Public Economics

Chapter 2
THE ECONOMIC BASIS
OF GOVERNMENT
ACTIVITIES

1
 2

Chapter 2: The Economic Basis of

Government Activities
2.1. Public goods 2.4.1. Identification of asymmetric
2.1.1. Public goods information
2.1.2. Government intervention 2.4.2. Asymmetric information and
2.2. Externalities efficiency
2.2.1. Identification and classification of 2.4.3. Government intervention
externalities 2.5. Income inequality and poverty
2.2.2. Externalities and efficiency 2.5.1. Concept and measurement
2.2.3. Government intervention 2.5.2. Income inequality/poverty and
2.3. Monopoly efficiency
2.3.1. The concept and causes of 2.5.3. Government intervention
monopoly (income/substitution effect)
2.3.2. Market failure due to monopoly 2.6. Economic cycle
2.3.3. Government intervention 2.6.1. Economic cycle and the role of
government
2.4. Asymmetric information 2.6.2. Government intervention
 3

Market failures

 Market failure: A problem that violates one of the

assumptions of the 1st welfare theorem and causes the
market economy to deliver an outcome that does not
maximize efficiency
 06 market failures in terms of efficiency:
 (i) public goods;
 (ii) externalities;
 (iii) monopoly (imperfect competition);
 (iv) asymmetric information;
 (v) income inequality and poverty;
 (vi) macro instability.
 4

2.1. Public goods

 Public goods are
commodities whose
consumption by an
individual does not
affect or reduce the
benefits derived from
the consumption of
others.
 5

2.1.1. Public goods

 Characteristics of public goods

- Non-excludability: it is costly or impossible to
exclude someone from using the good.
- Non-rivalry: when one person uses the public good,
another can also use it.
 6

2.1.1. Public goods

 Pure public goods: are those that exhibit the two traits of
public goods, when provided to an individual, all other
individuals in the community can also consume and
benefit from them.
 Impure public goods: are those that either exhibit one of
the two traits of public goods, or satisfy the two
conditions to some extent, but not fully.
 7

2.1.1. Public goods

Rivalry Non-rivalry

Excludability Private goods: Club goods:

Houses Cable television
Foods E-zine
subscriptions
Non- Common goods: Public goods:
excludability Tuna in the National defense,
ocean Firework
Public beaches
 8

2.1.1. Public goods

 “Free Rider” Problem

Some people know that if they don't pay, once the good
is provided, they still reap all the benefits of the good,
so even though there is a need, they do not express
that need (so as not to pay money) and when the good
is provided, they can still consume it as usual.
Social welfare loss when charging public goods
(Loss due to use below design level)
Bridges: How a user fee can
Bridge
result in welfare loss capacity
Price
As a result of a toll, p, some (toll)
trips across the bridge are not A Demand
for trips
taken, even though they
B
would be beneficial to society P

as a whole. The total welfare

loss created by the toll is
O Qf Qm QT
represented by the shaded
Number
region. of trips
taken
Public goods that have high transaction costs

Price Bridge
(toll) capacity

Public (free) provision:

A Demand
deadweight loss is CDQm for trips
D
Charging fee P: deadweight P
B

loss is BCQtQf C
P*

O Qf QT Q* Qm Number
of trips
taken
 11

2.1.1. Public goods

 Local public goods: are provided by local
governments mainly to local citizens. Local
public goods usually satisfy only one of the two
traits or both but to a certain extent.
 Some typical local public goods are universal
education, public health, environmental
sanitation, and clean water supply.
 12

2.1.2. Government intervention

 Thepublic sector directly produces and provides public

goods
 SOEs are the main production force, using budget-costs
 Advantages: advantage of goods quality control
 Disadvantages: may lead to monopolies, limited
production scale, spending deficit
 Publicsector and private sector cooperate in the
production and provision of public goods: public-private
partnership
 BOT, BTO, BT
 13

2.2. Externalities

2.2.1 Identification and classification

 Externalities arise whenever the actions of one economic
agent directly affect another economic agent outside the
market mechanism.
 Classification: 2 types
 Negative externalities
 Positive externalities
2.2.1 Identification and classification

Characteristics:
 They can be caused by production or consumption
activities
 The fact who causes damages (or benefits) to whom is
often relative
 The distinction between negative externalities and
positive externalities is relative
 All externalities are inefficient, from a social point of view
 15

2.2.2 Externalities and efficiency

Negative externalities
• Negative production externality: When a firm’s
production reduces the well-being of others who are not
compensated by the firm.
• Marginal private cost (MPC): The direct cost to
producers of producing an additional unit of a good
• Marginal external cost (MEC): Any additional costs
associated with the production of the good that are
imposed on others but producers do not pay for that.
• Marginal social cost (MSC): The private marginal cost to
producers plus marginal external cost.
 16

2.2.2 Externalities and efficiency

Negative externalities
Suppose a chemical plant MB, MC
MSC = MPC + MEC
and a residential area share
C
a lake. MPC
A
MSC = MPC+ MEC Profit B
Market optimal output level: added
to the MEC
Q1: MPC = MPB factory
E MPB
b
Socially optimal output level: a Additional
Q0: MSC = MSB damage to
residential
Q1>Q0 => social welfare 0 Q0 Q1 areas Q

loss = area of ABC Negative externality

 2.2.2 Externalities and efficiency

Positive externalities

• Positive production externality: When a firm’s

production increases the well-being of others but the
firm is not compensated by those others.
• MPB: marginal private benefit
• MEB: marginal external benefit.
• MSB: marginal social benefit
MSB = MPB + MEB
 18

Positive externalities MB, MC

MSB=MPB+MEB MSB = MPB + MEB

MEC=0
MSC=MPC MPB
MC
In the absence of Z

government regulation, V

the social welfare loss at

U T
the Q1 consumption level
is area of UVZ . MEB

Solution: The goal is to

increase output to the 0 Q1 Q0 Q
socially optimal output Positive externalities
level.
 19

2.2.2. Government intervention

 Command-and-control solution:
Command-and-control regulation can come in the form of
government-imposed standards, targets, process
requirements, or outright bans. Such measures make
certain behaviors either required or forbidden with the goal
of addressing the externality.
2.2.2. Government intervention
 Market-based solution
+ Fine or tax (Eg.Pigovian tax): designed to make
marginal private costs equal marginal social costs, and
marginal private benefits equal to marginal social
benefits. They are called corrective taxes, or
Pigouvian taxes.
+ Subsidies: the government paying part of the cost to
the firm; this reduces the price of the good and should
encourage more consumption.
2.2.2. Government intervention
 Market-based solution
+ Marketable permit: commonly referred to as
tradable permits, which operate under a cap and
trade system. A limit, or cap, is placed on the total
amount of a pollutant that may be emitted, and this
limit is either allocated or sold to firms in the form
of emissions permits.
 22

2.2.3. Government intervention

Fine or tax

Correction of negative
externalities:
In the absence of a tax
on pollution, firms will
set price equal to
marginal private cost.
There will be excessive
production (Qm). By
setting a tax equal to the
marginal pollution cost,
efficiency is obtained.
 23

2.3. Monopoly
2.3.1. Identification and causes of
monopoly
 Monopoly is the situation where there is only one
seller.
 Pure monopoly: exists when a single firm is the sole
producer of a product for which there are no close
substitutes.
 Natural monopoly: a producer achieves economies of
scale resulting in the most efficient for production to be
concentrated in a single firm.
 24

2.3.1. Identification and causes of

monopoly
Causes:
 Outcomes of the competitive process: more efficient
businesses will take over and dominate the market
 Public franchise: electricity, postal, petroleum
 Intellectual property rights for discovery, inventions…:
Microsoft
 Ownership of a special resource: natural resources
such as oil, diamonds, gold …
 Economies of scale (natural monopoly)
 25

2.3.2. Welfare loss due to monopoly

Welfare loss due to pure monopoly
 26

2.3.2. Welfare loss due to monopoly

Welfare loss due to natural monopoly
 27

2.3.3. Government intervention

Pure monopoly
 Objectives
 Increase output
 Decrease selling price
 Eliminate social welfare loss
 Solutions
 Antitrust laws and policies (Competition Law No.
27/2004/QH11)
 State ownership
 Price control
 28

2.3.3. Government intervention

Natural monopoly
Price controls
 P = MC
 P = AC
 29

2.4. Asymmetric information

2.4.1. Identification of asymmetric
information
 Perfect information: Producers & consumers have
complete market information (prices, quality of goods,
trading conditions...). Perfect information is a condition
for the existence of a perfectly competitive market.
 Lack of information: Producers and consumers cannot
make effective decisions → The market operates
inefficiently.
 30

2.4.1. Identification of asymmetric

information

 Asymmetric information: is a condition under which one

business party possesses more information than the
other party they are dealing with.
 31

2.4.2. Information asymmetry and

consequences

 Information asymmetry: adverse selection & moral

hazard
 Adverse selection occurs in the market when one
economic entity (usually the seller) owns more
information about the good than the other (usually the
buyer).
 Moral hazard arises when an economic entity tends to
be dishonest in its behavior or engages in risky
behaviors because the consequences of their actions
are borne by another entity.
 32

2.4.2. Information asymmetry and

consequences

Examples
 Used cars: only seller knows true quality of car
 Insurance markets: insured people may not take
necessary precautions — raises the avg. payment of
insurance company and, therefore, average premium
 Labor markets: the employer cannot guarantee the
attitude of the worker.
 33

2.4.2. Information asymmetry and

consequences

Eg: Asymmetric information on the buyer's side

The shaded area is the DWL due to underconsumption
 34

2.4.2. Information asymmetry and

consequences

Eg: Asymmetric information on the buyer's side

The shaded area is the DWL due to overconsumption
 35

2.4.3. Government intervention

Private solutions:
✓ Signaling is a solution to the problem of asymmetric
information in which the knowledgeable party alerts the
other party to an unobservable characteristic of the
good.
✓ Education—specifically the granting of degrees—is a
classic case of signaling. Information provision
✓ Product warranty: Offering a 10-year warranty
✓ Certification from independent organizations,
professional associations
 36

2.4.3. Government intervention

Public solutions:
✓ Providing additional information to the market: provide
information like providing a public good. Giving
information to one more individual does not reduce the
amount others have.
✓ The government providing certifications
✓ Regulations on information provision
✓ Consumer protection
 37

2.5. Poverty and income inequality

2.5.1. Concept and measurement of
poverty
 Poverty is a state of
deprivation in many
aspects such as: limited
income, lack of
opportunities to generate
income, lack of assets to
ensure consumption,
vulnerability to shocks, little
participation in decision-
Young children in the Democratic Republic of
making processes... Congo await a meal of porridge.
Photo: Jon Warren
 38

2.5.1. Concept and measurement of

poverty Three approaches to poverty
Poverty is a Poverty is a Poverty is a

Capability approach
Basic needs approach
The monetary approach

phenomenon phenomenon phenomenon

where one or where one or where one or
more more more
individuals in a individuals in individuals are
society do not society do not unable to
achieve the have access to develop their
minimum level basic goods capability to
of economic and services to perform
welfare (or ensure quality necessary
income) to of life. functions.
ensure a life at
the lowest level
according to
society's
standards.
 39

2.5.1. Concept and measurement of

poverty

 Poverty line: is the threshold at which an individual or

household whose income or expenditure falls below
that threshold will be considered poor (e.g. income
poverty, expenditure poverty, food poverty, etc.)
 40

2.5.1. Concept and measurement of

poverty

 Absolute poverty: when a household earns an income

that is below a level that allows them to buy even the
basic necessities of life such as nutritious food, shelter,
clothing, education and health.
 Relative poverty: when certain households earn an
income that makes them poor relative to the richer
households in a nation.
 41

2.5.1. Concept and measurement of

poverty

 Head count ratio (HCR): the proportion of the population

that exists, or lives, below the poverty threshold.
 Poverty gap: the ratio by which the mean income of the
poor falls below the poverty line. It measures the intensity
of poverty in a country.
 Squared poverty gap: a weighted sum of poverty gaps,
where the weights are the proportionate poverty gaps
themselves. It accounts for inequality among the poor,
and measures the severity of poverty in a country.
 42

2.5.1. Concept and measurement of

poverty
Aggregate
poverty index:
 HPI (Human
Poverty
Index)
 MPI (Multi-
dimensional
Poverty
Index)
2.5.1. Concept and measurement of
poverty

International poverty lines 6.85

3.63
2.15

International Lower middle Upper middle

poverty line income class income class
poverty line poverty line

Unit: 2017 PPP dollar

2.5.1. Concept and measurement of
poverty

Vietnam’s national poverty lines: Decree

07/2021/ND-CP on multidimensional poverty line for
the 2022-2025 period
 Minimum standard of living: from 2 million
VND/person/month or less in urban areas and 1.5
million VND/person/month in rural areas.
 Deprivation of access to six basic social services (job,
healthcare, education, housing, clean water and
sanitation, and information).
2.5.1. Concept and measurement of
poverty

Consequences of poverty:
 Low living standards
 Lack of access to sufficient healthcare
 Low levels of education
 Cycle of poverty
 46

2.5.1. Concept and measurement of

poverty
Cycle of poverty/ Poverty trap

Children born to
poor families

Young people who Children grown

have limited assets without enough
and opportunities, nutrition, well
young women get education or less
pregnant early access to services

Minors with no Children who do not

vocational skills and complete all levels of
limited education, education or drop
unemployment or no out of school to
full-time work work to support
their family
 47

2.5.2. Concept and measurement of

income inequality
 In economics, equality is a moral concept. Equality is
when each person and everyone receives income levels
(or enjoying economic achievements) worthy of their
ability, effort, education and willingness to bear risks
(Malcolm Gillis)
 Equality is a subjective concept: changes over space
and time
 Although there are many different ways of
understanding, all imply the recognition that there should
be a certain level of inequality.
 48

2.5.2. Concept and measurement of

income inequality
Compare equality & equity
 Equity focuses on outcomes. It allows for people to be
treated differently as long as the end effect of this
treatment is to bring them to the same outcome.
 Equality, by contrast, focuses on requiring people to be
treated equally regardless of circumstances.
 Equity is defined as “the absence of avoidable or
remediable differences among groups of people,
whether those groups are defined socially, economically,
demographically or geographically” (WHO)
 49

2.5.2. Concept and measurement of

income inequality

Horizontal equity and vertical equity

 Horizontal equity refers to the idea that people in the
same circumstances should be treated in the same way.
 Vertical equity refers to the idea that people on higher
incomes should take on a greater share of the
responsibility for paying for public services.
 50

2.5.2. Concept and measurement of

income inequality
Horizontal equity and vertical equity
 Horizontal equity aims to produce a tax system whereby those
on the same income pay the same amount in tax. Most
countries take horizontal equity as a starting point for their
taxation systems. It can, however, become very difficult to
maintain horizontal equity as soon as tax-deductible expenses
are introduced.
 Vertical equity aims to ensure that those who earn more pay
more. It is compatible with horizontal equity because it is still
possible for people in the same situations to be treated in the
same way. Vertical equity is also often known as “progressive
taxation” because tax levels progress upwards along with
income.
2.5.2. Concept and measurement of
income inequality
100%
Lorenz curve
 Built by American
statistician - Lorenz in
1905

Cumulative income (%)

 Lorenz curve
indicates the
relationship between A Lorenz curve
the population group
ranked by cumulative B
income from low to
high and their
respective income Cumulative population (%) 100%
rates
 2.5.2. Concept and measurement of
income inequality
Steps to plot a Lorenz curve

3. Calculate
2. Divide the 4. Represent the % of
1. Arrange the % of
population into cumulative national
the cumulative
groups with income on the vertical
population in national
equal axis, % of the cumulative
order of income of the
numbers population on the
ascending corresponding
(usually 5 horizontal axis and
income cumulative
groups) connect the points
population %
 53

2.5.2. Concept and measurement of

income inequality

Eg: Suppose there is a community of 10 individuals with

income as follows: (Unit: million VND/month)

A B C D E F G H I K
10 2 8 4 6 7 25 20 15 3

Draw a Lorenz curve reflecting inequality in income

distribution of the above community.
 54

B K D E F C A I H G
2 3 4 6 7 8 10 15 20 25
5% 10% 15% 25% 45%
5% 15% 30% 55% 100%
H
100
% national income

55
A
30

15 B
5
% population
0 20 40 60 80 100
Remarks on the Lorenz curve
Advantages:
 Lorenz curve reflects the cumulative percentage of the total
national income that is distributed corresponding to the
cumulative percentage of known population groups.
 Line L provides an intuitive look at the income inequality
 Line L in reality is always in the middle of absolute equality
line and absolute inequality line.
Limitations:
 Does not quantify inequality into an index so every
comparison is only qualitative.
 In the case of intersecting Lorenz lines, it is difficult to get a
consistent conclusion on the level of inequality.
2.5.2. Concept and measurement of
income inequality
Gini coefficient
 Gini coefficient is calculated based on Lorenz curve.
 How to calculate the Gini coefficient:
G = Area A/(Area A+ Area B)
Value of the Gini coefficient: 0 ≤ G ≤ 1
 WB has summarized that Gini in fact was 0.2 <Gini <0.6.
The greater Gini is, the higher the level of inequality. Low-
income country: 0.3-0.5; High-income country: 0.2-0.4.
 Limitations: There is no comparison between the highest
and lowest income group in a country.
56
 57

2.5.2. Concept and measurement of

income inequality
◼ The Gini coefficient is most commonly used and
calculated as follows:

A
g = =2A (because A+B = ½ ) g ∈ [0;1]
A+B

◼ Calculate the Gini coefficient of the following example:

B K D E F C A I H G
2 3 4 6 7 8 10 15 20 25
 58

2.5.2. Concept and measurement of

income inequality
Remarks on the Gini coefficient
Advantages:
- It is a convenient measure to compare the inequality
between countries and regions through different stages.
Limitations:
- Does not decompose inequality into different causes
of the inequality.
 59

2.5.2. Concept and measurement of

income inequality
Some key factors are seen as making a person more
“at risk” of being in poverty such as
 Inequality in unemployment or low-quality (i.e. low-paid
or precarious) jobs
 Low levels of education and skills
 Size and type of the household
 Gender
 Disability or ill-health
 Ethnicity, migrants/undocumented migrants status
 Remote or very disadvantaged community
 60

2.5.3. Government intervention

(income/substitution effects)
The solution will depend on the recognition (definition) of
poverty and measurement method.
Some interventions:
• Redistribution: progressive income/asset taxes
• Expanding opportunities for the poor
• Empowering the poor
• Social security system
 61

2.6. Economic cycle

2.6.1. Economic cycle and
government role
 The economic cycle is the fluctuation of the economy
between periods of expansion (growth) and contraction
(recession). Factors such as gross domestic product
(GDP), interest rates, total employment, and consumer
spending, can help to determine the current stage of
the economic cycle.
 An economic cycle has four stages: expansion – peak
– recession – trough
2.6.1. Economic cycle and government
role
 63

2.6.2. Government intervention (self-

study)

 Macroeconomic stabilization and long-term growth

promotion: see Macroeconomics/Development
economics