INTRODUCTION

What is Public Finance?

 Public finance is the study of the spending and taxing decisions of the public sector with
special reference to the efficiency and equity implications of government decisions.
 It examines the relationship between public expenditure, taxation and the behavior of
economic agents such as individuals, households and firms.
 PF explores the fiscal tools of the state and how best they can be used to meet the goals
of public policy. How fiscal instruments function is a matter of economics but the
purpose to which the instruments are put depends on the role of the state and on the
image of a good society
 It is the area of economics or economic theory devoted to the study of how government
policy i.e. tax and expenditure policy, affects the microeconomic behavior as well as the
aggregate economic activity.
 Public finance does not concentrate on financial arrangements of governments but on
the economic consequences of public policy on:
- Resource allocation
- Income distribution
- Level of economic activity- stabilization

HISTORICAL DEVELOPMENT OF PUBLIC FINANCE

During the 18th century the mercantilists were of the view that the government should actively
promote trade and industry.

Adam Smith who is often viewed as the founder of economics wrote THE WEALTH OF
NATIONS (1776). This was partly in response to the mercantilists. He argued for a limited role of
government. Smith attempted to show that the profit motive would lead individuals/firms to
compete against each other in supplying goods and services. Only that firm that produced and
supplied what was wanted and at the lowest possible price would survive. He argued that the
economy was led by an invisible hand to produce what was desired and in the best possible way.

According to Smith the state had only three duties to attend to:
1) The duty of protecting the society from violence and invasion by independent societies
(The defence function)
2) The duty of protecting as far as possible every member of society from the injustice or
oppression of every other member of it or the duty of establishing an exact administration
of justice (The law and order function)
3) The duty of erecting and maintaining certain public works and certain public institutions
which it can never be in the interest of any individual to erect and maintain because the

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 profit could never repay the expense of any individual or small number of individuals,
though it may frequently do much more than repay it to greater society.
4) Much later: to meet the expenses necessary to support its sovereignty (the taxation
function of the government)

Other 19th century economists such as John Stuart Mill and Nassau Senior promulgated the
doctrine of laissez faire. They advocated for a purely market oriented economy. In their view the
government should leave the private sector alone, it should not attempt to regulate or control
private enterprise. Unfettered competition would serve the best interest of society.

Not all 19th century thinkers were persuaded by Adam Smith because of the poor living
conditions among the workers, and the high levels of unemployment (Charles Dicken-writers,
Karl Marx not only wrote about the conditions but also developed theories to try to reorganise
society) many attributed the evils in society to the private ownership of capital-what Adam Smith
saw as virtue they saw as vice.

Marx was the most influential among those who advocated for a greater role for the state in
controlling the means of production. Others such as Robert Owen saw the solution neither in the
state nor in the private enterprise but in smaller groups getting together and acting cooperatively
for their mutual interest.1

The great depression was the event that most fundamentally changed attitudes towards
governments. The US unemployment rate reached 25% while output fell buy about 1/3 from its
1929 level. There was a widespread view that markets had failed in an important way and there
was pressure for government to do something about this market failure. John Maynard Keynes,
writing in the midst of the great depression, forcefully argued that the government could do
something about the economic slumps.

Other roles of government

 Allocative role
The gvt pursues that allocation of resources which maximises efficiency. Gvt has to deal with
market distortions caused by monopoly power and other forms of market failure.
 Distributive role
Gvt balances efficiency with equity in the allocation of resources by using taxation, social
security and the distribution of public sector services to influence the distribution of income.
 Regulatory role
Gvt legislates and enforces laws of contract, consumer protection, justice etc in order that the
market may function.
 Stabilisation Role
This is macroeconomic in nature- using fiscal, monetary and other economic policies to pursue
objectives for the control of inflation, unemployment, BOP, etc.

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 Austrian authors such as Sax and Wieser joined with the group of Italians such as Mazzola
and Pateloni and traced market failure in the provision of public goods to their non-rival and
or non- excludable nature. They also addressed the issue of efficient provision of public
goods through equating price payable by consumers with the MU they derived.
 Wicksell accepted their principle but questioned it on the basis that preferences have to be
known and the problem of preference revelation. Had to be confronted for the benefit charges
to be assessed. Although in the market for pvt gds, consumers can reveal their preferences by
bidding consumers for the jointly available non-rival gds, many act as free riders as free
riders, therefore links to tax expenditure voting would be necessary to overcome the problem.
 Lindahl later extended the concept thru his marker analogy where an equilibrium is reached
at the intersection AS= AD arrived at by vertical addition of individual demand curves.
 Samuelson (1954) set down the theory of the demand for public goods
 Arrow (1950) examined the logical problems of collective choice and the social welfare
function.
 For A Marshal (1930) PF was confined to the theories of tax shifting and tax incidences. He
provided a positive theory for analysing the relative price and output effect of alternative
taxes on individuals and firms thru his comparative static analysis.
 Pigou’s (1950s) utilitarian approach to the question of how the tax burden shld be allocated
btwn the individual provided a normative theory of taxation. In this case the state seeks to
correct the market determined distribution of income and wealth, moving it towards what
society views as free and fair.
 Collective choice, decision making rules and voting procedures were combined into a theory
of public choices by Buchanan (1962)
Modern public sector economics (public Finance terms can be used interchangeably) is an
exciting and challenging branch of economics in which many problems remain to be solved.

Government as Referee
• Government defines and protects property rights.
• Government arbitrates disputes (the courts).
– It enforces contracts.
– Also limits types of “legal” contracts.
• Illegal activities
• Bankruptcy
• Anti-trust
• Safety regulations
• Government provides the legal framework within which all transactions occur.

Government views of society

Organic View
• “Society is a natural organism. Each individual is a part and government is its heart.”
• Social (common) well being matters, not individual well being.
• Government’s goal is to guide individuals to accomplish societal goals.
Mechanistic View
• Government created by individuals to better achieve individual goals.
• Social goals not important except as a collection of individual goals.

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 • Within the mechanistic view there can be differences about how to weigh the benefits for
different individuals. When is it correct to transfer property from one person to another?

MICRO-FOUNDATION OF PUBLIC FINANCE

Inter-sector resource allocation and scarcity

✓ With scarcity there are unlimited human wants at the same time there are alternative uses of
resources, therefore resource have to be allocated.
✓ Scarcity is a major concern both in the private sector and public sector.
✓ Scarcity of resources e.g minerals, land, labour leads to a need for their allocation
✓ In most economies 2 institutions exist to take care of decisions concerning what is to be
produced i.e. the GVT which form the public sector and the market which forms the private
sector.
✓ Public finance partly deals with the allocation of scarce resources by the Public sector in an
economy that is largely private sector dominated.

Sub-optimal / optimal

✓ The allocation of resources between the Public and the Private Sector can either be optimal
or sub-optimal
✓ If there is an optimal allocation then a social balance exist
✓ The points of actual and optimal intersector resource allocation may or may not coincide
✓ If they do not coincide, then the allocation is sub-optimal or alternatively a social imbalance
or inter-sector misallocation exists.

.public sector output

% of total Nat. output
B
Over allocation
A

Under allocation
C

under all Pvt Over all.Pvt private sector output - % of total

Nat. output

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✓ Assume that at point A represents an optimal division of national output btwn the private and
public sectors with the pvt sector controlling 75% of resource allocation and the public
controlling 25% of resources in the society
✓ If point A represents optimal inter-sector resource allocation and the actual mix of resources
btwn the pvt and the public sector is at that point, then actual and optimal points of inter-
sector resources allocation coincide. In this case it is not possible to reallocate resources
without leaving some pple worse off. No social imbalance exists.
✓ Point A is the preferred position of society based on the society’s voting power, the society’s
income distribution and the society’s wealth.
✓ If point A represents an optimal inter-sector resource allocation. If actual allocation is at
point B or C, then a suboptimal or social imbalance exist.
✓ B= over allocation to public sector
= under allocation to the pvt sector
✓ C= over allocation to pvt sector
= under allocation to the public sector.

Indifference curve Approach

✓ The same concept can also be illustrated using indifference curves
✓ We use a PPC and ICs
✓ The PPC shows optimal combinations btwn the pvt and the public sector
✓ It is concave to reflect scarcity and its slope is the MRT(PG, PVTG)
✓ Social ICs are used and each IC represents the MRS (PG, PVTG)
✓ Differing combinations of the public and private goods can be consumed while a constant
level of welfare is achieved along each IC
✓ The ICs are convex to the origin to reflect diminishing MRS btwn the pvt and the public gds
in providing a given level of societal welfare.

NB you may first draw IC and then PPC and finally the third diagram which is as shown
below.

Public sector Output

b

c d

I3
I2

I1

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 PPC

Private sector output

✓ Point A is where social welfare is maximised because the MRT (slope of PPC) = MRS
(slope of IC)
✓ Effective social preferences are equal to productive capabilities
✓ Since A is on the societal PPC it represents a condition of pareto optimality
✓ The two points may not coincide; actual allocation may be at its own point while optimal on
its own. This may be due to the problem of revealing preferences or market failure.
✓ Points b, c and d reveal actual allocation which diverts from optimal condition
✓ b = over-allocation to the public sector
= under-allocation to the private sector
✓ d = over allocation of the pvt sector
= under allocation to the public sector
✓ b and d are both suboptimal becoz they are at a lower IC
✓ A point on the PPC is a necessary but not sufficient condition for there to be optimal
allocation of resource
✓ Points inside the PPC represents both social imbalance and unemployment of resources, the
case of point c.

Changes in inter-sector resource allocation

✓ There are two changes that may occur in inter-sector resource allocation over time.
1. changes in actual inter-sector resource allocation with optimal inter-sector resource
allocation remaining the same.
2. changes in both actual and optimal inter-sector resource allocation
- society can move from sub optimal to an optimal position
- cld also move from an optimal to a sub optimal position
- can also change the direction of sub optimal allocation
- society can change the degree of sub optimal moving closer or further away from
A
- society can move from PPC to a point inside the PPC
REASONS – changes in quality and quantity of productive resources eg economic growth,
war, catastrophe which will shift the PPC
- changes in the macroeconomic stability of the economy
- changes in preferences of society and/or changes in income distribution
could lead to shifts in the IC
- changes in Institutional efficiency of the market or of the political process.

PARETO OPTIMALITY CONDITIONS FOR AN EFFICIENT ALLOCATION OF

RESOURCE

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Definations of Terms
Let - X and Y be any two gds
- K and L be any two factors of production
- 1 and 2 any two consumers
- Px , Py, Pk. PL, be prices of X, Y, K and L respectively.

Marginal Rate of Substitution.

✓ MRS of X for Y is denoted by MRSXY .
✓ This is the amount of Y that a consumer must surrender to compensate for the gain of one
( marginal) unit of X ( substituting X for Y) in order that he remain on the same IC
✓ MRS of K for L is denoted by MRSKL .
✓ This is the amount of L that a producer must surrender to compensate for the gain of one
( marginal) unit of K in order that the consumer remain on the same isoquant.
Y (L) IC or isoquant

Budget (isocost line)

X ( K)
✓ MRSKL is slope of the isoquant
✓ MPL is the marginal product of the (one) unit of L surrendered or given up.
✓ MPK is the marginal product of the (one) unit of K gained
✓ For output to remain constant we have :- MRSKL = MPK
or MRSKL= MPK/ MPL
✓ Consumer equilibrium position is at the point of tangency between the budget line and the
indifference curve (as shown above)
✓ At this pt the slope of the budget line( ratio of commodity prices PX/ PY) equals the slope of
idifference curve (MRSXY)
✓ Similarly the producers minimize costs for a given amount of output or maximise output at a
given cost requirement: tangency of iso-cost line and isoquant (in equilibrium) and thus
equality btwn factor price ratio PX/ PY and MRSKL

Marginal Rate of Transformation

✓ MRT of Y into X is denoted by MRSYX
✓ This is the amount of Y that must be given up in order to produce one more (marginal) unit
of X, assuming efficient allocation of factors.
✓ MRSYX is the slope of the PPC
✓ MCY is the additional cost of one amount of Y given up while MCX is the additional cost of
one unit of X gained.
✓ Efficient allocation requires that MCY. MRTYX = MCX or MRTYX = MCX/ MCY
✓ . MRTYX is the opportunity cost of X in terms of Y
✓ The maximum value of output will be attained at the highest isorevenue line that still touches
it at this point.

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