PUBLIC

FINANCE
Urvashi Gill Dhingra

Books recommended
1. Rosen & Gayer, Public Finance, 8 th edition, McGraw Hill
2. Stiglitz, J.E. Economics of the Public Sector, 3 rd edition
3. Musgrave R. A. and Musgrave P. A. Public Finance in
Theory and Practice, McGraw Hill
4. Singh S. K. Public Finance in Theory and Practice, S.
Chand and Company Ltd., 2008.
5. Tyagi, B. P. Public Finance, Jai Prakash Nath & Co.,
6. H. L Bhatia, Public Finance, Vikas Publishing House
Pvt. Ltd., 2008

Introduction
Public Finance: Field of economics which studies
government activities and the alternative means
of financing government expenditure
Public Sector over the years
Mercantilist View
Adam Smiths invisible hand
Karl Marx socialist ideology
Keynes View
Mixed economy of today

Role of the Public Sector

Basic functions- providing legal framework
To effectively enforce laws of contract between
individuals to determine exchange
To effectively define property rights
To provide criminal laws and enforce them to ensure
orderly functioning of civil society and markets
Other functions:
Production of goods and services
Regulation and subsidization of private production
Purchase of goods and services
Redistribution of Income

Functions of the Government in a

mixed economy- Musgraves
Classification
Allocation function: concerned with the determination of the process
by which total resources of the community are divided between
private and social goods. It also chooses the mix of social goods
Instrument: political process of voting
Distribution function: aims at shifting resources from the disposal of
one individual to that of another to ensure conformance with what
society considers fair and just distribution
Instruments: taxes and transfers, progressive taxations and
welfare programmes
Stabilization function: Involves maintaining high level of
employment, reasonable price stability with appropriate economic
growth
Instruments: Monetary Policy, Fiscal policy

Pareto Optimality.A recap

How do we evaluate alternatives?
In a pure exchange economy: Based on Pareto
Efficiency criteria
Resource allocation that have the property that
no one
can be made better off without someone
else being made worse off are said to be Pareto
efficient.
Efficiency criteria:
Exchange efficiency:
Production efficiency
Product Mix efficiency

Pareto Optimality.A
recap
Properties of Pareto criteria

Concerned with each individuals welfare and

not with relative wellbeing of different
individuals

Based on each individuals perception of his or

her own welfare

MARKET FAILURE
When markets do not lead to efficient outcomes i.e.
are not Pareto efficient
Reasons:
1. Failure of Competition
2. Public goods
3. Externalities
4. Incomplete markets
5. Imperfect information
6. Unemployment and other macro economic
distributes

Failure of Competition or
Imperfect Competition
Reasons:
1. Declining average costs
2. Natural monopoly
3. High transportation costs
4. Imperfect information
5. Strategic behaviour to discourage competition
6. Government action- e.g. granting of patents

Public Goods
Two characteristics of a Pure Public good:
1. Non rival
2. Non excludable
Markets will either not supply such goods or supply in
insufficient amounts
Classic examples: A Lighthouse, National Defence

Externalities
When actions of one individual or firm affects other
individuals or firms, generating either a cost on them,
but does not compensate them; or alternatively
generates a benefit for other individual or firms, but
does not reap a reward for providing those benefits.
Externalities are of two types:
1. Positive externalities
2. Negative externalities

QUIZ: What kind of

externality do these
activities
generate?
Additional
car on a congested
road
Additional oil rig in the same oil pool
Immunization drive preventing spread of Polio
Education
Air pollution caused by a steel plant
Significant improvement in your home garden
Improving driving habits
Cigarette smoking
A factory dumps its products in a nearby river
R & D investment by a firm

Incomplete Markets
Goods which markets fail to provide even though their cost of
provision is less than what individuals are willing to pay

Insurance and capital markets

Reasons:
1.
2.

Asymmetries of information
Adverse selection

.Complementary markets

Information failures
Information in many respects is a public good and
efficiency requires that information be freely
disseminated
Private market will supply inadequate amount of
information

Unemployment, Inflation
and Disequilibrium
High rate of unemployment and inflation are some of the
most convincing evidences of market failure