Theme 2 – Public Sector and

Mixed Economy

Public Economics

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Public Sector and the Economy

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The Size of Government

• How to measure the size of government

– Number of workers
– Annual expenditures
• Types of government expenditure
– Purchases of goods and services
– Transfers of income
– Interest payments
• Budget documents
– Unified budget
– Regulatory budget

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Government spending, % of GDP
1870 1913 1920 1937 1960 1980 1990 1996

Austria - - 14.7 15.2 35.7 48.1 48.6 51.7

Belgium - - - 21.8 30.3 58.6 54.8 54.3
Canada - - 13.3 18.6 28.6 38.8 46.0 44.7
France 12.6 17.0 27.6 29.0 34.6 46.1 49.8 54.5
Germany 10.0 14.8 25.0 42.4 32.4 47.9 45.1 49.0
Italy 11.9 11.1 22.5 24.5 30.1 41.9 53.2 52.9
Japan 8.8 8.3 14.8 25.4 17.5 32.0 31.7 36.2
Netherlands 9.1 9.0 13.5 19.0 33.7 55.2 54.0 49.9
Norway 3.7 8.3 13.7 - 29.9 37.5 53.8 45.5
Spain - 8.3 9.3 18.4 18.8 32.2 42.0 43.3
Sweden 5.7 6.3 8.1 10.4 31.0 60.1 59.1 64.7
Switzerland - 2.7 4.6 6.1 17.2 32.8 33.5 37.6
Britain 9.4 12.7 26.2 30.0 32.2 43.0 39.9 41.9
United States 3.9 1.8 7.0 8.6 27.0 31.8 33.3 33.3
AVERAGE 8.3 9.1 15.4 18.3* 28.5 43.3 46.1 47.1
Australia - - - - 21.2 31.6 34.7 36.6
Ireland - - - - 28.0 48.9 41.2 37.6
New Zealand - - - - 26.9 38.1 41.3 47.1
AVERAGE - - - - 25.4 39.5 39.1 40.4
TOTAL AVERAGE 8.3 9.1 15.4 20.7 27.9 42.6 44.8 45.9 7
Source: IMF *Average without Germany, Japan and Spain undergoing war or war preparations at his time
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The future
of the
state...

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Reasons for government
growth
• Macro models
– Wagner and the stages of development
– Peacock and Wiseman’s displacement effect
• Micro models
– Baumol’s unbalanced productivity growth
– Brown and Jackson’s microeconomic model

– Role of politicians, bureaucrats and interest groups.

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 What are the Legitimate Economic
Functions of a Government?
Depends on chosen economic system…
Least Most
individual individual
freedom freedom

• Centrally Planned • Decentralized Capitalist

Socialism: Economy: Limited
Government owns all government; individuals
resources and makes and firms make all
all important economic important economic
decisions decisions

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Three Normative Aspects of
Public Sector Economics
1. Public expenditure theory
– What government expenditures do we expect,
and why?
– How should government carry out its desired
functions?
2. Theory of taxation
– What principles should guide design of
government tax policy
3. Theory of fiscal federalism
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Two Goals of Economies
1: EFFICIENCY
• Efficiency is mainly a positive concept
• Economists measure efficiency as Pareto Optimality
• Definition: An economy-wide allocation of resources
is efficient if in order to increase one person’s utility at
least one other person’s utility must be decreased

Example
• An allocation in which I have everything and you have
nothing is an ‘efficient’ allocation (Pareto Optimal)
– The only way to make you better off is to take some
away from me
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(Efficiency continued…)
Consider all ‘efficient’ points given our existing resources
• Called the Utility Possibility Frontier
1. Must be downward sloping
• To increase 1’s utility we must
take utility away from 2
2. Points below line are attainable but
not efficient
• Could give some to both 1 and
2 and make them both better
off (Pareto Superior moves)
3. Points beyond line are unattainable
• Would require giving more
utility to both 1 and 2 which is
impossible

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 2: EQUITY (FAIRNESS)
Equity is mainly a normative concept
End-results equity
• Asks whether outcomes are fair.
– For example: Is it fair that over half of income in the country
goes to 20% of households? If not, what should be done to
correct it?
Process equity
• Asks whether rules determining process are fair, regardless of
allocation.
– For example: Do children of wealthy families start with an
advantage due to their family’s wealth? If so, then what
should be done to level the playing field?

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Allocative function

– Market failures distort the allocation of

resources in the economy
– Incomplete markets
• Characteristics of goods and services prevent
efficient supply
• Existence of externalities.

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Distributive function

– Fairness
– Inequality in income distribution
– Criteria for evaluation.

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Stabilisation function
– Macro-economic objectives
– 3 premises of stabilisation (Keynes):
• The market economy is inherently unstable
• Macroeconomic instability is a form of market
failure that is highly costly to an economy
• Governments are able to stabilise the economy
by means of appropriate macroeconomic policies.
– New Classical Macroeconomics
– Neo-Keynesian theory.

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Direct versus indirect
government intervention
•Direct government intervention refers to the actual
participation of government in the economy.

•Indirect government intervention to the regulatory

function of government.

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 Direct versus indirect government
intervention
Direct intervention Indirect intervention
– Actual participation in the – Regulatory function
economy
– Enacting law or proclaiming
– Tax individuals and
companies
legally binding rule
– Borrow on financial markets – Indirect taxes and
subsidies
– Execute budgeted spending
– Examples: – Examples:
• National defence • Labour laws
• Electricity • Anti-tobacco laws
• Infrastructure
• Provision of school text
books

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