Public Finance In Economics

(Econ 3122)
Introduction: definition, scope, rational,
and welfare economics

Addis Ababa University

Department of Economics
Course instructor: Kefyalew Endale (Ph.D.)
March 2021
4/7/2021 1
Contents of chapter one
– Definition of public finance
– Scope of public finance
– Private versus public finance
– significance of public finance
– Welfare economics
• Definition
• Pareto criterion, pareto improvement, and pareto
efficiency
• Efficiency in consumption, production, & overall
• New welfare economics: compensation principle
– Kaldor-Hicks criterion
– Scitovsiky paradox

4/7/2021 2
Definition of Public Finance or public sector
economics or public economics
– It focuses on the taxing and spending activities of
government and their influence on the allocation of
resources and distribution of income.
• To achieve desirable objectives (eg. Economic growth,
poverty reduction) and to reduce undesirable ones (like
unemployment, instability, inflation).
• The collections of revenues and public expenditures are
made in the interest of the public for the welfare of the
country.

4/7/2021 3
 Scope of public finance

• The scope of public finance is not just to study the

composition of public revenue and public expenditure.
• Its scope further include discussing the influence of
governments fiscal operations in the overall economic
activity such as employment, inflation, and economic
growth.

4/7/2021 4
 Public Finance and Private Finance
• Similarities
– Same welfare objective: individual welfare
and social/community welfare
– Rationality: private as well as government
finance are used rationally to maximize the
respective welfare.
– Scarcity of resources: both private and public
finance experience limited resources.
– Loans are repayable: both individuals and
government could borrow. But these loans are
payable.
4/7/2021 5
 Public Finance and Private Finance
Differences
Public finance Private (individual finance)
•Public authority adjusts its income •An individual adjusts his/her
to its expenditure expenditure to his /her income
•Public authority spends all •An individual tries to have a
resources it collected through taxes , surplus of income over
fees, loans expenditure
•Public authority can borrow money •An individuals can also
both from domestic and foreign borrow but only from
sources domestic sources
•Public authority can use coercion to •Private individuals can’t use
collect its revenue coercion to get their income
•Government can print currency •Individuals can’t print
notes to finance public expenditures currency notes.
6
4/7/2021
Significance (importance) of government intervention
• General Agreements
– Government is necessary to protect people from
internal conflict as well as from invasion by other
countries.
– To do so government must have a strong coercive
power. Other wise anarchy might develop and life of
the people will be solitary, nasty, poor, brutish, and short
(Hobbes).
– When anarchy develops clan/group armies are common
and stronger than the government army
– Signs of anarchy have been observed in Ethiopia
following the recent political transitions.
4/7/2021 7
Significance (importance) Cont’d
• Economic rational (see Brown and Jackson)
i. Allocative role of government
– Markets fail to achieve efficient outcomes because
of the existences of public goods, externalities,
imperfect competition (the presence of decreasing
cost industries and increasing returns to scale),
imperfect information, and uncertainty.
– Each of the aforementioned causes of market
failures will be explored in detail in Chapter 2
– According to Musgrave, the interventions to correct
these market failures or introducing policies to
compensate their effects is called the allocative role
of government.
4/7/2021 8
Significance (importance) Cont’d
• Economic rational (see Brown and Jackson)
ii. Distributive role of government
– Market might also fail to produce a socially just
distribution of welfares (i.e., inequality in income
and standards of living could vary considerably in
the society between rich and poor, between rural
and urban residents, between pastoral and non-
pastoral farmers and so on).
– Government often intervenes to influence the
distribution of income for a just and fair distribution
of income and welfare or standard of living

4/7/2021 9
Significance (importance) Cont’d
• Economic rational (see Brown and Jackson)
iii. Stabilization role
– Economies periodically suffer from inflation,
unemployment, lack of economic growth, balance of
payment problems, huge external debt and so on.
– Government plays a stabilizing role in the economy to
correct these macroeconomic problems.
iv. Regulatory role
– This role includes governments enactment of the general
law and justice system and enforcement of the enacted
laws.
– Doing so facilitates economic activities of individual
economic agents by ensuring the enforcement of the
agreed contracts between the contracting parties.
4/7/2021 10
 Welfare economics
• The objective of government is the welfare of its nations.
• Thus, it is necessary to review the concept of welfare
economics.
Definitions of Welfare economics:
• It is a branch of economics which analyzes the social
desirability of alternative economic states.
• It deals with using resources optimally so as to maximize
social welfare.
– Welfare analysis heavily rely basic economic tools, particularly
in the use of indifference curves.

4/7/2021 11
 Welfare economics cont’d
Efficiency and Equity criterions
• They are fundamental concepts in economics.
• Economic efficiency has to do with producing and
facilitating as much consumption as possible with
available resources,
• whereas equity has to do with how equitably goods are
distributed among individuals.
• The following are some of the fundamental efficiency
and equity related questions under welfare economics.
– Do competitive markets lead to the most preferable/desirable
state of society?
– What are the distributional effects of imperfect competition and
monopoly power?
4/7/2021 12
The Pareto Principle
Welfare cont’d
• Any allocation of goods and services across the many households in
the economy is referred to as a state of the economy.
• Associated with each state is an H element utility vector (u1, u2, u3,
…uH) that gives the level of utility for every household where H is
the number of households in the economy.
• The Pareto Principle allows us to compare the social welfare of two
states by determining whether the utility vector of one state
dominates that of another state: strong vs weak pareto criterion
• Strong Pareto criterion: if the utility of every household is higher in
state x than state y then state x yields a higher level of societal
welfare than state y and is preferred.
• Weak Pareto criterion: if the utilities of some households are higher
in state x than in state y and the utility of no household is lower in
state x than state y then state x yields a higher level of societal
welfare than state y and is preferred.
4/7/2021 13
 Welfare cont’d
Pareto optimality
• A feasible state is one that can be achieved given the
economy’s resource constraints.
• If state x allows a welfare improvement over state y
according to the Pareto criterion, then state x is said to be
Pareto superior to state y, and state y is said to be Pareto
inferior to state x.
• If all households enjoy the same level of utility in state x
and state y then states x and y are Pareto indifferent.
• If state x is neither Pareto superior, nor Pareto inferior,
not Pareto indifferent to state y then states x and y are
Pareto non-comparable.
• Pareto optimal (efficient)-refers to any feasible state for
which no feasible Pareto superior state exists (i.e. there is
no scope for Pareto improvement)
– Points a, b, and c of Figure 1 below are pareto efficient.
4/7/2021 14
 Welfare cont’d
• Pareto improvement: is a reallocation of resources
which makes one better of without making anyone
else worse off (eg. Any reallocation from d to b or d
to c in Figure 1 below).
Exchange economy
• In the case of pure exchange economy pareto
efficiency requires that the MRS be equal for all
consumers.
𝑷𝒙
𝑴𝑹𝑺𝑨𝒃𝒆
𝑿,𝒀 =𝑴𝑹𝑺𝑩𝒆𝒌
𝑿,𝒀 =
𝑷𝒚
• These conditions can be generalized to an economy
with many households and many goods and are
referred to as the exchange efficiency conditions.
• These shows pareto efficiency in exchange.
4/7/2021 15
 Figure 1: Edgeworth box and Contract Curve in
pure exchange economy

Bekele

Good Y d
c Joining up
these Pareto
efficient
b points yields
the contract
a curve

𝑷𝒙
𝑷𝒚
Abebe
Good X

4/7/2021 16
 Welfare cont’d
Production economy
• Suppose only two inputs (L and K) and two different outputs ( X
and Y) and two firms.
• Each firm’s efficient production decision is when slope of their
respective isoquant (𝑀𝑅𝑇𝑆𝐿.𝐾 ) equals with the input price ratio
𝒘
(𝑴𝑹𝑻𝑺𝑳.𝑲 = )
𝒓
• It is possible to combine the two separate equilibria and construct
an Edgeworth box of production.
• The dimensions of the Edgeworth box are equal to the total
factor endowments owned by the households.
• Any point in the Edgeworth box represents an allocation of
the factors of production to the two goods.
• Efficient factor allocations are those in which it is not
possible to increase the output of one good without reducing
the output of the other good.
4/7/2021 17
 Welfare cont’d
• A Pareto optimal production requires that the marginal
rates of technical substitution for each output must be
equal and this must be equal to the relative (equilibrium)
prices of the two factors of production.
𝒘
𝑴𝑹𝑻𝑺𝑿
𝑳,𝑲 =𝑴𝑹𝑻𝑺𝒀
𝑳,𝑲 =
𝒓
• These conditions can be generalised to an economy with
many factors of production and goods and are referred to
as the production efficiency conditions.
• Pareto optimality in production requires that inputs are
allocated in such a way that it is not possible to produce
more of one good without producing less of another.
4/7/2021 18
 Figure 2: Edgeworth box and Contract Curve in
production economy

Input K k
n

m
l

X
Input L

4/7/2021 19
 Welfare cont’d
• The contract curve of production economy can be
translated into the production possibilities curve (PPC)
which bounds the set of all feasible output combinations
that can be produced from the given factor endowments.
• The points on the PPC boundary are Pareto optimal
because more of one good cannot be produced without
producing less of another good. These therefore dominate
interior points.
• Slope of PPC represents the rate at which one good can
be transformed into another by reallocating the factors of
production between the two goods.
𝑑𝑌 𝑀𝐶𝑋
– Slope of ppc= = = 𝑀𝑅𝑇𝑋,𝑌
𝑑𝑋 𝑀𝐶𝑌
• Pareto efficiency in production requires the following
𝑀𝐶𝑋
= 𝑀𝑅𝑇𝑋,𝑌
𝑀𝐶𝑌
4/7/2021 20
 Production Possibility Curve
• McX=Ya-Yb (Incremental cost of producing more X from a to b)
• Similarly, the incremental cost of producing more Y from b to a is mcY (=Xb-Xa)

𝑷
Slope=𝑷𝒙
𝒚

a
Ya

Yb b

Xa Xb
x
Each point on the production possibility curve is (Pareto) efficient
4/7/2021 21
Fundamental theorems of Welfare economics and
overall efficiency
• Large number of allocations satisfy both the exchange
& production efficiency conditions.
• An allocation is pareto optimal overall if it is not
possible to reallocate production and distribution so
as to make one person better off without making
another person worse off.
• Many allocations are exchange efficient (requiring
that allocations occur on the Contract curve of
consumption) and production efficient (requiring that
production occurs on the PPC).

4/7/2021 22
• To have an overall Pareto efficiency , we have to aggregate
individuals preferences and production possibility curves.
• Both consumptive and productive efficiencies are needed for
Pareto efficiency.

• At point A, the indifference curve is tangent to the PPC (the

slope of these two curves MRS and are equal).
– Point A represents a Pareto efficient combination of X and Y.
4/7/2021 23
Fundamental theorems of Welfare economics and
overall efficiency
• Overall efficiency is achieved only if there does not
exist any feasible production possibility that is in the
interior of the CCC and PPC).
• In competitive market:
MRSx , y 
A Px
MRSx , y 
B Px
Mcx  Px Mcy  Py
py py
• Hence, the overall efficiency condition is given as
follows
Mcx Px
MRTx, y  MRS A
x, y  MRS
B
x, y  
Mcy py
• The first theorem of welfare economics
states that a competitive market automatically
allocates resources efficiently.
4/7/2021 24
Fundamental theorems of Welfare economics and
overall efficiency
• The first theorem is concerned with pareto efficient
allocation of resources and produced goods regardless
of how fair/just the distribution of these inputs and
goods among individuals in the society.
• Government intervention might be necessary to
achieve a fair/desirable distribution of welfare.
• Second fundamental theorem of welfare: society
can attain any pareto-efficient allocation of resources
by making a suitable assignment of initial
endowments of inputs and by letting people to trade
each other.

4/7/2021 25
 New Welfare Economics: Compensation principle
• Pareto criterion states simply that an economic change which
harms no one and makes someone better off indicates an increase
in social welfare
– Thus, this criterion does not apply to those economic changes which harm
some and benefit others.
• Compensation principle: Economists like Kaldor, Hicks and
Scitovsky have made efforts to evaluate the changes in social
welfare resulting from any economic reorganization which harms
somebody and benefits the others.
– Kaldor’s welfare criterion: if a certain change in economic
reorganisation or policy makes some people better off and others
worse off, then a change will increase social welfare if those who
gain from the change could compensate the losers and still be
better off than before.
– Kaldor’s criterion is from the view point of gainers.

4/7/2021 26
 Compensation principle cont’d
– Hick’s welfare criterion: Hicks supported Kaldor for employing
compensation principle to evaluate the change in social welfare
resulting from any economic reorganization that benefits some people
and harms the others.
• Hicks criterion states that, “the loser should not be able to bribe the
gainer profitably to avert the change” or the gainer should have some
leftover income after compensating the loser for the policy change.
• Hicks’s criterion is from the view point of losers.
• Assume a movement from Q to T on the Figure in the next slide on
the utility possibility curve DE.
– This movement cannot be evaluated by means of Pareto criterion because
individual A is worse off by the change.
– However, the compensation principle propounded by Kaldor-Hicks enables
us to say whether or not social welfare has increased as a result of movement
from Q to T.
– According to Kaldor-Hicks criterion, we have to see whether the individual
B who gains with the movement from position Q to position T could
compensate the individual B who is loser and still be better off than before.

4/7/2021 27
 Compensation principle cont’d
• By mere redistribution of income between the two individuals, that is, if
individual B gives some compensation to individual A for the loss
suffered, they can move from position T to the position R.
• At position R, individual A is as well off as at the position Q but individual
B is still better off as compared to the position Q.
• Therefore, according to Kaldor-Hicks criterion, social welfare increases
with the movement from position Q to position T, because from T they
could move to the position R through mere redistribution of income (i.e.
compensation).
– Now, the implications of KH criterion become more clear if through redistribution
the position of the two individual changes from T to G as both the individuals A
and B are better off than at the position Q.

4/7/2021 28
 Compensation principle cont’d
• The previous HK example is for a movement from inside a UPC
to a point on the UPC (utility possibility frontier)
• what happens to social welfare if as a result of the adoption of a
certain economic policy the UPC moves outward and the two
individuals move from a point on a lower UPC (UV) to a point
on a higher UPC (U’V’) as shown in the figure below?
• Suppose there is a movement from point Q on UV to point R on
U’V’,
– Is this movement a welfare improvement?
• In a movement from Q to R, utility of A has increased and that of
B has decreased.

4/7/2021 29
 Compensation principle cont’d
• But position R denotes greater social welfare on the basis of KH
criterion compared to Q because it is possible to move through mere
redistribution of income from position R to position S where individual
B is fully compensated for his loss of Utility and A is still better of
compared to the situation at point Q.

• To conclude, any change in the economy that moves the individuals

from a position on a lower utility possibility curve to a position on a
higher utility possibility curve increases social welfare.
4/7/2021 30
 New welfare theory cont’d
Scitovsky paradox
• Scitovsky pointed out an important limitation of KH criterion that
it might lead to contradictory results.
• He showed that, if in some situation, position B is shown to be an
improvement over position A on KH criterion, it may be possible
that position A is also shown to be an improvement over B on the
basis of the same criterion.
• Since Scitovsky was the first to point out this paradoxical result in
KH criterion, it is known as ‘Scitovsky Paradox’.
• In the next figure JK and GH are the two UPCs which intersect
each other. Now suppose that the initial position is at point C on
JK.
– Suppose a certain policy change causes a shift in UPC to GH and the two
individuals at position D.
– Position D is superior to position C on the basis of KH criterion because through
mere redistribution it is possible to move from D to F at which B has been fully
compensated and A is still better off compared to original position C.
• Thus movement from position C to position D satisfies Kaldor-
Hicks criterion.
4/7/2021 31
 New welfare theory cont’d
• A reverse movement from position D on the new UPC GH to the position
C on the old utility possibility curve JK also represents an improvement
i.e., C is socially better than D on the basis of KH criterion.
• This is because from position C movement can be made by mere
redistribution of income to position E on the UPC JK on which position
C lies and which also passes through the position E.
• And that at position E, individual A is as well of as at position D, the
individual B is still better off than at D.
• C is better than D and D is better than C. This is the paradox

4/7/2021 32
 Assignment 1
1. Algebrically show how a perfectly competitive
industry leads to a pareto optimal allocation of
resources
2. Ethiopia is a federal state comprising federal
and regional governments.
a. Briefly describe the main powers and functions
of the federal government
b. Briefly describe the main powers and functions
of the regional governments

4/7/2021 33