PUBLIC ECONOMICS

UNIT 1
INTRODUCTION and NATURE OF PUBLIC
ECONOMICS

BY – SHEETAL GERA
 RECOMMENDED BOOKS:
BOOKS AUTHOR CHAPTER
Public Finance in Theory R.A. Musgrave and Ch 1
and Practice P. B. Musgrave
Public Finance And Jonathan Gruber Ch 1
Public Policy
Basic Concepts Of Public IGNOU Readings Block 1 (Unit 1)
Economics
Intermediate Public Jean Hindriks and Ch 1
Economics Gareth D. Myles
 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 implementation of government policy.
• Public economics builds on the theory of welfare economics and is ultimately used as
a tool to improve social welfare.
• The study of public economics has a long tradition. It developed out of the original
political economy of John Stuart Mill and David Ricardo, through the public
finance tradition of tax analysis into public economics, and has now returned to its
roots with the development of the new political economy.

• From the inception of economics as a scientific discipline, public economics has

always been one of its core branches. The explanation for why it has always been so
central is the foundation that it provides for practical policy analysis.

• Public economics is the study of economic efficiency, distribution, and government

economic policy. The subject encompasses topics as diverse as responses to market
failure due to the existence of externalities, the motives for tax evasion, and the
explanation of bureaucratic decision-making.
• In order to reach into all of these areas, public economics has developed from its initial
narrow focus on the collection and spending of government revenues to its present
concern with every aspect of government interaction with the economy.
• Public economics attempts to understand both how the government makes decisions
and what decisions it should make.
• To understand how the government makes decisions, it is necessary to investigate the
motives of the decision makers within government, how the decision makers are
chosen, and how they are influenced by outside forces.
• Determining what decisions should be made involves studying the effects of the
alternative policies that are available and evaluating the outcomes to which they lead.
● The modern "capitalist" economy is a thoroughly mixed system in which public and
private sector forces interact in an integral fashion. The economic system, in fact, is
neither public nor private, but involves a mix of both sectors.
● The economics of the public sector includes not only financing but has broad bearing
on the level and allocation of resource use, the distribution of income, and the level of
economic activity.
● The need for fiscal measures is determined by how the private sector would perform
in their absence.
● In an analysis of the public sector, various types of questions may be asked:
1. What criteria should be applied when one is judging the merit of various budget
policies?
2. What are the responses of the private sector to various fiscal measures, such as
tax and expenditure changes?
 3. What are the social, political, and historical forces which have shaped the
present fiscal institutions and which have determined the formulation of
contemporary fiscal policy?
Question 1 requires a "normative" perspective, i.e., a type of economic analysis
that deals with how things should be done and asks how the quality of fiscal
institutions and policies can be evaluated and how their performance can be
improved. The answer requires setting standards of "good" performance.
Question 2 must be asked if the outcome of alternative policies is to be traced.
Analyzing the effects of fiscal measures thus involves what has been referred to as
"positive" economics, i.e., the type of economic analysis which deals with
predicting, on the basis of empirical analysis, how firms and consumers will respond
to economic changes and with testing such predictions empirically.
Question 3 likewise involves a "positive" approach, asking in this case why the
fiscal behavior of governments is what it is.
 PUBLIC ECONOMICS AND WELFARE
ECONOMICS: INTERFACE
• The basic objective of public economics is to provide insights for policy interventions by
the government to correct any distortion prevailing in the decision making space of various
agents in the economy.
• The main characteristic of a competitive market economy is the existence of large
number of buyers and sellers who are fully informed and do not face any barriers or
transactions costs for entry and exit in the markets.
• The markets may be for goods and services or for factors of production.
• The distortions may appear in the form of:
(i) monopoly or monopsony power for sellers or buyers,
(ii) taxes on or subsidies to firms or households,
(iii) existence of public goods where individual ownership or consumption is impossible or
 (iv) external economies or diseconomies which affect individuals.

• All these cases are examples where the individual agents fail to attain their optimal welfare
levels. Further, if individuals are not able to attain their optimum, it is not expected that the
aggregate welfare of the economy will be able to attain its optimum.
• Any policy measure undertaken by the government in such a competitive market economy is
solely aimed at improving the outcome of the decentralised actions of the individual agents in
the economy.
• If households consume with the main objective of maximising their utility, then with any
distortion in the functioning of the competitive economy, the consumers will be left with a
lower level of utility than the maximum.
• In such situations, government has to devise suitable policy interventions to correct the
outcome leading the economy to its optimum.
• Thus, welfare considerations form the backbone of economic policies in general and any
public economics oriented decisions in particular.
• Public economics has therefore considerable overlaps with welfare economics.
• Welfare economics deals mostly with aggregate levels of welfare while public economics
focuses on representative individual buyer or seller.
• Therefore, in public economics, welfare is often measured as the sum of consumer’s surplus
(in terms of utility), producer’s surplus (in terms of profit) and government’s surplus (in terms
of net tax revenue).
• Thus, public economics views any kind of surplus to be welfare enhancing.
• This perspective is essential to pinpoint the features of those welfare considerations which will
form the basis of public economics.
 NATURE OF PUBLIC ECONOMICS
The study of the government’s role in the economy involves answering four questions:
a) When should the government intervene in the economy?
b) How might the government intervene?
c) What is the effect of those interventions on economic outcomes?
d) Why do governments choose to intervene in the way that they do?
When should the government intervene in the economy?
• There are two reasons why governments may want to intervene in market economies: market
failure and redistribution (Wolf, 1987).
• The first fundamental theory of welfare states that, a Pareto efficient allocation of resources
emerges if all producers and consumers act as perfect competitors and if markets exists for
every commodity.
• This theory further implies that, a competitive economy automatically allocates resources
efficiently without the need for any centralized direction (Hindriks and Myles, 2013).
• If a market is efficient then there may be no need for government intervention.
• A market is said to be efficient if the quantity of goods and services produced and exchanged
is such that the marginal benefit to all the members of the society from the last unit of that
good is equal to the marginal cost of all members of the society(Betleys, 2000; Diamond and
Dybvig (1983).
• The failure of the market is therefore the strongest justification for the role of the state in
allocating economic resources.
• It does not, however, imply that government intervention will necessarily improve efficiency
because there could be government failure too (Datta-Chaudhuri, 1990; Black and Dollery,
1989; and Wolf, 1987).
• Apart from market failure, the other reason for government intervention is redistribution
(Wolf 1987). Redistribution implies the shifting of resources from some groups of society to
others.
• The type of income distribution produced by the market may be considered as unfair or unjust
by the society.
• Wolf (1987) also observed that when left on its own, the free market will produce less
redistribution than is efficient (that is, socially desirable). Such a situation, according to
Wolf (ibid), arises because of the free-rider problem that that characterizes externalities, public
goods and incomplete markets.
• The intervention is needed to correct resource misallocation by redistributing resources
from groups that are deemed to be “too well off” to those groups the society considers “not
• However, redistribution of resources from one group to another may result in efficiency
losses. These losses occur because the act of redistribution causes individuals to shift their
behaviour away from the efficiency-maximizing point.
• For instance, if we tax the rich to distribute income to the poor, then this tax may cause the
rich to work less hard and the poor to work less hard (Gruber 2016).
• Another form of redistribution is the existence of merit and demerit goods.
How might the government intervene?
There are several different approaches that the government can use for intervention. These
include:
1. Tax or subsidize private sale or purchase: One way that the government can try to address
failures in the private market is to use the price mechanism, whereby government policy is used
to change the price of a good in one of two ways:
i) through taxes, the government can raise the price of private sales or purchases of goods
that are overproduced, or
ii. through subsidies, which lower the price for private sales or purchases of goods that
are under produced.
2. Restrict or Mandate Private Sale or Purchase: Alternatively, the government can directly
restrict private sale or purchase of goods that are overproduced, or mandate private purchase of
goods that are under produced and force individuals to buy that good.
3. Public Provision: Another alternative is to have the government provide the good directly,
in order to potentially attain the level of consumption that maximizes social welfare.
4. Public Financing of Private Provision: Finally, governments may want to influence the
level of consumption but may not want to directly involve themselves in the provision of a
good. In such cases, the government can finance private entities to provide the desired level of
provision.
What are the effects of alternative interventions?
• In assessing the effects of government interventions, policy makers must keep in mind
that any policy has direct and indirect effects.
• The direct effects of government interventions are those effects that would be predicted
if individuals did not change their behaviour in response to the interventions
• whilst the indirect effects are effects that arise only because individuals change their
behaviour in response to the interventions (Gruber, 2016).
Why do governments do what they do?
• Governments face enormous challenges in figuring out what the public wants and how
to choose policies that match those wants.
• In addition, governments may be motivated by much more than simply correcting
market failures or redistributing income.
 • Just as there are a host of market failures that can interfere with the welfare- maximizing
outcome from the private market, there are a host of government failures that can lead
to inappropriate government interventions (Datta-Chaudhuiri, 1990).
• Politicians must consider a wide variety of viewpoints and pressures, only two of
which are the desire to design policies that maximize economic efficiency and
redistribute resources in a socially preferred manner.
Why Limit Government intervention?
The following are some of the reasons:
a) Government failure: Government failure can arise because government may have
limited control over private market’s response to its action. For example, government’s
rent control legislation can cause supply of rental houses to decline as landlords divert their
investments elsewhere in response to the fall in their returns from apartments.
b) Information problems: Due to information problems it may be difficult for government to
determine what consumers preferences are, so that determining what must be produced
becomes difficult. There is also the difficulty of aggregating preferences based on the number
of people that are willing and able to pay for a particular good or service.
c) Providing more public goods require more distortionary taxation, which can lead to
inefficiency in production.
d) Deadweight loss of large governments: The consequences of many actions of government
are complicated and often difficult to foresee.
e) Incentive effects: In the free market, individuals have a profit incentive to innovate and cut
costs, but in the public sector, this incentive may be lacking. Therefore, government
intervention can lead to inefficient production. For example, state-owned industries have
frequently been inefficient, overstaffed and produce goods not demanded by consumers.
f) Providing more social insurance can induce bad incentive effects: Government
intervention to provide health care services, for instance, may be limited by tax revenue. It is
more likely that services will be rationed leading to longer waiting lists and some
treatments not available.

g) Additional redistribution leading to distortions in incentives: Redistribution of income

through the imposition of taxes can have adverse effects on work, investment and savings.
This can create important trade-offs in any policy analysis.