ECN 312 Public sector economics

UNIT 3

Role of government

• Emerging consensus
• Growth and Development Role
• Stiglitz (1996) sees the role of government in developing countries as establishing infrastructure in its broadest sense to allow markets to fulfill their central role in increasing wealth and living standards.
• This broad-based infrastructure includes six roles:
• promoting education,
• promoting technology,
• supporting the financial sector,
• investing in infrastructure,
• preventing physical degradation, and
• creating and maintaining a social safety net

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1.6. GOVERNMENT FAILURE �

• The foregoing analyses emphasized the importance of government intervention as a means of correcting market failure as well as stimulating development and growth.
• However, government can also be inefficient.
• The imperfections of government can be described as government failure.

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1.6. Government failure..

• Causes of Government failure
• (1) short-sighted regulation.
• Government regulation may focus on a very specific area of activity without considering some of the social or environmental effects of the activity.
• Example, Public transport may be regulated by creating bus terminals in certain city areas thereby leading to congestion and pollution problems.
• Regulation may also impose significant implementation costs on the economy
• These costs include the administrative costs of monitoring the system as well as the compliance costs imposed on individuals.
• Regulation costs can be financed by taxes which make some individuals worse off in terms of a reduction in welfare.
• Therefore, by interfering with the market mechanism, government may reduce the welfare of citizens

1.6. Government failure..

• Causes of Government failure
• (2) voter ignorance and short-sightedness
• When voters are ignorant of the real benefits and costs of public policies, they may oppose beneficial projects and support costly and inefficient ventures.

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• Voter ignorance may lead to overspending and over taxation

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• Voter ignorance persists because citizens do not have the time to carry out the type of research necessary to evaluate government projects.

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• Additionally, many voters are myopic, preferring policies with short-run benefits

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1.6. Government failure..

• Causes of Government failure…
• (3) Rent-seeking behaviour of special interest groups and lobbyists.
• Rent can be defined as a return in excess of a resource owner's opportunity cost.
• Rent-seeking is an important activity of special interest groups.
• These groups may be able to influence government to pass legislation or implement policies in their own interests rather than in the interests of the economy as a whole.
• Government can also create rents for certain interest groups by granting legal rights to certain firms or individuals to pursue specified activities or perform certain services.

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1.6. Government failure..

• Causes of Government failure
• For example:
• government can grant firms franchises to operate services, or licences to sell certain goods.
• contracts can be assigned to particular businesses to build highways or implement housing projects.
• In this way, government creates property rights for favoured individuals which lead to barriers to enter certain industries or businesses.

Government failure

• Causes of Government failure
• (4) low productivity in the civil service and the lack of incentive for technological efficiency.
• Government inefficiency is characterized by bureaucratic red tape.
• The public sector in many ways resembles Baumol’s non-progressive sector which experiences zero productivity growth.
• Baumol (1967) asserts that the labour intensive nature of public services offers less scope for technological change that improves productivity.
• refers to a concept from economic theory known as Baumol's cost disease.
• Peacock (1979) has also observed that because of the non-profit nature of many government services there is a lack of incentive to introduce innovations.

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1.6. Government failure..

Suggestions to address government failure

• (1) There should be an upgrading in the quality of management in the public service, with greater emphasis on strategic planning.
• (2) In public utilities and other productive services, efficiency can be increased by reducing political interference in day-to-day management.
• (3) productivity can be enhanced by the implementation of incentive systems based on productivity gains.
• This calls for the establishment of performance criteria for departments.
• (4) the public sector needs to improve its information system to ensure that relevant information is fed to managers to improve decision making.

1.6. Government failure..

Suggestions to address government failure

• (5) Privatisation
• The process by which government sells 51 percent or more of certain properties to the private sector is known as privatization.
• This can be done by direct sale or through the selling of shares to the private sector.
• It is an aspect of market-oriented development to reduce the size of government, relieve the public sector of burdensome enterprises and stimulate competition in the market.
• Privatisation is therefore a partial solution to government failure.
• It is seen as a means of improving the efficiency of enterprises by limiting the scope of political interference
• A weaker form of privatization can be achieved by contracting out certain government services to the private sector.

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1.6. Government failure..

Arguments for privatisation

• The main argument in support of privatization is that of efficiency and property rights theory
• (1) "inefficiency“ of public enterprise
• It is argued that the performance of a state enterprise is not only a function of state ownership , but also a function of the type of management and the appropriate culture in the firm.
• Some state-owned enterprises function efficiently.
• Nevertheless, the organizational culture of state enterprises tends to be government oriented rather than customer oriented.
• This is reflected in political interference in day-to-day decision making, which in many cases prevents public sector managers from pursuing strategic planning.

1.6. Government failure..

Arguments for privatisation

• (1) the problem of property rights
• Different forms of property ownership give rise to different economic incentives and different economic results.
• Private enterprises are free to use and exchange their private property rights, which give individual owners a claim on the assets of the enterprise.
• Private sector managers ultimately face the bottom line, which measures the profits or losses that owners claim.
• Public managers and employers, on the other hand, allocate assets that belong to taxpayers.
• However, such managers do not bear the costs of their inefficient decisions, nor do they gain from efficient behaviour.
• Only the politicians are ultimately accountable to the taxpayers.

1.6. Government failure..

Arguments for privatization

• Economic theory gives general guidelines to privatization
• However, the political decision to privatize an enterprise should be based on the application of specific economic and political criteria to the special case.
• Such criteria would include:
• economic and social efficiency,
• financial viability,
• managerial performance, and
• the perceived impact of the privatized enterprise on employment, prices, and output.

1.8. Tools of Public Sector Economics

• (1)Theoretical tools
• The set of tools designed to understand the mechanics behind economic decision making.
• The primary theoretical tools of economists are graphical and mathematical.

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• The graphical tools are typically supply and demand diagrams and indifference curve/budget constraint graphs
• They help to understand the key points of theory

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• Mathematical expositions can also help to illustrate the details of an argument.

1.8. Tools of Public Sector Economics

• (1)Theoretical tools
• The core of theoretical analysis in public sector economics is the assumption that individuals have well-defined utility functions
• utility functions: mathematical function representing an individual’s set of preferences, which translates her well-being from different consumption bundles into units that can be compared in order to determine choice
• Economists assume that individuals then undertake constrained utility maximization
• constrained utility maximization: The process of maximizing the well-being (utility) of an individual, subject to her resources (budget constraint).
• Armed with this assumption, economists proceed to develop models
• Models mathematical or graphical representations of reality
• This helps to show how constrained utility maximization leads people to make the decisions that they make every day.

1.8. Tools of Public Sector Economics

• Empirical tools
• The set of tools designed to analyze data and answer questions raised by theoretical analysis.
• Empirical public finance: the use of data and statistical methodologies to measure the impact of government policy on individuals and markets.
• Many of these tools were developed more recently than the classical analyses of utility maximization and market equilibrium.
• As a result, they are also more imperfect, and there are lively debates about the best way to approach problems like estimating the labor -supply response of single mothers.

1.8. Tools of Public Sector Economics

• Empirical tools
• The fundamental issue faced by those doing empirical work in economics: disentangling causality from correlation.
• Two economic variables are correlated if they move together.
• Higher cigarette taxes are correlated with lower smoking rates.
• Analysis: While there is a strong negative correlation, we cannot immediately conclude causality without considering other factors like anti-smoking campaigns, societal attitudes towards smoking, and health awareness programs that might also contribute to lower smoking rates.
• But a relationship is causal only if one of the variables is causing the movement in the other. : A city implements a new public transportation subsidy, and public transportation usage increases by 20% within a year.
• Analysis: To establish causality, the city can analyze data before and after the subsidy, compare with similar cities without the subsidy, and control for other factors like fuel prices or changes in population. If the analysis shows that the subsidy is the primary factor driving the increase, causality can be claimed.

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1.8. Tools of Public Sector Economics

• Empirical tools…
• Randomised trials : this is the “gold standard” for measuring the causal effect of an intervention
• Randomized trial is the ideal type of experiment designed to test causality, whereby a group of individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not.
• Treatment group : The set of individuals who are subject to an intervention being studied.
• Control group: The set of individuals comparable to the treatment group who are not subject to the intervention being studied. This is commonly used medical studies, clinical trials, and experiments in social sciences.

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1.8. Tools of Public Sector Economics

• Empirical tools…
• Estimating Causation with Data
• observational data : Data generated by individual behavior observed in the real world, not in the context of deliberately designed experiments. It is collected in a natural setting and the researcher does not influence the variables being measured. e.g Survey responses on consumer preferences, health records from hospitals and traffic patterns observed through cameras.

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• Time Series Analysis: One common approach to measuring causal effects with observational data is time series analysis, documenting the correlation between the variables of interest over time.
• Time series analysis examines the comovement of two series over time. Observations are made at regular intervals (e.g., daily, monthly).e.g. Daily stock prices over a year, monthly sales revenue for a company, annual average temperature of a city.

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1.8. Tools of Public Sector Economics

• Empirical tools…
• Estimating Causation with Data
• Cross -Sectional Regression Analysis
• A second approach to identifying causal effects is cross-sectional regression analysis,
• a statistical method for assessing the relationship between two variables while holding other factors constant.
• Cross-sectional regression analysis is a statistical technique used to examine the relationship between a dependent variable and one or more independent variables at a specific point in time.
• Unlike time-series regression, which analyzes data points collected over a period of time, cross-sectional regression focuses on observations from multiple subjects (such as individuals, companies, countries, etc.) at a single point in time.
• In its simplest form, called a bivariate regression, cross -sectional regression analysis is a means of formalizing correlation analysis, of quantifying the extent to which two series covary.

1.8. Tools of Public Sector Economics

• Empirical tools…
• Estimating Causation with Data…
• Control Variables: Regression analysis has one potential advantage over correlation analysis in dealing with the problem of bias: the ability to include control variables.

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• Control variables: Variables that are included in cross -sectional regression models to account for differences between treatment and control groups that can lead to bias.

1.8. Tools of Public Sector Economics

• Empirical tools…
• Estimating Causation with Data…
• Quasi-Experiments;
• Quasi-experiments are research designs that allow for causal inferences without the use of random assignment.
• These are particularly useful in public sector economics where true randomized controlled trials (RCTs) are often impractical or unethical. Quasi-experiments rely on methods such as , difference-in-differences and other research designs.
• Difference-in-Differences (DiD)
• Example: Evaluating the Impact of a Minimum Wage Increase
• Context: Suppose a state raises its minimum wage while a neighboring state does not.
• Method: The DiD approach compares the employment outcomes in the state with the minimum wage increase to those in the neighboring state before and after the policy change.
• Application: This can help determine whether changes in employment levels can be attributed to the minimum wage increase rather than other factors.

Evaluation of public policies

• Logically, to decide whether a policy is good or bad involves two steps :

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• (1) Positive economics: Positive economics deals with the objective analysis of economic phenomena, focusing on what is and what will be. In the evaluation of public policies, positive economics is concerned with determining the consequences of the policy in terms of resource allocation and income distribution.
• This involves assessing the measurable or observable outcomes of the policy, such as changes in employment levels, GDP growth, income distribution, and resource utilization.
• For example, if a government implements a policy to subsidize agricultural production, positive economics would analyze the policy's effects on the allocation of resources (e.g., shifting investment towards agriculture) and income distribution (e.g., impact on employment in the Agric sector)..

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• (2) Normative economics : Normative economics, on the other hand, deals with value judgments and what ought to be. In the evaluation of public policies. It must be decided whether the consequence themselves are desirable.

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• Using the same example of the agricultural subsidy policy, normative economics would evaluate whether the cost (natural resource depletion , soil and water pollution etc) associated with the policy outweigh the benefits(food security, affordable prices ,GDP growth etc) .

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Criteria for policy evaluation�

• (1) Equity - situation in an economy in which the apportionment of resources or goods among the people is considered fair.
• Policies should ideally promote fairness and reduce inequalities in society. For instance, a tax policy may be evaluated based on its redistributive effects on income distribution.
• Economists often distinguish between vertical and horizontal equity
• (i). Horizontal equity: Horizontal equity refers to the principle that individuals with similar circumstances or characteristics should be treated equally.
• In other words, people with the same level of income, wealth, or other relevant attributes should face similar tax rates, receive similar benefits, or have access to similar public services.
• This principle aims to ensure fairness and consistency in the treatment of individuals who are in comparable situations.
• If two individuals each earn $50,000 a year, horizontal equity would require that both individuals pay the same amount in taxes, say 10% of their income, or $5,000 each.
• This ensures that individuals with the same income level are treated equally.

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Criteria for policy evaluation

• (ii) vertical equity: This deals with the principle that individuals with different circumstances or characteristics should be treated differently in a way that is considered fair.
• This often means that those with greater ability to pay (e.g., higher income or wealth) should contribute more, and those with greater needs should receive more benefits.
• Vertical equity is concerned with addressing inequalities by redistributing resources to achieve a more equitable outcome.
• A progressive tax system is designed with vertical equity in mind. In such a system, individuals with higher incomes pay a larger percentage of their income in taxes.
• For instance, someone earning $50,000 might pay 10% of their income in taxes, while someone earning $200,000 might pay 25%.
• This ensures that those with higher incomes contribute more to public revenues.

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Criteria for Policy Evaluation

• (2) Economic Efficiency: sometimes called, Pareto optimality
• In common language, then, efficiency means both “doing things in the right way” (technical efficiency and cost–effectiveness), and “doing the right things” (allocative efficiency).
• Pareto Optimality (or Pareto Efficiency): This is a specific condition of economic efficiency named after the Italian economist Vilfredo Pareto.
• A situation is Pareto optimal if no reallocation of resources can make someone better off without making someone else worse off. In other words, any change to improve one individual's situation would harm another individual.
• In short, when the economy is operating efficiently, there is no scope for further improvements in anyone’s wellbeing unless someone else is harmed.
• Achieving Pareto optimality in public sector policy implementation is crucial because it ensures that resources are used in the most efficient manner, maximizes social welfare, minimizes negative consequences, and provides a strong economic justification for policy decisions.
• It also helps policymakers navigate trade-offs and continuously improve policy effectiveness.

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Figure 1: Welfare frontier�

Welfare Frontier

• The concept of the welfare frontier is an important tool in public sector economics, particularly when analyzing the efficiency of resource allocation and the trade-offs involved in public policy decisions.
• The welfare frontier represents the maximum attainable level of social welfare or utility for a given set of resources and constraints.
• In the context of public sector economics, the welfare frontier can be understood as the maximum level of collective well-being or social welfare that can be achieved with the available resources, considering the trade-offs between different individuals or groups in society.

Welfare Frontier Cont

• The welfare frontier is typically represented graphically, with the utility or welfare levels of different individuals or groups plotted on the axes.
• Each point on the frontier represents a Pareto efficient allocation of resources, where it is impossible to make one individual or group better off without making someone else worse off.

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Welfare Frontier Cont�Shape and Position of the welfare frontier

• The shape and position of the welfare frontier depend on various factors, including:
• Resource constraints: The total amount of resources available, such as government budgets, natural resources, and production capabilities, determines the overall feasible level of social welfare.
• Technology and productivity: Advancements in technology and productivity can shift the welfare frontier outward, expanding the possibilities for achieving higher levels of social welfare with the same resources.

Shape and position of the welfare frontier cont.

• Distributional considerations: The welfare frontier reflects the trade-offs between different individuals or groups in society, as different allocations of resources may favor some groups over others.
• Social preferences: The shape of the welfare frontier also depends on the societal values and preferences regarding equity, fairness, and the relative importance of different individuals or groups.

Usefulness of the welfare frontier

• The welfare frontier is a useful analytical tool for policymakers and economists in several ways:
• Identifying efficient allocations: Any point on the welfare frontier represents an efficient allocation of resources, as it is impossible to make someone better off without making someone else worse off.
• Evaluating trade-offs: The welfare frontier helps policymakers understand the trade-offs involved in resource allocation decisions, as moving from one point on the frontier to another implies sacrificing some level of welfare for one group to benefit another.

Usefulness of the welfare frontier cont.

• Assessing policy impacts: By analyzing the position of different policy options relative to the welfare frontier, policymakers can evaluate the efficiency and distributional consequences of various policy alternatives.
• Setting policy goals: The welfare frontier can guide the formulation of policy goals by identifying the maximum attainable level of social welfare and the corresponding resource allocation required to achieve it.
• The welfare frontier does not necessarily capture all relevant considerations, such as equity, sustainability, or other non-economic factors that may influence public policy decisions.

Criteria for Policy Evaluation

• (3) Paternalism
• Government policy may, in some cases, be intentionally designed to promote services that would not be selected by people if they had a choice

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• Instead of catering to the wants of people, the government overrides, or disregards, their wants
• A policy of this type could be described as paternalistic and is ultimately based on the premise that some individuals are not competent to make wise choices
• The assumption is that government knows better

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• Examples include :

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• Mandatory education
• Restrictions on harmful substances (e.g., drugs, tobacco)
• Social security and pension schemes
• Health regulations (e.g., mandatory vaccinations)

Criteria for Policy Evaluation

• (4) Individual Freedom
• place a high value on individual freedom by reducing government activities that restrict that freedom of individuals
• Individualism in public sector economics emphasizes the importance of individual autonomy and freedom. It argues that individuals are the best judges of their own needs and preferences, and thus, minimal government intervention is preferred. E.g Deregulation and reduction of government control , Privatization of public services etc
• The four criteria discussed so far do not exhaust all the ways in which economic policies may be evaluated, but they do provide some idea of the range of effects that may be considered. Forming an overall evaluation of a policy is clearly a difficult task.
• Not only is it necessary to determine how well the policy satisfies each of the criteria deemed relevant, but a decision of how much weight to give each separate criterion is also necessary. Generally it will be impossible to satisfy all criteria simultaneously.

Trade-off between Equity and Efficiency

• If the distribution of resources or goods in an economy is fair between different members of the society, it indicates equity.
• Efficiency is making the best out of scarce resources at the best possible price
• The efficiency-equity trade-off is a fundamental concept in public sector economics, which highlights the potential conflict between achieving economic efficiency and promoting equity or fairness in the distribution of resources and opportunities.
• . Economic efficiency refers to the optimal allocation of resources in a way that maximizes social welfare. It involves producing goods and services at the lowest possible cost and ensuring that resources are allocated to their most productive uses. Efficient allocation of resources leads to higher productivity, economic growth, and overall societal well-being.
• On the other hand, equity refers to the fair distribution of resources, income, and opportunities among individuals or groups in society. It is concerned with reducing economic disparities, promoting social justice, and ensuring that everyone has access to basic necessities and opportunities for upward mobility.
• The trade-off arises because policies or interventions aimed at improving economic efficiency may sometimes conflict with the goal of achieving greater equity, and vice versa
• Market-based policies, such as deregulation, privatization, and free trade, can improve economic efficiency by promoting competition and allocating resources to their most productive uses.
• However, these policies may also lead to increased income inequality, as the benefits may accrue disproportionately to certain groups or sectors, while others may experience job losses or reduced incomes.

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Case for equity-efficiency trade off

• The best example of trade off between equity and efficiency can be explained with environmental policy of the government. Who gets the most out of exploiting the natural resources and what cost is a policy question that needs to be answered. The projects undertaken would have an adverse effect on the local people who might be living there from many generations.

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• These become the victims of the project. But government programmes and projects would have multiple objectives in the larger interest of the nation. So there would have to be a trade off between the efficient use of resources in that area and the equity of resources distribution to the people of that area. In order to do that the people who are enjoying the benefits of the policy would have to pay for the victims of the policy and make them the stakeholders in the developmental works undertaken.

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