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31 M.A. PART - II Group (I) PAPER-IV PUBLIC ECONOMIC © UNIVERSITY OF MUMBAI Dr. Sanjay Deshmukh Vice Chancellor, University of Mumbai Dr.AmbujaSalgaonkar Dr.DhaneswarHarichandan Incharge Director , Incharge Study Material Section, IDOL, University of Mumbai IDOL, University of Mumbai Programme Co-ordinator : Ms. Rajashri Pandit Asst. Prof-cum-Asst. Director, IDOL, Universityof Mumbai, Mumbai-400 098 Course Writer : Dr.Sujata Khodilkar Head of Departments of Economics, S.K. Somaiya College, Vidyavihar, Mumbai : Prof. Shashikant Mundhe Siddharth College, Fort, Mumbai : Prof. Vitthal Sontakke Kirti College, Dadar, Mumbai APRIL 2016 M.A. PART - II, GROUP(I), PAPER IV, PUBLIC ECONOMICS Published by Incharge Director Institute of Distance and Open Learning , University of Mumbai, Vidyanagari, Mumbai - 400 098. DTP Composed : Ashwini Arts ipin Enterprises Gurukripa Chawl, M.C. Chagla Marg, Bamanwada, VileTantia Parle Jogani (E), Mumbai Industrial - 400 Estate, 099.Pace Unit Computronics No. 2, "Samridhi" Paranjpe 'B' Scheme, Vile Parle (E), Mumbai - 57. Printed by : Ground Floor, Sitaram Mill Compound, J.R. Boricha Marg, Mumbai - 400 011 CONTENTS Unit No. Title Page No. Module - 1- Government in a Market Economy 1. Allocative Efficiency, Market Failures & Govt. Intervention 01 2. Social Welfare Functions & Govt. Failures 24 3. Interest Group Capture and Politico Economic Interactions 46 Module - 2 - Public Expenditure Rationale & Evaluation 4. Public Expenditure : Rationale and Evaluation - I 59 5. Public Expenditure : Rationale and Evaluation - II 83 6. Public Expenditure : Rationale and Evaluation - II 115 Module - 3 - Taxation & Public Sector Pricing 7. Taxation - I 158 8. Taxation - II 170 9. Public Sector Pricing 181 Module - 4 - Deficits, Debt and Solvency 10. Government Budget Constraint 187 11. Financial Programming Model 196 12. Taxation, Inflation and Interest Rates 203 Module - 5 - Fiscal Policy & The Macroeconomy 13. Macroeconomics Effects of Fiscal Deficits 211 14. Twin Deficit Approach to Growth 227 15. Financial Crisis 253 Module - 6 - Public Finance with Many Jurisdictions 16. Fiscal Federalism 268 17. Intergovernmental Grants & Revenue Sharing 283 1 1 MODULE -1 : Government in a Market Economy ALLOCATIVE EFFICIENCY, MARKET FAILURES & GOVT. INTERVENTION Unit Structure : 1.1 Objectives 1.2 Introduction 1.3 Efficiency in Resource allocation 1.4 First Best Economy 1.5 Market Failures 1.6 Rationale for State Intervention 1.7 Regulation and Taxation 1.8 Distributional Objectives of the State 1.9 Questions 1.1 OBJECTIVES 1. To understand the concept of Efficiency in Resource allocation. 2. To study and understand the Market Failures. 3. To understand Rationale for State Intervention and Regulation and Taxation. 1.2 INTRODUCTION Public economics or economics of the public sector is the study of government policy through the lens of economic efficiency and equity. At its most basic level, public economics provides a framework for thinking about whether or not the government should participate in economics markets and to what extent its role should be. In order to do so, microeconomic theory is utilized to assess whether the private market is likely to provide efficient outcomes in the absence of governmental interference. Inherently, this study involves the analysis of government taxation and expenditures. This subject encompasses a host of topics including market failures, externalities, and the creation and 2 implementation of government policy. Public economics builds on the theory of welfare economics and is ultimately used as a tool to improve social welfare. Broad methods and topics include: • the theory and application of public finance • analysis and design of public policy • distributional effects of taxation and government expenditures • analysis of market failure and government failure. Emphasis is on analytical and scientific methods and normative- ethical analysis, as distinguished from ideology. Examples of topics covered are tax incidence, optimal taxation, and the theory of public goods. 1.3 EFFICIENCY IN RESOURCE ALLOCATION There is a scarcity of almost everything that brings people happiness. Economics is the analysis of how society determines how it will distribute, or allocate, its scarce goods to a population and to a set of purposes that has an infinite desire for more. This is the first and most fundamental reason why economics is sometimes referred to as "the dismal science": never can all desires be satisfied. Society accomplishes its allocation through market system or/and command system: • Market systems use prices as signals to allocate its resources. • Command systems make use of political choice to allocate its resources. For our purposes, we shall focus on explaining how market allocation functions. Productive and Allocative Efficiency Through these means, society strives to achieve both productive efficiency and Allocative efficiency. An example of productive inefficiency is when a method of production yields the same as another that uses less of any 3 resource but does not use more of any other resource. Hence, there would be no reason to use the less productive method. An example of Allocative inefficiency is when a method of production using more of a certain resource and less of another than another method costs more to society overall. Even if it is productively efficient, the resources are not used in the best distribution--the allocation is inefficient. In this situation, the inefficient method should be swapped for the more efficient method by a redistribution of which combination of resources is used for a certain mode of production. Another interpretation of Allocative inefficiency is the distribution of goods to members of society in a way that yields less than optimal happiness. This interpretation is almost never achieved but is nevertheless the goal toward which economists strive. Productive efficiency must be satisfied before Allocative efficiency may be. Allocative efficiency is a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing. In the single-price model, at the point of allocative efficiency, price is equal to marginal cost. At this point the social surplus is maximized with no deadweight loss, or the value society puts on that level of output produced minus the value of resources used to achieve that level, yet can be applied to other things such as level of pollution. Allocative efficiency is the main tool of welfare analysis to measure the impact of markets and public policy upon society and subgroups being made better or worse off. Although there are different standards of evaluation for the concept of allocative efficiency, the basic principle asserts that in any economic system, choices in resource allocation produce both "winners" and "losers" relative to the choice being evaluated. The principles of rational choice, individual maximization, utilitarianism and market theory further suppose that the outcomes for winners and losers can be identified, compared and measured. Under these basic premises, the goal of maximizing allocative efficiency can be defined according to some neutral 4 principle where some allocations are objectively better than others. For example, an economist might say that a change in policy increases allocative efficiency as long as those who benefit from the change (winners) gain more than the losers lose. Conditions It is possible to have Pareto efficiency without allocative efficiency. By shifting resources in the economy, a gain in benefit to one individual could be greater than the loss in benefit to another individual (Kaldor-Hicks efficiency). Therefore, before such a shift, the market is not allocatively efficient, but might be Pareto efficient. When a market fails to allocate resources efficiently, there is said to be market failure. Market failure may occur because of imperfect knowledge, differentiated goods, concentrated market power (e.g., monopoly oroligopoly), or externalities. In contract theory In contract theory, allocative efficiency reflects a contract in which the skill the offering party demands and the skill of the party that agrees to the contract are the same. Allocative Efficiency and the Production Possibilities Frontier Because resources are scarce, a society must decide how to use those resources for its maximum benefit. When resources are used to produce one good or service, those resources become unavailable for any other purpose. Therefore, to understand how an economy allocates resources, it is best to look at a simplified economy that consists of the production of only two goods. In this simple economy, a production possibilities frontier, or model, can be constructed that shows every combination of the production of the two goods. Because economic resources are scarce, society has to decide what those resources will be used to produce, since any resources that are used to produce one good reduce the resources available for the production of other good. To better understand the allocation of resources, there are several assumptions for this simplified economy: • full employment and productive efficiency, • fixed resources, and • fixed technology. 5 The purpose of the assumptions is to show how the production possibilities of an economy changes with the allocation of its resources, so we must assume that nothing else changes
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