Lecture 1
Econ 0050 Economics of the Public Sector
Dr Silvia Dal Bianco s.dalbianco@ucl.ac.uk
Introduction and overview
Scope, scale and trends in government spending and taxation. The role of
the public sector: positive and normative perspectives.
THE ECONOMICS OF THE
PUBLIC SECTOR OR PUBLIC
ECONOMICS
Public Economics
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Public economics is the study of the role of the government in the
economy
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Three key questions:
1) When should the government intervene in the economy?
2) How might the government intervene?
3) What is the effect of those interventions on economic outcomes?
WHAT ARE THE ROLES OF GOVERNMENT AS AN
ECONOMIST WOULD THINK ABOUT
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Role: achieving a better outcome than the market; Economic
mechanism/rationale/justification: the market mechanism is
intrinsically imperfect and there are market failures (Examples: public
goods, asymmetric information, externalities)
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Role: redistributing income and wealth; Economic rationale:
behavioural, we (as society) prefer to live in an equitable world (i.e.
poverty and inequality)
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Role: stabilizing the economy in the case of a shock; Economic
rationale: getting the economy back on track (i.e. monetary and fiscal
policy)
THE ECONOMIC FUNCTIONS OF GOVERNMENTS
The US public economist Richard Musgrave defined three
functions of government:
Allocative: economic efficiency
Distributional: equity (fairness between rich and poor)
Stabilisation: macroeconomic management
What is the public sector? Government functions?
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Public spending
Public revenues - taxation, borrowing, user fees, etc
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More broadly the role of government intervention in the economy
Public spending, taxation and regulatory actions by government can be substitutes, or
complementary, and understanding the impact of government on the economy may
require us to look at these together.
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The US public economist Richard Musgrave defined three functions of government:
• Allocative
- economic efficiency
• Distributional
- equity (fairness between rich and poor)
• Stabilisation
- macroeconomic management
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This course is primarily about the first two, and we will cover issues of macroeconomic
management in Lecture 2
WHAT IS THE RIGHT SIZE/SCOPE FOR GOVERNMENT?
NORMATIVE AND POSITIVE STATEMENTS
Analysing the public sector – two perspectives
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Positive
What explains economic behaviour in the public sector?
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Normative
What should be the role of the public sector in the economy?
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“IS” and “OUGHT” are VERY DIFFERENT PERSPECTIVES
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The two perspectives interact.
• One reason we have a public sector is that it is useful.
• But we need to be realistic about how governments behave, and
what they can achieve.
The normative perspective
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Where should we draw the economic “borders” of the state?
• What should the private sector do?
• What should the public sector do?
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Economists typically think of this in terms of market failure.
• The public sector should do the things that the private sector does
badly or gets wrong.
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"The best way to understand market failure is to first understand
market success" (Ledyard, 1987)
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This helps to identify precisely what is meant by market failure.
ALLOCATIVE FUNCTION OF THE
GOVERNMENT
The market economy and the “common good”
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Adam Smith, in The Wealth of Nations, (1776) argues that a market
economy has a remarkable property:
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"Every individual ... generally ... neither intends to promote the
public interest nor knows by how much he is promoting it. By ...
directing ... industry in such a manner as its produce may be of the
greatest value, he intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to promote an end
which was no part of his intention…. By pursuing his own interest
he frequently promotes that of the society more effectually than
where he really intends to promote it"
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Roughly-speaking, Smith argues that the pursuit of self-interest in a
market context promotes the common good.
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Why might this be true?
Why, and where, might markets fail, and policy intervention be
required?
Markets and voluntary transactions
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Markets provide a mechanism for allocating scarce resources to
their most highly-valued uses
• Maximising the value of output, given resource constraints
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Through a succession of voluntary transactions, by self-interested
individuals, resources are allocated to their highest-valued uses,
and the value of total output is maximised.
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Voluntary exchange is Pareto-improving, in the sense that at least
one party to the transaction is made better-off, and neither is made
worse off by the transaction.
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Prices play a key role
• Prices transmit information about costs and values
• In a competitive market economy, prices (of resources, goods,
etc) reflect their opportunity costs (- ie their value in their nextbest use)
The fundamental theorems of welfare economics
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First Fundamental Theorem of Welfare Economics
• A perfectly-competitive market economy leads to a Pareto
optimum, provided that certain conditions are met.
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This is a claim about efficiency (in a specific sense). A market
economy, under specified conditions, maximises the value of output.
It makes no claims about the equity (“fairness”) of the outcome.
Second Fundamental Theorem of Welfare Economics
• After a suitable redistribution of initial wealth, any desired
Pareto-efficient allocation can be achieved by a perfectlycompetitive market economy, provided that certain
conditions are met.
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This is a claim about both efficiency and equity.
If we think that the outcome of a market economy is inequitable (in a
distributional sense), we can choose between a whole range of efficient
outcomes, differing in terms of the distribution of welfare between
people, and can implement these through initial redistributions of
wealth, coupled with the market economy.
Defining market failure
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Stating the First Fundamental Theorem of Welfare Economics more rigorously:
If…..
• there is a complete set of markets with well-defined and costlessly-enforced
property rights, such that buyers and sellers can trade freely in all current and
future goods and contingencies;
• producers and consumers behave in an optimising manner, by maximising their
benefits and minimising their costs;
• all markets are perfectly-competitive, and market prices are known by all
individuals and firms;
• transactions costs are zero, so that the use of the price mechanism does not, in
itself, consume resources;
…..then the allocation of resources will be a Pareto optimum.
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If the above conditions do not hold then the outcome of a market economy may
not be Pareto optimal. There is "market failure".
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Sources of market failure include:
• the presence of monopoly power on the part of either buyers or sellers in a
market
• incomplete or asymmetric information, which means that some potentially
Pareto-improving trades do not take place
• the absence of markets for certain types of commodity, such as "public goods“
and "externalities"
Public goods
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Private goods are “rival” and “excludable”.
• Rival: An individual's consumption of the good has an opportunity cost, in that it
reduces the amount available for consumption by others.
• Excludable: It is possible to prevent someone consuming the good. This means
that supply of the good can be restricted to those who pay.
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Public goods are non-excludable and non-rival.
• Non-excludable: Once the good has been provided to one individual it is
impossible to prevent others benefitting from it.
• Non-rival: An individual's consumption of the good has zero opportunity cost (ie
does not reduce the amount of the good available for consumption by anyone
else).
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Examples include street lighting, public order policing, the classic textbook example
of a lighthouse to guide shipping, etc
Non-excludability implies public goods cannot be provided by normal private sector
mechanism (supplying the good in exchange for payment)
Non-rivalry implies exclusion would be inefficient, even if practicable.
Externalities
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Externalities arise where the utility of an individual or the production function
of a firm is directly affected by the decisions of another agent in the economy
(individual or firm), and where this effect occurs without their consent.
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Since individuals experience externalities without their consent, their interests
in the matter may not be taken into account
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no way they can express their preferences
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An unregulated market economy will tend to have excessive levels of
activities that generate negative externalities (eg pollution)
à a case for regulation to correct this market failure
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a caveat: the Coase Theorem indicates that sometimes individuals may be
able to bargain with polluters, and this may correct externalities without the
need for public intervention.
Market failures due to information problems
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Asymmetry of information between buyers and sellers in markets can
lead to inefficient outcomes (ie market failure).
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For example, people may wish to insure against major risks to their
well-being, such as sickness or unemployment
But if individuals face very different risks of these events, and if they
know more about the risks they face than the insurer, full insurance
may not be offered by private insurers.
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There may be a role for public policy in correcting this market failure
• Either by regulating private insurers,
• Or by providing public insurance.
Equity (fairness) and the case for intervention
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A market economy leads to efficiency (ie maximising the total value of output)
But it does not guarantee that the distribution of output will be equitable.
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The second fundamental theorem indicates that if there are public objectives
of equity, these can be dealt with through initial redistribution.
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Why might people care about equity (eg about the distribution of income, or
about poverty)?
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Moral values: a sense of fairness
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Social cohesion: ensuring that everyone feels they have a stake in society
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Safety net: anyone could find that one day they are poor, sick, old, etc,
and need help.
What normative arguments might apply to different areas of public spending
and public policy?
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This is an area of considerable controversy and political disagreement. Ultimately it is a matter of
judgement how far the various market failures justify public sector involvement, and whether they
outweigh the disadvantages of public provision.
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Examples of where each of the normative arguments for public intervention might apply include:
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Public goods
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Defence, policing, public infrastructure (paving, street lighting, roads, etc).
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But some of these (eg certain aspects of policing, some roads, etc) have the character of private goods, and
could be privately provided (private security, road tolls, etc)
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Externalities
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environmental policy, public transport (congestion-reducing impact), education (we all gain from living in a more
educated community).
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Information
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Health-care, education, social care for the elderly
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consumers cannot always make informed choices about quality etc
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Equity
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Health-care, low-income benefits, state pension, social care for the elderly, public transport, education
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All involve significant redistribution when tax-financed
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By the end of the course we will have seen how to weigh up these arguments more thoroughly.
There is scope for government intervention but
WARNING there are limitations of government
• Informational limitations
Doing better than the market may be possible in theory, but may
sometimes require unrealistic information.
• Decision-making limitations
The outcome of majority voting will not please everyone, and some might
have preferred the non-government outcome.
• Implementational limitations
Voters may not be able to ensure that the government does what they
want. A principal/agent problem arises from information asymmetry, and it
may be difficult to resolve this by any appropriate incentive structure.
• Financing limitations
Raising taxes to pay for public action can cause collateral damage in the
form of the excess burden of taxation (distortionary cost).
The positive perspective: What explains economic behaviour in the
public sector?
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This is a matter of description and explanation. The analysis can be objective, based on
evidence.
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People with different views about underlying social objectives (eg with different views
about equity) should in principle be able to weigh up the evidence in the same way.
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Philosophers sometimes characterise this form of analysis as questions of “is” rather
than “ought”.
• By contrast, normative issues are about what “ought” to be done.
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One example of a “positive” rather than “normative” question is:
What explains the growth in the scale of the public sector in the 20th century?
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People might differ about whether they think this growth is a good thing.
It is true that certain explanations tend to be more popular with people who this this
growth is a bad thing (and vice versa)
But in principle it’s a question about explanation of matters of fact, rather than
about moral judgement
Theories about the growth of government
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Numerous theories, not always mutually exclusive
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Stage-of-development models
Wagner’s Law
Baumol’s Law
Various models of political competition, eg
• Responding to voter preferences
• “Log-rolling” models (bribing voters)
Ratchet effect
Bureaucratic models
….and more
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Development models and Wagner’s Law
Various “stages” of development
Early stage
Middle stage
Developed stage
• Movement
to urban
areas
• Private sector
complementary to
infrastructure
• Increased social
problems
• Increased complexity
of economy
• Equity
considerations
• Social
fragmentation
• More infrastructure
investment
• New laws and legal
structure
• Transfer
payments, public
pensions, health,
education, etc
• Public care for
elderly
• Public
sector
spending on
infrastructure
investment
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Also, in Wagner’s Law:
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Behavioural explanation
Public spending has high
income elasticity of demand
Education, recreational
facilities, health-care, social
insurance
Public expenditure rises with
income as demand increases
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Empirical support? Causality?
Baumol’s Law
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Explains rising costs of public sector in terms of characteristics of production
technology in the public sector
• Labour intensive relative to private sector
• No scope for substitution between capital and labour
But wage rates in public and private sector must be similar
Increasing use of capital-intensive technology in the private sector à higher
labour productivity à higher wages
Maintaining a constant level of public sector output means higher costs
How plausible is this as an explanation for the growth in public spending?
• Is everything driven by technology?
• Where does the political process come in?
• Is there really no scope for cost-reducing technology in public sector?
Federal government spending in the United States over two centuries
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Thomas A. Garrett and Russell M. Rhine (2006), " On the Size and Growth of Government", Federal Reserve Bank of
St. Louis Review
The ratchet effect
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The model works like this:
• Citizens like public spending, but dislike paying taxes
• Governments (politicians?) are always happy to spend more, but in
normal times are constrained by the desire to be re-elected, and so must
pay attention to citizen preferences.
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Citizens consent to higher spending during wartime or other major crises
(the re-election constraint becomes less binding)
After the crisis, expenditure does not fall back to its previous level.
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Why?
• Citizens become accustomed to higher spending
• Cutting spending is much harder than increasing spending (the losers
protest louder than the gainers)
• Higher borrowing during crisis means that higher debt service costs
• Promises of a better world during war or crisis
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Model gives constant spending until crisis, and then higher spending
afterwards
Explains what happened. Fits the data.
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A model of bureaucracy (Niskanen, 1971)
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Underlying mechanism:
Government bureaucrats are able to influence spending (due to principal:agent failure),
and have an interest in maximising their agency’s budget (higher salary, prestige,
power).
Bureaucrats’ preferences push public spending above the level warranted by voters’
preferences.
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Key feature in these models is monitoring failure (principal:agent failure).
• Voters, politicians and senior public sector managers cannot measure output
accurately, and therefore cannot judge efficiency.
• Bureaucrats know their true costs of producing output, but the people involved in
the budget allocation process do not. Bureaucrats make requests for funding on a
take-it-or-leave-it basis.
• Absence of competitive pressures (which would drive agencies out of business if
they operated like this)
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Model is a rather unsophisticated view of bureaucratic behaviour. Public sector has
various mechanisms (eg audit agencies), to improve monitoring and reduce budgetmaximising behaviour.
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See Mueller (2003), chapter 16
To summarise
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The public sector is a large part of the economy in all developed countries, and has
grown rapidly in most developing countries.
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We can analyse the role of the public sector – and government intervention in the
market economy more generally – from various perspectives. There is an important
distinction between normative and positive analyses: ie between those that discuss what
role the public sector should have, and those which analyse how the public sector
operates.
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From a normative perspective, government can play a role in enhancing efficiency, by
correcting various forms of market failure (eg through the supply of ‘public goods’).
Equity objectives may also be pursued through public spending: redistributive social
spending has grown rapidly in many industrialised economies.
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From a positive perspective, we can identify various factors and processes which may
explain the growth of public spending. Not all of these imply improvements in efficiency.
Some indicate that government failure may be important.
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The role of public spending in the economy is an area of intense political controversy in
most countries. While this course will focus on the key economic issues, we should not
lose sight of the crucial political dimension underlying government behaviour and public
attitudes.