sum of debt amortization and interest
● Defense (DND) payment, including commitment fees and
● Social Services (DSWD, DepEd) other charges on foreign and domestic
4. The redistribution of income borrowings of the National Government.
● Taxes and transfer (payment) - from Disbursement
one individual to another but not in ● A settlement/liquidation/payment of an
return for the provision of goods and obligation incurred in the current prior years,
services involving cash or non-cash transactions and
● Social Insurance (partly production, covered by disbursement authorities.
and redistribution) (SSS)
● Hidden redistribution through subsidy
programs and quotas

Government Activities
Ambiguities in categorizing government activities

Healthcare:
1. Producing Goods - government providing Government Expenditures:
healthcare services
2. Regulation - government providing guidelines
for private healthcare services
3. Purchasing Goods - government providing
free medical supplies or equipment
4. Redistributing Income - free healthcare for
the poor
 MARKET EFFICIENCY
Market Efficiency
● Primary reliance on the private sector for the
production and distribution of goods rather
than the public sector.
● This leads to efficient resources.
● If private markets were to be inefficient, this is
where the government intervenes in the
market.
Invisible Hand
● Competition would lead the individual in the
pursuit of his private interests (profits) to
pursue the public interest, as if by an invisible
hand.
● He intends only his gain.
● By pursuing his own interest, he frequently
promotes that of the society more effectively
than when he really intends to promote it.
Government exists due to these insights.
Assume a competitive market:
● Demand for goods and services > willing to
pay > PRoduction of goods and services >
value of goods > costs of production > there
is a potential for profit > the firm will produce.
Government does needs to:
● Determine what to produce because the
private sector can do this oversight for the
market because competition will drive out
inefficient producers.
Welfare Economics
● The branch of economics that focuses on
what were termed normative issues.
● It answers the questions - “What should be
produced?”, “how it should be produced”, “for
whom it should be produced”, and who
should make these decisions.
Fundamental theorems of welfare economics:
● Every competitive economy is Pareto
Efficient
● Every Pareto efficient resource allocation can
be attained through a competitive market
mechanism, with the appropriate initial
redistribution.
Pareto Efficiency
● Named after Vilfredo Pareto
● Resource allocations that have the property
that no one can be made better off without
being made worse off are said to be Pareto
Efficient or Pareto Optimal.
● It implies that resources are allocated in the
most economically efficient manner but does
not imply equality or fairness.
Pareto Improvement
● Is a change which makes some individuals
better off without making anyone worse off.
Economists are always on the lookout for Pareto
improvements.
Pareto Principle is a belief that any such
improvements should be instituted.
PARETO EFFICIENCY
Criterion:
Individualistic
● It is only concerned with each individual’s
welfare, not the relative well-being of different
individuals.
Consumer Sovereignty
● It holds that individuals are the best judge of
their own needs and wants, or what is in their
own best interest
Fundamental Theorems of Welfare Economics:
Competitive Economy
● Every competitive economy is Pareto
Efficient
● Every Pareto Efficient resource allocation can
be attained through a competitive market
mechanism, with the appropriate initial
redistribution.
Economic Efficiency in a Single Market
● In deciding how much to demand: Individuals
equate the marginal benefit they receive from
consuming an extra unit with the marginal
cost.
● In deciding how to supply: Firs equate the
marginal benefit they receive with marginal
costs.
 Analyzing Economic Efficiency
Exchange Efficiency
● Marginal rate of substitution (MRS) between
any two goods must be the same for all
individuals.
Production Efficiency
● Marginal rate of technical substitution
(MRTS) between any two inputs must be the
same for all firms.
Product Mix Efficiency
● Marginal rate of transformation (MRTS) must
be equal with marginal rate of substitution
(MRS)
Competitive Economies satisfy all the
conditions.
Utility Possibilities Curve
● The benefits that an individual gets from
consumption as the utility that individual gets
from the combination of goods the person
consumes.
Budget Constraint
● The amount of income a consumer can
spend on various goods.
Indifference Curve
● Gives the combinations of goods among
which an individual is indifferent, or which
yield the same level of utility.
Exchange Efficiency
● Concerns the distribution of goods.
● Given a particular set of available goods,
exchange efficiency provides that those
goods are distributed so no one can be made
better off without someone else being made
worse off
● It requires that there is no scope for trades, or
exchanges that would make both parties
better off.
● The amount of one commodity which an
individual is willing to give up in exchange for
a unit of another commodity is called
Marginal rate of substitution.
MARKET FAILURE
Government Activities
LV: Police Force, Property Rights, and Public Goods
Without property rights, no one has the
incentives:
● To maximize inputs
● To take care of resources
● To improve the yield
Without a contract to enforce, transactions must
not be feasible.
For contracts to exist:
● Government to enforce agreements
three ● Buyer and Seller having a transaction
● Agreement between the two
These government activities provide foundation on
market economics.
GOVERNMENT ACTIVITY
Providing a legal system - required if a market
economy is to function
1. Producing Goods - defense, education,
healthcare (sometimes)
2. Affecting what the private sector produces,
through subsidies, taxes, credit, and
regulation.
3. Purchasing goods and services from the
private sector, which are the supplied by the
government to firms and household
4. Redistributing Income
Transfer Payments - transfer money from
someone to another.
Social Insurance - a universal insurance or
safety net for everyone.
Basic Market Failures
Market Failures - Market is not Pareto efficient.
Market failures provide the rationale for government
activities.
1. Imperfect Competition ○ Negative externalities - where one
● Perfect competition - homogeneous market, individual’s actions impose a cost on
market determines the price, perfect other
information, no barriers to entry and exit. 4. Incomplete markets
○ Monopoly -single firm ● Complete market would provide all goods
○ Oligopoly - few firms and services for which the cost of provision is
○ Monopolistic Competition - many less than what individuals are willing to pay
firms but differentiated goods (WTP > Cost
● Reason why competition is Imperfect: ● Whenever private markets fail to provide
○ Larger Firms > Smaller Firms (Cost, good or service even though the cost of
quality of products) providing it is less than what individuals are
○ Natural Monopoly - naturally willing to pay, there is incomplete market
cheaper for a single firm to produce (WTP > cost but no private market willing to
the entire output than for each of provide)
several firms to produce part of it ○ Traits of Imperfect markets:
○ Firms engaging in strategic innovation, transaction costs,
behavior (offering lower prices, price asymmetries of information and
collusion, price fixing, output enforcement costs E.g, Insurance
limitations) ○ Adverse Selection: the tendency of
○ Government (Patents) high-risk individuals obtaining
insurance or when one negotiating
2. Public Goods party has a valuable information
● Goods that either will not be supplied another lacks
by the market or if supplied, will be ○ Complementary Markets:
supplied in insufficient quantity. Production based on complementary
○ E.g, Roads (Toll way or limited goods
to elected individuals) 5. Imperfect Information
● Pure public goods. Properties are: ● Information Failures
○ Zero marginal costs (MC = 0) ● Pro on information disclosure : If too little
for the additional individual information about the goods, the government
enjoying the good. should regulate.
○ Difficult or impossible to ● Against on the information disclosure:
exclude individuals from the ○ Unnecessary: the competitive market
enjoyment of a pure public. provides incentives for firms to
○ E.g, Defense, Disaster disclose relevant information.
response, Lighthouse ○ Irrelevant: consume pay little
3. Externalities attention to the information the law
● If actions of one individual or one firm affect requires
other individuals or firms, then externalities ○ Costly: for the government
exist. (administer) and firms (compliance)
● In some instances, where one firm imposes a ● Information as a public good. E.g, Weather
cost on other firms but does not compensate Forecast
them, or alternatively, where one firm confers 6. Unemployment and other macroeconomic
a benefit on other firms but does not reap a disturbances
reward of providing it. ● If unemployment exists, there must be a
○ Positive externalities - where one market failure.
individual’s action confer a benefit ● Unemployment is considered as the prima
upon others facie evidence that something is not working
well in the market.
 ● High unemployment - convincing evidence TWO PERSPECTIVE ON THE ROLE OF
of market failure GOVERNMENT:
● The same for inflation
The fundamental theorems of welfare economics are
Redistribution and Merit Goods useful because they clearly delineate a role of the
Given the economy pareto efficient: there are two government
further arguments for government intervention
In the absence of market failures and merit goods,
● Income Distribution - nothing about pareto the government is with distribution income
efficiency (resources). The private enterprise system ensures
● Individuals may not act in their own best that
interests
○ Individual’s perception of his own
welfare may be unreliable criterion for
making welfare judgment
○ E.g, Cigarette smoking, wearing of
seat belts
● Merit Goods - goods that the government
compels individuals to consume, like seat
belts and elementary education.
● Paternalism - the view that the government
should intervene because it knows what is in
the best interest of individuals better that they
do themselves.
● E.g, Cigarette Smoking
○ Externalities - sin tax; charge smokers
to compensate nonsmoker
○ Paternalism - individuals should not
be allowed to smoke
● Libertarianism - the view that the government
should not interfere with the choices of
individuals

Caveats against Paternalism

● Children - who should act in their own best
interest?
● Social Security
○ The protection that a society provides
to individuals and households to
ensure access to health care and to
guarantee income security,
particularly in cases of old age,
unemployment, sickness, invalidity,
work injury, maternity or loss of a
breadwinner.
○ Rationale for intervention in social
security: individuals who do not save
for their retirement become a burden
on the government