Lecture 6

Lecture Six: Public Finance
PART ONE: THE ECONOMIC BASIS

FOR GOVERNMENT ACTIVITY
Chapter 5: Public Choice and Political

Process
Dr. Yara El-Sehaimy

Ya b d e l k h a l e k @ e c u . e d u . e g
Chapter 5 Outline
2
 Government and politics.

 Allocation of recourses between public and private sectors.
 How much government is enough.
 Positive and normative economics.
 Marginal condition for efficiency.
 Market failure.
 Externalities and internalization.
 Types of goods.
 Free-rider problem.
 How are they all interconnected?
 Median voter theory.
Governments and Politics
3
 Public Finance: is the field of economics that studies government

activities and the alternative means of financing government
expenditures.
 In order to understand and analyze the role of government we need first

to understand the following:
 Government expenditures.
 Regulations.
 Taxes
 Investment.
 Consumption.
 Borrowings.
 Government is an organization formed to exercise authority over the

actions of people who live together in a society and to provide and finance
essential services.
Allocation of Resources between Government
and Private Sector
4
 Government supply goods and services, right?
 To make such goods and services, government requires labor,

equipment, buildings, and land, which are the factors of production
that the private sector needs too.
 So, the question now is, how we are going to allocate the factors of
production between public and private sector?
 This trade off could be illustrated by the Production Possibility Frontier

PPF.
and Private Sector
5
 Government Goods and services
such as roads, schooling, and fire
protection, usually are not sold in
markets.
Government Goods
 Private goods and services such as
A D
food and clothing, usually made
available for sale in markets.
B
 Recourses are either used in public

or private sector. C
 A &B Efficient points. Private Goods

 C inefficient
 D unattainable
and Private Sector
6
 As long as the economy is on the
PPF line; therefore, the economy is
at equilibrium.
 In which, scarce recourses are
Government Goods
A
efficiently allocated based on the
market benefits and preference.
B
 If the economy moves from A to B,
it will still be efficient but with
more recourses allocated to the
private sector than the public one.
Private Goods
How Much Government is Enough?
7
 One reason we demand government services is that in many cases it provide us

with items that can’t easily make available for ourselves or purchase from
others in markets.
 Government power is extracted through establishing rules that regulates the

social interactions among individuals and to settle disputes among citizens.
 Government use their power to redistribute income and economic

opportunities among citizens through tax brackets, income support,
unemployment transfers, stabilize economic performance, regulate production
and consumption.
 Government provide goods and services that the market/private sector fails to
supply.
 Therefore, government should interfere as long as there is a market failure.

How Much Government is Enough?
8
 In order to analyze the role of the government, we need to set a ground

based on which our analysis could take place.
Economics
Positive “is” Normative “should”

Marginal Condition for Efficiency
9
Efficiency = Marginal Social Benefit (MSB) - Marginal Social Cost (MSC)

Producing a • Extra benefit obtained by • The minimum sum of money
desired making one more person satisfies required to compensate the
result with a by using one extra produced unit. producers for making one extra
minimum unit.
of effort or • MSB = ∆TSB/ ∆Q
expense • MSC = ∆TSC/ ∆Q
 So, what is the condition for efficiency?
 Efficiency attained when:

MSB = MSC
 What happened when MSB>MSC or MSC>MSB?

MarketMarket
Failure
Failure Types
10
Concentrate Asymmetric
Externalities Public Goods
Market Power Information
Externalities Types
11
Externalities
Positive Negative
 Are benefits to 3rd parties other  Are costs to 3rd parties other than
than the buyers or the sellers of a good the buyers or the sellers of a good or
or service not reflected in prices. service not reflected in prices.
Buyers and sellers of goods that Buyers and sellers of goods that
results in +ve externality do not results in -ve externality do not
consider the fact that each unit consider the fact that each unit
produced provided benefits to others. produced provided damage/ cost to
others.
Internalization of Negative Externality
12
Private + Social Cost

Price
Private Cost
P’*
P*
Demand
Q’* Q* Quantity
Taxes
Give me 1 example of negative Externality?
Internalization of Positive Externality
13
Price
Supply
P’*
P*
Private + Social Benefit
Private Benefit
Q* Q’* Quantity
Subsidies
Give me 1 example of Positive Externality?
How Goods are Classified?
14
 In order to understand public goods market failure, we need to

understand first how goods are classified.
 We classify goods based on many factors such as:

 Based on income.
 Based on relative goods.
 Based on benefit.
 Based on social gain.
 Rivalry and excludability.
 Let’s understand each type!

How Goods are Classified? –Rivalry & Excludability-
15
Characteristic
Rival Non-Rival
Excludable Common Resource

Private Goods
Goods
Non-Excludable
Club Goods Public Goods
Free-Rider Problem
16
 A free-rider is a person who seeks to enjoy the benefits of a public good

without contributing anything to the cost of it.
 The free-rider problem evolved from the incentive people have to enjoy
the external benefits financed by others, with no additional cost applied
to them.
 There aren’t penalties of free-riding behavior, so why not doing it.
 What makes free-rider strategy succeed is that few people apply it; but
if it turned to be a collective action, all the society will be worse off.
How are they all interconnected?
17
 Democracy  Voting  Constitution  Political Parties  Politics 

Government and Presidency  Affect Everything!!
 Choice of taxes, subsidies, expenditures, laws, public goods,

externalities, interfering in the market, etc.
 Who controls it all? CITIZENS through voting!
 Citizens always choose the candidate that decreases their total cost.
 The main voting mechanism used is majority role (50%+1).

Median Voter Theory
18
 Under the majority voting role.
 Median voter is the one whose most preferred outcome is the

median/average of the most preferred outcomes of all those voting.
 Within majority-rule voting systems, the results of the voting will

depend on the preferences of the median voter.
15 Minutes
19
 Let’s talk economics 
 Could you identify a +ve and –ve externalities in the Egyptian

economy?
 Identify 5 public goods in the Egyptian economy.
 Do you think Egyptian policy makers follow positive or normative

economics in decision making?
 Do you think efficiency condition is achieved in the Egyptian economy?

Thank You!
20
!SIX LECTURE DOWN SIX TO GO!

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Lecture Six: Public Finance

PART ONE: THE ECONOMIC BASIS

Chapter 5: Public Choice and Political

Dr. Yara El-Sehaimy

 Government and politics.

 Public Finance: is the field of economics that studies government

 In order to understand and analyze the role of government we need first

 Government is an organization formed to exercise authority over the

 Government supply goods and services, right?

 To make such goods and services, government requires labor,

 This trade off could be illustrated by the Production Possibility Frontier

 Recourses are either used in public

 A &B Efficient points. Private Goods

 In which, scarce recourses are

 One reason we demand government services is that in many cases it provide us

 Government power is extracted through establishing rules that regulates the

 Government use their power to redistribute income and economic

 Therefore, government should interfere as long as there is a market failure.

 In order to analyze the role of the government, we need to set a ground

Positive “is” Normative “should”

Efficiency = Marginal Social Benefit (MSB) - Marginal Social Cost (MSC)

 So, what is the condition for efficiency?

 Efficiency attained when:

 What happened when MSB>MSC or MSC>MSB?

Private + Social Cost

Private + Social Benefit

 In order to understand public goods market failure, we need to

 We classify goods based on many factors such as:

 Let’s understand each type!

Excludable Common Resource

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

 There aren’t penalties of free-riding behavior, so why not doing it.

 Democracy  Voting  Constitution  Political Parties  Politics 

 Choice of taxes, subsidies, expenditures, laws, public goods,

 Who controls it all? CITIZENS through voting!

 The main voting mechanism used is majority role (50%+1).

 Under the majority voting role.

 Median voter is the one whose most preferred outcome is the

 Within majority-rule voting systems, the results of the voting will

 Let’s talk economics 

 Could you identify a +ve and –ve externalities in the Egyptian

 Identify 5 public goods in the Egyptian economy.

 Do you think Egyptian policy makers follow positive or normative

 Do you think efficiency condition is achieved in the Egyptian economy?

!SIX LECTURE DOWN SIX TO GO!

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