1.

3 Public finance vs private finance

Generally
• Public finance is primarily made to finance
activities that maximize the social and
economic benefits of the majority or all the
people
• Private finance is primarily made to maximize
self benefit/return/profit.
 1.4 Why public finance/sector is needed
Fundamental reasons for public finance
i. Market failure – externality, public goods, asymmetric
information and imperfect competition.
ii. Political failure – mal-political, structural and
administrative system, spoilage

Details
 It enables government to correct undesirable side
effects of market failure.
 These side effects are called spillovers or externalities
Examples
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 Water pollution, air pollution, sound pollution, soil
pollution that affect people who are not responsible for
their emissions.

 Government can encourage or restrict certain activities to

correct them; through: recycling programs, pass laws,
imposition of taxes and charges,

 Public finance moderate the incomes of the wealthy and

the poor; through social security, welfare and other
programs.
Example: Assisting the elderly, disabled and other who cannot
work, redistribute income by collecting taxes from the
wealthier to provide resources for the needy ones.
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Generally the basic function of public
finance are
1. Allocation functions
2. Distribution functions
3. Regulatory functions
4. Stabilization functions
5. Coordination functions
• Spending taxes, taxes, deficits, and debts
• The size and growth of the government
• Decentralization of power and resources
 How government goods and services are
distributed
• Government goods and services are distributed through the
use of nonmarket rationing.

• They are not made available to persons according to their

willingness to pay and their use is not rationed by prices.

• In some cases, they are available to all, with no direct charge

and no eligibility requirements. Example: provision of national
defense services.

• In other cases, criteria such as income, age, family status,

residence, or the payment of certain taxes, fees, or charges are
used to determine eligibility to receive benefits.

• Government supplies a considerable amount of goods and

services and regulates private economic activity.
 …cntd
• Government expenditures typically amount from the
smallest up to one-half of GDP.
• Governments usually regulate private economic
activities and use taxes and subsidies to affect
incentives to use resources.
• Provision of a significant amount of goods and services
takes place through political institutions.
• This involves interaction among all individuals of the
community, rather than just buyers and sellers
• Political decisions often compel citizens to finance
government services and programs, regardless of their
personal preferences.
 Output

Markets

Income support and

Subsidies
Subsidies
Households Government
Taxes, Fees, Charges Taxes, Fees, Charges Firms

Government services Government services

Money
Money

Resources
Money

Input

Markets

Figure 1.2: Circular flow in the mixed economy

1.6 Economic rationale for modern state

• The role of government in an economy

is increasing and changing.
• Competition, efficiency, optimality, R&D,
innovation
• Globalization
• Technology
• Environmental and climate changes
• Growing population
• Increasing market demand
• Change in choice and preferences.
 1.6 Should public sector be small or larger
Supporters of large Supporters of small government
government (minimalist state):
• Believe that many case • Emphasize that while the private sector is not a
of market failure exist, perfect organizer of resources, the public sector
policy process is an is imperfect as well (i.e., government failure)
efficient means by
• Government or state failures refer to condition
which voters and policy
whereby public policies result in resource
makers organize
allocations that are more inefficient or
resources, and policy
inequitable.
makers are driven by
• Such inefficiency or inequality may be a result of
public spirit.
• technical inability of the policy makers or
• Policy makers should • the self interest nature of policy makers
base their policies on • They emphasize in the importance of individual
paternalism. liberty and the importance of protecting voters from
the coercive powers of the public sector.
1.7 Changing the role of government
 The role of the state is once again in
spotlight
 Recent developments:
• The reform in the command economies
• Fiscal crisis in industrial countries
• Rapid economic growth and poverty
reduction in some East Asian Countries
• The speed and amount of inflation
reductions
• The usefulness of an income or wage
policy, etc.
 …cntd

• Given the growing up demands for state and the

state’s capabilities, how can states become credible
and effective agents for development?
• The World Development Report 1997 points to a
part strategy:
i. Matching the state role to its capabilities; try to
do too much with too few resources and too little
capacity often do more harm than good. Give due
priority to social and institutional fundamentals.
ii. Increasing the state’s capability by reinvigorating
public institutions.
1.8 Limitations of government
(Government failures)
Government failures can be defined as
the activities of the state that lead to
Pareto inefficiency.
 Governments can fail in several ways:
 Inadequate information
 Majority votes may not please the
minority
 Non-merit based rewarding of special
groups
 A principal-agent problem
Summary
• Four questions of public finance
1. When should the government intervene in the
economy?
• When the market fails
• Before the market fails through regulation
• When monopoly power increases
• In the absence fair distribution of resources
2. How might the government intervene?
• Through fiscal and monetary policies
3. What are the effects of alternative interventions?
4. Why do governments do what they do?