BA(H) Economics

Sem V
Public Economics

Unit 1: Public Economic Theory

Role of Public Sector – Justification of Public Sector, Public Sector Growth; Excessive Govt.
Reference: Hindriks and Myles : Chapter 5
In this chapter, the author tries to answer the following questions
* why public sector is needed at all?
* Would it not be possible to function satisfactorily without any government intervention?
* Is there a theory which explains the increase in the size of public sector and the composition of expenditure?

Justification for the public sector

There are two basic lines of argument which can be explained to justify the role of the public sector. They are efficiency
and equity.

Bases Efficiency Equity

Meaning Achieving the maximum output with the Fair distribution of wealth and resources,
given resources, ensuring that goods and ensuring that outcomes are just, do not
services are produced and distributed at necessarily equal.
the lowest possible cost.
Focus Maximising total social welfare or output Fairness in the distribution of resources
without wasting of resources and outcomes, often focusing on reducing
inequalities
Policy Goal Promotes economic growth and wealth Address, inequalities, provide
creation by minimising opportunities for disadvantaged groups,
inefficiencies and ensure access to basic needs.

What Is the Basic Motivation for the Existence of a Public Sector?

• The basic motivation for the existence of a public sector follows from the observation that entirely unregulated
economic activity cannot operate in a smooth way
• In short, an economy cannot function effectively if there are no property rights that is the rules that defined the
ownership of property, or contract laws that is the rules governing the conduct of trade
Property Rights
• Thomas Hobbes viewed the government as a social contract that enables people to escape from the anarchic “state of
nature” where their competition in pursuit of self-interest would lead to a destructive “war of all against all”. The
institution of property rights is a first step away from this anarchy .
• Their food without property rights, satisfactory exchange of commodities could not take place, given the lack of trust
that would exist between the contracting parties.
Contract Laws
• Contract law is determine the rules of exchange.
• They exist to ensure that the participants in a trade receive what they expect from the trade or, if they do not, have
open an avenue to seek compensation.
• These laws encourage trade by removing some of the uncertainties in trade

* The establishment of property rights and contract laws is not sufficient in itself. Unless they are policed and upheld in
law, they are of limited consequence. Such law enforcement cannot be provided free of cost. Enforcement officers are
employed and Courts are provided in which redressal can be sought. Moreover , once a country develops its economic
activity, it will need to defend its gains from being stolen by outsiders. This implies the provision of defence for the
nation.

* Even if only the minimal requirements of the enforcement of contract and criminal laws, and the provision of defence
are met , a source of income must be found to pay for them. This need for income requires the collection of revenue,
whether the services are provided by the state or by private sector.
* From this arises the first role of the public sector, which is to assist with the attainment of economic efficiency by
providing an environment in which trade can flourish.

The minimal state provides contract law, police’s it and defends the economy against the outsiders. It does nothing
more than this, but without it organised economic activity cannot take place.

Market versus the government

• Giving free hand in the economy for organised economic activity is beneficial. However, minimal intervention by the
government is still required. The situations where intervention may be warranted can be divided into two categories:
A. The situations which involve market failure.
B. The situations which do not involve market failure.

When market failure is present: if economic activity generated externalities(effects that one economic agent imposes on
another without their consent), so that there is a divergence between private and social outcomes or valuations and the
competitive outcome is not efficient, it may be felt necessary for the state to intervene to limit the inefficiencies that
result.
However, it does not imply that intervention will always be beneficial. If the public sector fails to exhibit their ability to
improve on what the unregulated economy can achieve, it will be undesirable for government intervention.
Further more, a government managed by non-benevolent officials and subject to political constraints may fail to correct
market failures and me instead introduce new costs of its own creation.

Public Sector Growth

Development Models

The basis of the development models of public sector growth is that the economy experiences changes in its structure
and needs as it develops. Tracing the nature of the development process from the beginning of industrialisation, through
to the completion of the development process, is why the public spec expenditure increases.

Stage I:
• In the early stages of development, as characterised by industrialisation, the population moves from the countryside to
the urban areas. To meet the needs arising from this, there is a requirement for significant infrastructural expenditure
in the development of cities. The rapid growth experienced in this stage of development results in a significant
increase in expenditure and the dominant role of infrastructure determines the nature of expenditure.
Stage II
• In the middle stage of development, the infrastructural expenditure of the public sector becomes increasingly
complimentary with expenditure from the private sector. Development of the private sector, such as factory
construction, or supported by investments from the public sector, such as building of connecting roads. As
urbanisation proceeds and cities, increase in size, so does the population density. This generates a range of externality
such as pollution and crime. Then an increasing proportion of public expenditure is diverted from spending on
infrastructure and building of assets to the control of these externalities
Stage III
• Finally, in the developed phase of the economy, there is less need for infrastructural expenditure or for the correction
of market failure. Instead, expenditure is driven by the desire to react to issues of equity. This results in transfer
payments, such as social security, health, subsidies Being the main components of expenditure.

Wagners Law or Law of Increasing State Activities

Adolph Wagner was a 19th century economist, who analysed data on public sector expenditure for european countries,
Japan and United States.
• The data analysed by him revealed: the share of public sector in cross domestic product has been increasing over
time.
• Wagner’s analysis provided a theory for this, rather than just a description.
• Wagner’s law is a principal in public finance as suggests a long-term tendency for the government expenditures to
grow relative to the overall economy.
• Wagner theorised, that as an economy, develops and industrialisation, there is a natural progression towards increased
public spending.
Key Points of Wagner’s Law
• Increased public spending is needed for infrastructure, education, healthcare, and other public services.
• Industrialisation and economic growth will lead to changes in the society, such as urbanisation, which require more
social services like welfare, social security. These demands result in higher public suspending.
• Economic development raises the demand for nonmarket goods and services such as law and order, public
administration and defence, which only the government can provide
• As the society is become well dear, there is a greater emphasis on reducing inequality, requiring the government to
spend more on social welfare programmes and progressive taxation.

• Wagner’s law provides a good explanation of public sector growth. However, it fails to determine the interaction
between demand and supply. The supply side is analysed in the next model.

Baumol’s Law or Baumol Cost Disease

• Baumol’s Law starts from an observation about the nature of the production technology in the public sector.
• The basic hypothesis is that the technology of the public sector is labour-intensive relative to that of the private sector.
• In addition, the type of production undertaken leaves little scope for increases in productivity, and that makes it
difficult to substitute capital for labour. For example, hospitals need minimum number of nurses and doctors for each
patient, and maximum class sizes, please lower limits on teachers numbers in the schools.
• This law describes a phenomenal in economics, where productivity in certain sectors, particularly labour intensive
services like healthcare, education, tends to lag behind other sectors like manufacturing or technology, yet the wages,
still rice, leading to increased costs.

Key Points

• There is a Differential Productivity Growth: in the labour intensive sectors, slower productivity growth is observed
because the nature of their services requires constant human input. For example, a teacher can only teach a fixed
number of students in a class. However, technological sectors like manufacturing experience, rapid productivity,
growth due to automation and technological advancements.
• However, there are still a Rising Wages Across Sectors: Despite the low productivity, growth, wages in the labour
intensive sectors, must rise to match wages in the high productivity sectors, otherwise the workers will migrate to
industries with higher pay. This will occur because wages in an economy were often set by productivity in the high
growth sectors, thus creating a pressure to increase wages in the low growth sectors to retain workers.
• This leads to a Cost Disease: as the productivity in the labour intensive sectors, does not increase proportionally with
the wages., The cost of providing the services rises over time, causing sectors like healthcare, education, and public
services to become more and more expensive.
• There are a number of problems with this theory. It is entirely technology driven and does not consider aspects of
supply and demand or political processes. There are also reasons for believing that substitution can take place in the
public sector. For example, additional equipment can replace the nurses, and less qualified staff can take on more
mundane tasks. Major productivity improvements have also been witnessed in universities and hospitals. Finally,
there is evidence of a steady decline in public sector pages relative to those in the private sector. This reflects lower
skilled labour being substituted for more skilled?

A Political Model

Aim of the political model: a political model of public expenditure needs to capture the conflict in public preferences,
between those who wish to have higher expenditure and those who wish to limit the burden of taxes.
It must also incorporate the resolution of this conflict and show how the size and composition of actual public spending
reflects the preferences of the majority of citizens as expressed through the political process.
The Design of the Model
Consider an economy, with H consumers whose incomes fall into a range between a minimum of 0 and a maximum of
ŷ.
The government provides a public gold that is financed by the use of proportional income tax. The utility of consumer i
who has income yi is given by
The above conditions relates to the marginal benefit of an additional unit of public good, b’(G) to its
Marginal costYi/Hu. The quantity of public good demanded by the consumers, depends on their income relative to the
mean, since this determines the marginal cost.
The marginal benefit of the public good has been assumed to be a decreasing function of G , so it follows that the
preferred public good level is decreasing as income increases. The reason for this is that with a proportional income tax,
the rich pay a higher share of the cost of public good than the poor. Thus Public good provision will disproportionately
benefit the poor.

The usual way to resolve this disagreement over the desired level of public good is to choose by majority voting. If the
level of public goods to be determined by majority voting, which level will be chosen?
• In the context of this model, the answer is clear cut because all consumers would prefer the level of Public good to be
as close as possible to their preferred level.
• The alternative that is closest for the largest number of consumers will receive maximum support. There is only one
option
• There is in fact only one option that will satisfy the requirement: the option preferred by the consumers with the
median income. The reason is that exactly 1/2 of the electorate, above the median income that is the rich, would like
less public good and the other half which is below the median that is the poor would like more of the public goods.
Any alternative that is better for one group would be a post by the other group with opposite preferences.
• The political equilibrium G* determined by the median, is then the solution to

Since the marginal benefit decrease, as the public provision increases, the political equilibrium level of public good
increases with income inequality as measured by the ratio of the median to mean income.
Accordingly, more inequality as measured by a lower ratio of the median, income to mean income would lead the
decisive median voter to require more public spending.
Government activities are perceived as redistributive tools. Redistribution can be explicit, such as social security, and
poverty elevation programmes, or it can take a more disguised form of public employment, which is probably the main
channel of redistribution from rich to pour in many countries.
Because of this nature, and interaction with the tax system, the demand for a distribution will increase as income
inequality increases as demonstrated by this political model.

Ratchet Effect

Models of Rachit effect develop the modelling of political interaction in a different direction. They
assume that the preference of the government is to spend the money. Explanations of why they should
be so can be found in the economics of bureaucracy (explained later)
Government spending or the production levels are increased at times of crisis or economic growth, but they
never revert to their previous value once the crisis subside. It is a very common and pervasive feature in both
economics and public finance, and it explains why, over time, government spending tends to rise.

Important features of ratchet effect:

I. Irreversibility of change: once the government expenditure or output levels have increased, they are
likely to stay at that higher level, even after the original cause of the boom, which could be a war,
depression, or other crisis have passed.
For example, the government increases its defence, health or social welfare spending when there is a war or
epidermic. Once the crisis has passed, these expenditures do not necessarily returned to the precrisis levels
because of political, institutional or social pressure.

II. Public sector expansion: one of the reasons for expansion in the public sector is that ratchet effect. When
the expenditure of governments is hiked, government is establish a new program, institutions, agencies that
are difficult to abolish later after the crisis. Bureaucracy is a government departments to resist cuts as well,
there for leading to permanent increases in the size and spending of government departments.

III. Public expectations: during the time of crisis, the public may become accustomed to increases in services
or benefits. After the crisis, it becomes politically challenging for governments to reduce the services or
programmes as it would result in public dissatisfaction.
This leads to a higher baseline level of government expenditure aimed to meet public expectations

IV : taxation and deficits: the ratchet effect can be higher taxes or a larger government deficit. Since the
spending does not fall, government may have to raise taxes or borrow more to cover the continuation of
higher than past spending levels. However, there is another important site of government budgeting: political
opposition to cuts.
Spending cuts post shock or not as popular politically because they likely involve labour, services, or benefit
cuts. Into groups and physical players who benefited from the higher spending will resist cuts to it. These are
not particularly politically easy moments.

V: inflationary pressures: this Rachit effect increases inflationary pressures. The high-level of government
spending continues to be financed by demand, pull in prices, rising and funding through borrowing or money
creation.

VI Economic Inflexibility: the higher rachet effect reduces the physical flexibility of the government as
commitments involving higher spending, make it difficult to decrease the budget or even react to future
prices without increasing both the debt and taxes further.

Excessive Government

Bureaucracy

• A traditional view of the bureaucrat is that they are motivated solely by the desire to serve the common
good.
• They achieve this by conducting the business of the government in the most efficient manner, possible
without any political or personal bias.
• Having said this, there is no reason why bureaucrats should be any different from other individuals. From
this perspective, it is difficult to accept that they are not subject to the same motivations of self serving.
• Adopting this latter perspective, the theoretical analysis of bureaucracy starts with the assumption that
bureaucrats are indeed motivated by maximisation of their private utilities. If they could, they would turn
the power and influence that their positions give them into income. But due to the nature of their role, they
face difficulties in achieving this.
• Unlike individuals working in the private sector, they cannot exploit the market to raise their income.
Instead, they resorts to obtaining utility from pursuing non-pecuniary goals.
• A complex theory of bureaucracy may include many factors that influence utilities, such as patronage,
power and reputation. However, to construct a basic variant of this theory, it is sufficient to observe that
most of the factors can be related to the size of the bureau.
• The bureaucrat can, therefore, be modelled as aiming to maximise the size of his bureau in order to obtain
the greatest non-pecuniary benefits. It is as a result of this behaviour that the size of the government
becomes excessive.
Now we will demonstrate excessive bureaucracy.
 • We wish to contrast the bureaucracy outcome with the outcome that occurs when the government has full
information.
• With full information, there exists a variety of ways to model efficiency.
• One way is that to place the bureau with in a more general setting and consider its output as one
component of overall government intervention.
• A cost benefit calculation for government intervention would then determine the efficient level of bureau
output.
• A simpler alternative, and the one we choose to follow, is to determine the efficient output by drawing an
analogy between the bureau and a profit maximising form
• The firm chooses its output to ensure that the difference between revenue and cost is made as large as
possible. By the same logic, the bureau should choose output that maximise its budget less costs,B(y)- C(y)
• Differentiating with respect to why, we quit the marginal effect of output on the budget to the marginal
effect of cost and determine the efficient output y*
• The efficient output satisfies B’(y*) = C’(y*)
• The output level chosen by the bureaucrat can easily be shown to be above the efficient level.

The increasing marginal cost curve

and declining Marshall benefit curve
or consequences of the assumptions
already made.

The efficient output occurs at the

intersection of these curbs. In contrast,
the output chosen by the bureaucrats
satisfies B’(y b) = C’(y b), so it must lie
on the right of y*.

In fact, the budget covers costs when

the area under the marginal benefit,
curve a equals the area under the
marginal cost curve b.

This simple model shows how the

pursuit of personal objectives by
bureaucrats can lead to an excessive size of bureaucracy. Adding together the individual bureaus that
comprise the public sector makes this excessive in the aggregate. The excessive size is simply an event
efficiency, since money is spent on the bureau is that or not generating sufficiently valuable results.


 Budget setting
An alternative perspective on excessive bureaucracy can be obtained by considering a different process of
budget determination.
The motivation behind this is the fact that each government department is headed by a politician who obtains
satisfaction from the size of the budget. Further more in any government system, budget for the department
or determent annually by a cabinet meeting. This meeting takes the budget bids from individual departments
and allocate a central budget on the basis of these bids
• A simple process of this form can be the following: let the budget for year ‘t’ be given by Bt.
• The budget claim for year t+1 is then given by

The meeting of the cabinet then takes these bits and proportionately reduces them to reach the final
allocation. The agreed budget is written as:

• All the either case is possible, the observe pattern of growth lend some weight on the former assumption
• This form of model could easily be extended to incorporate more complex dynamics, but without
enhancing the content of the simple story, it tells.

Monopoly Power
• The basis of elementary economics is that market equilibrium is determined by the balance of supply and
demand.
• In the absence of monopoly power, the equilibrium that is achieved will be efficient. If the same reasoning
could be applied to the goods supplied by the public sector, the efficiency would also arise there.
• Unfortunately, there are two reasons why efficiency is not possible
• First, the public sector can award itself a monopoly in the supply of its goods and services.
• Second, this monopoly power may be extended into the market capture
• Generally, profit maximising monopolist always wants to restrict its level of output below the competitive
level so that the monopoly power will provide a tendency for two little government rather than the
converse.
• The government can choose not to exercise its monopoly power in this way.
• If it is attempting to achieve efficiency, then it will certainly not do so.
• Further more, since the government may not be following a policy of profit maximisation, it might actually
exploit its monopoly position to oversupply its output. This will take our analysis back in the direction of
the bureaucracy model.

• The idea of market capture is rather more interesting and arises from the nature of goods supplied by the
public sector. Natural examples of such goods would be education andhealthcare.
• The consequence of market capture is that the specialists can set the level of output for the market that
most meet their objectives.
• Since most would benefit from an expansion of their profession, within limits, this gives a mechanism that
leads to supply in excess of the efficient level.
• The limits arise because they won’t want to go so far. That competition reduces the payment received or
lower standards too far.
• The resulting outcome has no grounds in efficiency and may well be too large.

Corruption
• Corruption does not emerge as a moral aberration, but as a general consequence of government
officials miss using that power for personal gain
• It distorts the allocation of resources away from productive to words rent seeking occupations.
• Rent seeking is the attempt to obtain a return above what is judged adequate by the market. For
example, monopoly profit
• Corruption is not just redistributive that is taking wealth from others to give it to some special
interests, it can also have enormous efficiency costs.
• The most important form of corruption in many countries is predatory regulation
• This is the process by which the government intentionally creates regulations. That entrepreneurs
have to pay bribes to get around. Because it raises the cost of productive activity, this form of
corruption reduces efficiency.
• The damage is particularly large when several government officials, acting independently, create
distinct obstacles to economic activity so that each can collect a separate bribe in return for
removing the obstacle.
• How could we give a positive role for a bride? Best corruption system?
• One possibility is that bribery is like an auction mechanism that directs resources to the best
possible use. For example, corruption in procurement is similar to optioning of the contract to the
most efficient entrepreneur who can afford the highest price.
• However, there are some problems with the bribery-based system.
• First, we care about the means as well as the ends. Bribery is noxious. Allowing bribery will
destroy much of the goodwill that supports the system
• Second, people should not be punished for their honesty.

Government Agency
• Another Explanation for Excessive Government Is the Lack of Information Available to Voters.
• The imperfect information of voters enables the government to grow larger by increasing the tax
burden. From this perspective, government growth reflects the abuse of power by pretty
bureaucrats.
• The central question is then how to set incentives that encourage the government to work better,
and to costless, subject to the information available
• To illustrate this point, consider a situation where the cost of the government of supplying a
public good can vary.
• The unit cost is either low at Cl, or is high at Ch
• The gross benefit of the public from a level Gi of public good is given by the function : b (Gi) ,
which is increasing and concave
• The net benefit is : b(Gi)-ti, where ti is the tax paid to the government for the public good
provision.
• The chosen quantity of the public good will depend on the unit cost of government
• The benefit to the government of providing the public good is the difference between the tax and
the cost
• So, when the cost is Ci , the benefit is : ti- ci. Gi
• When the public is informed about the level of cost of the government, the quantity of public
good will be chosen to maximise the net benefit subject to the government breaking even.
• For cost Ci, the public net benefit with the government breaking even is b(Gi) - ci.Gi.
• The public will demand a level of public goods, such that the marginal benefit is equal to the
marginal cost, namely b’(Gi) =ci
• And will pay the government ti= ciGi, for i=h,l.

• Now assume that the public cannot observe whether the government has cost Cl or Ch.
• The government can then benefit by misrepresenting the cost to the public: for instance, it can
exaggerate the cost by adding expenditures that benefit the government, but not the public
• When the cost is high, the government cannot exaggerate.
t
• When the cost is low, the government is better of pretending that the cost is high to get tax h for

the amount Gh of public “instead of t Gl.

getting l for producing
• Misrepresenting in this way, leads to the benefit ofGh[Ch - Cl] for the government.
• To eliminate this temptation, taxpayers must be an extra amount r>0 to the government in excess of its
cost, when the government pretend to have a low cost. This is called the information rent.
t
• Since the truly high cost, government cannot further inflated cost, the public pays h =ch Gh when the
government reports a high cost
• If the reported cost is low, the taxpayers demand the amount Gl of public good defined,by b’(Gl) = Cl

t c
And pay the government l= l Gl+r where are is exactly the extra revenue, the government could
have made if it had pretended to have high cost.
• To give a government with a low-cost just enough revenue to offset its temptation to pretend to
have higher cost, it is necessary that r=[ Ch- Cl ]Gh.
• This is the rent required to induce truthful revelation of the cost and have the provision of the
public good equal to that when the public is fully informed.
• It is possible for the taxpayers to reduce this excess payment by demanding that the high cost
government supply less than it would with full information
• Assume that cost is low with probability Pl and high with probability Ph=1-pl.
• Buy maximising their expected benefit subject to the government. Telling the truth, it can be
shown that revelation can be obtained at the least cost by demanding an amount Gh of public
services defined, by :
• This quantity is lower than that with full information
• The distortion of the quantity demanded from the high cost, government results from a simple
cost benefit argument. It trades of the benefit of reducing the rent, which is proportional to the
cost difference. [Ch - Cl] , and the probabilityPl that the government is of the low-cost tie against
the cost of imposing the distortion of the quantity on the high cost government that occurs with
probability 1-Pl.
• Therefore, if the government is truly low-cost, It need not be given the high tax
• However, to eliminate the temptation for cost, inflation, taxpayers have to provide the government
just enough of the rent as a reward for reporting, truthfully, when its cost of public services is low.

•
 Cost diffusion
• The last explanation for the possibility of excessively large government is the common resource problem.
• The idea is that spending authorities are dispersed while the treasury has the responsibility of collecting
enough revenue to balance the overall budget.
• Each of the spending authorities has its own spending priorities, with little consideration for others,
priorities, that it can be better met by raiding the overall budget. This is the common resource problem just
like that of several oil companies tapping into a common pool, underground of fishermen netting in a
single lake.
• In all cases, it leads to excess pressure on the common resource. The current trends towards federalism and
evolution aggravate this common pool problem. The reason is essentially that each district impose projects
were cost shared by all other districts, and so support, higher size, Projects and they would if they had to
cover the full costs.
• The problem can also be traced out to the individual level
• Consider public services like pensions, healthcare and schools and infrastructure work like bridges, roads,
and we’ll
• For these public services, the government does not charge the direct uses the full marginal cost, but
subsidises the activities partly or wholly from tax revenues.
• To sum up, many public services are characterised by the concentration of benefits to a small group of
users or recipients and the diffusion of costs to the large group of taxpayers. This results in bias is towards
continues demand for more public spending.

Conclusion
• Bureaucracy models are particularly attractive because the show how economic analysis can be applied to
what appears to be on non-economic problem
• In doing so, they generate an interesting conclusion that cast doubt on the efficiency of government
• The perineal question of whether the government has grown to large is difficult to answer
• The reason is that the government is both complementary to the market and a competitor of the market.
• As a major employer, the government companies with business looking to hire talented people
• The possibility that the best and brightest become public officials and politicians, rather than
entrepreneurs, it’s considered by many as a very costly to the society, since they are seen as devoting their
talents to taking wealth from others rather than creating it
• When people pay taxes, they have less money to spend on other goods and services provided by the
market.
• Weather in activities carried out in the public sector of the private sector is itself endogenous.

**************