 2010 Asiyah Kassim

2
The Role of Government

Mixed Economy

Market Failure

Public Goods

Externalities
1. To be able to explain the role of government
especially in the effort to achieve relative health of
economy
2. To explain the attributes of Mixed Economy
3. To discuss the various forms of market failure which
require government interventions
4. To analyze the characteristics of public goods and
the constraints of providing it
5. To understand the existence and the influences of
externalities in public financial management.
 THE SCENARIO OF GOVERNMENT FINANCE ACTIVITY

Public Finance The field of economics that studies

government activities and the
alternative means of financing
government expenditures.

Government Organizations formed to exercise

authority over the actions of people
who live together in a society
and to provide and finance
essential services.
The Role of Government
1. Maintaining political and economic stability in the
country
2. Protect the public interest at large
3. Encourage a stable economic growth
4. Reducing market failure

The government action to achieve relative health of

economy
1. Implement balance budget
2. Reform tax structure towards more equitable tax
policy
3. Control inflation and unemployment rate at the
minimum level
4. Generate better investment climate and infrastructure
5. Maintain foreign exchange rate
 THE SCENARIO OF GOVERNMENT FINANCE ACTIVITY

•A condition in which government supplies a

considerable amount of goods and services
and Regulates private economic activity.
•In such economy, government expenditure
typically amount to between one-quarter and
Mixed Economy
one-half of GDP.
•Taxes absorb at least one-quarter of national
income.
•Government usually regulate private economic
activities and use taxes and subsidies to affect
incentives to use resources
 Circular Flow in Mixed Economy

In a mixed economy, government participates in markets as a buyer

of goods and services.
•Government purchase inputs from households and acquire
ownership rights of such productive resources as land and capital.
•Government use these inputs to provide goods and services that
are not sold to household and business firms but are made
available through ‘nonmarket rationing’.
•Nonmarket rationing = Government goods and services are not
made available to persons according to their willingness to pay and
their use is not rationed by prices.
 Circular Flow in Mixed Economy

•Government also purchase outputs of business firms such as

paper, cars, bricks, and guns.
•To pay for them, government requires businesses and household
to make various payments such as taxes, charges and fees.
•Government uses the productive resources it acquires to produce
goods and services including national defense, roads, schooling,
police etc.
•Summary of the attributes
-Cooperative role between public and private sector
-Liberalization of economy
- Encouraging productivity
 Market Failure

Definition: Markets do not efficiently organize production or

allocate goods and services to consumers.
Or
Situations where market forces do not serve the perceived
public interest.
Closely related with public goods and externalities
 Market Failure

• Definition:
• Where the market mechanism fails to
allocate resources efficiently
– Social Efficiency
– Allocative Efficiency
– Technical Efficiency
– Productive Efficiency
 Market Failure

Social Efficiency = where external costs and benefits

are accounted for
Allocative Efficiency = where society produces goods
and services at minimum cost that are wanted by
consumers
Technical Efficiency = production of goods and
services using the minimum amount of resources
Productive Efficiency = production of goods and
services at lowest factor cost
 Market Failure

Allocative efficiency:
Also referred to as

Pareto Efficient Allocation – resources cannot be

readjusted
to make one consumer better off without making
another worse off – zero opportunity cost!
 The Existence of Market Failure

1.Exercise of Monopoly Power in Market

-when markets are dominated by only a few firms or by a single firm,
the potential exists for the exercise of monopoly power
-Firms exercising monopoly power can add to their profits by
adjusting prices to the point at which marginal revenue equals their
marginal private costs without fear of new entrants into the market.

Market Power:
Existence of oligopolies
Collusion – conspiracy in the market
Price fixing
Abnormal profits
Barriers to entry
 The Existence of Market Failure

2.Effects of Market Transaction on Third Parties Other Than Buyers

and Sellers
-when market transactions result in damaging or beneficial on third
parties who do not participate in the decision, the result will be
inefficiency. E.g. exhaust fumes from cars, trucks, factories, heating
systems, power plants decrease air quality and impair public health

External Costs and Benefits

External or social costs
The cost of an economic decision to a third party

External benefits
The benefits to a third party as a result of a decision by another party
3. Lack of a Market for a Good with a Marginal Social Benefit that
Exceeds its. / Private sector failure in producing goods – PUBLIC
GOODS
-in cases where useful goods and services cannot be provided
efficiently through markets because it is impossible or difficult to sell
the good by unit.
-Benefits of such goods can be shared only and these goods are
public goods. E.g. National Defense
4. Incomplete Information -People often demand that government
intervene in markets because of incomplete info about the risks of
purchasing certain products or working in certain occupations.
-E.g. We rely on government to test new drugs and to prevent
hazardous products from being sold. And we also rely on government
to established standards for safety in the workplace.
5. Economic Stabilization
-Market imperfection, such as downwardly rigid wages, give rise to
excessive unemployment in response to decreases in aggregate
demand
-Budget Constraints

6. Goods/Services are differentiated

-Branding
-Designer labels - they cost three times as much but are they three
times the quality?
-Technology – lack of understanding of the impact
-Labelling and product information
7. Imperfect Knowledge:

•Consumers do not have adequate technical knowledge

•Advertising can mislead or mis-inform

•Producers unaware of all opportunities

•Producers cannot accurately measure productivity

•Decisions often based on past experience rather than

future knowledge
8. Inequality:
•Poverty – absolute and relative

•Distribution of factor ownership

•Distribution of income

•Wealth distribution

•Discrimination

•Housing
 Government Functions to Overcome Market Failure

1. To prevent monopoly control over price, government typically

monitor markets to ensure that barriers to entry do not
encourage the exercise of monopoly power. E.g. regulate the
pricing policies of monopoly producers for electric power, natural
gas and water.
2. Government engage in monetary and fiscal policies in an effort to
stabilize the economy to correct for these market failures to
ensure full employment
-Monetary policy – determine the investment spending and
consumer spending
- Fiscal policy – changing the overall level of government taxing and
spending
3. Governments also seek to avoid excessive and erratic inflation
that can erode purchasing power and can impair the functioning
of financial markets.
 Public Goods

Definition: Goods with benefits that cannot be withheld from those

who do not pay and are shared by large groups of consumers.
The 4 major characteristics of public good
1. Government provision through tax – provided by government
using the fund collected from various taxes

2. Non-exclusion – Unfeasible to price units of a public good = it is

too costly to develop a means of excluding those who refuse to
pay from enjoying the benefits of a given quantity of a public
good.
-E.g. it is unfeasible to exclude those who refuse to pay for a
cleaner air from enjoying the benefits of a given amount of air
quality improvement.
 Public Goods

3. Non-rival in consumption
– a given quantity of a public good can be enjoyed by more than
one consumer without decreasing the amounts enjoyed by rival
consumers.
-E.g. television and radio transmission & national defense. If rival =
private goods.

-Large external benefits relative to cost – socially desirable but

not profitable to supply!

4. No direct user charge – no direct payment or fees imposed

except for certain provision
The present method of providing public goods
1. Free of charge to all the users
2. The cost completely borne by the government
3. Free rider and non-exclusive use

The constraints of providing public goods

1. Unlimited demand and limited supply
2. Short of fund
3. Higher Cost
4. Political influence
5. Free-rider problem

Other alternative ways

1. Pricing of public goods
2. Enforcing proper rules and regulations of consuming the
goods
 Who is a Free Rider?

A free rider is a person who seeks to enjoy the benefits of a public

good without contributing anything to the cost of financing the
amount made available.

The free rider problem stems from the incentive people have to
enjoy the external benefits financed by others, with no cost to
themselves.
 Externalities

Definition: Externalities is cost and benefits of market transaction

not reflected in prices

•When an externality prevails, a third party (other than buyers or

sellers of an item) is affected by its production or consumption.
•The benefits or costs of the third party (either household or a
business) are not considered by either buyers or sellers of an item
whose production or use results in an externality
•It can be divided into 2:- Negative and Positive Externalities
•Example of externalities : pollution
 How and Why Externalities…

How Externalities occur?

When one person’s actions affect another person’s well-being and
the relevant costs and benefits are not reflected in market.

Why need to address externalities?

• Government will have to spend more as marginal costs exceed the
marginal benefits (in a case of negative externalities).
• Facilitate benefit forecast as (in a case of positive externalities) it
can help to reduce the potential spending.
Negative Externalities
• also called external costs
• the price of a good or service does not reflect the full marginal
social cost of resources allocated to its production
• it means: costs to third parties other than the buyers or the sellers
of an item not reflected in the market price particularly in a case
like damage by industrial pollutants
• E.g. In the production of paper, each unit of output results in cost
to parties other than the buyers or the sellers of the product.
• Neither the buyers or sellers of the good consider these costs to
third parties.
• External Costs
• Decision makers do not
take into account the cost
imposed on society and
others as a result of their
decision
– e.g. pollution, traffic
congestion,
environmental
degradation, depletion of
the ozone layer, misuse
of alcohol, tobacco, anti-
social behaviour, drug
abuse, poor housing
Negative Externalities ( cont’)
• A negative externality might be associated with paper production
because of damages done by pollutants emitted into streams and
rivers.
• Pollutants decrease the benefit obtained by other users of
streams, rivers or lakes such as commercial fishers, recreational
user like boating etc.
Positive Externalities
• Prices do not fully equal the marginal social benefit of a good or
service.
• It means: benefits to third parties other than the buyers or the
sellers of service/goods not reflected in prices
• Note that, buyers or the sellers of goods that when sold, result in
positive externalities do not consider the fact that each unit
produced provides benefits to others.
•E.g. purchase of smoke alarm / fire proofing, prevent from the
spread of fire
Positive Externalities
•E.g. inoculation against a disease, in which those who are
vaccinated benefit themselves of course, by reducing the
probability that they will contract a contagious disease.
• But they also provide benefits to those who do not receive
inoculations by reducing the number of persons who will become
host of the disease. Thus reduce the probability of outbreaks of
disease.
• In general, when a positive externality exists, marginal private
benefit will fall short of marginal social benefit at each level of
annual output.
• External benefits –
– by products of
production and
decision making that
raise the welfare of a
third party
– e.g. education and
training, public transport,
health education and
preventative medicine,
refuse collection,
investment in housing
maintenance, law and
order
Internalizing of externalities
(Balancing or neutralizing the condition)
Occurs:
•When the marginal private benefit or cost of goods and services
are adjusted so that the users considers the actual marginal social
benefit or cost of their decision.
•In the case of a negative externality, the marginal external cost is
added to marginal private cost for internalization
•For positive externality, the marginal external benefit is added to
marginal private benefit to internalize the externality
•Internalizing an externality results in changes in prices to reflect
full marginal social cost or benefit of a good
How to internalize the externalities?
1. Corrective tax = designed to adjust the marginal private cost of a
good or service , the tax must equal the marginal external cost
per unit of output to achieve the objective (imposed
counteractive or remedial taxes)
In effect, a corrective tax is exactly like a charge fro emitting
wastes. It is designed to internalize a negative externality by
making sellers of the product pay a fee equal to the marginal
external costs per unit of output sold.
2. Corrective subsidies = as a mean of internalizing the positive
externalities – payment made by government to either buyers or
sellers of a good so that the price paid by consumers is reduced
for e.g. the provision of certain government services at levels
below the marginal cost of such service.
How to internalize the externalities? (Cont’)
3. Rules and regulations – to balance the cost n benefits
4. Government Monopoly – total power of a particular condition
5. Cost to government – on unavoidable situation or externalities
6. Effect public – to have the awareness on the cost and benefits of
the market transaction and to be aware of government’s
functions in internalizing the externalities.
 Economy Efficiency

•Efficiency is a normative criterion for evaluating the effects of

resources use on the well-being of individuals.
•The efficiency criterion is satisfied when resources are used over
any given period of time in such a way as to make it impossible to
increase the well-being of any one person without reducing the
well-being of any other person.
•Simply state: it means producing a desired result with a minimum
of effort or expense.
•Economic efficiency as a major factor to provide good n services.
1. To avoid wastage in cost of providing the goods
2. Limited resources
3. Higher demand
4. Competition with private sector
•One of the types of efficiency is Allocative efficiency.
•It is achieved when the value consumers place on a good or
service (reflected in the price they are willing to pay) equals the
costs of the resources used in production.

•Condition
required is that
price = marginal
cost
•When this
condition is
satisfied, total
economic welfare
is maximized.
 Economic Welfare & Subsidies

•Whenever one talks about economic welfare, the concept of

income subsidies and support will come into the picture.
•Subsidy = a monetary grant given by a government to lower the
price faced by producer or consumers of a good generally because
it is considered to be in the public interest.
•Income Subsidies & Support = monetary or incentives / assistance
support ( either direct or indirect) as welfare aids to the appropriate
groups.
The impacts on economic welfare
1. Increase income
2. Future financial security
3. Reduced the financial burden
4. Less dependency on individual support