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3 functions of gov (Musgrave)

1) Allocative --> economic efficiency
2) Distributional --> equity
3) Stabilisation --> macroeconomic management


Stats on gov spending (UKx2 + OECD)

- 44% of UK's national income, from less than 15% in 1900
- varies widely in OECD, from ~33% in Korea to 60% in Slovenia


2 perspectives on analysing the public sector

1) Positive = what explains its economic behaviour?
2) Normative = what should be its role? its optimal size? Typically thought of in terms of market failure


First Fundamental Theorem of Welfare Economics

A perfectly-competitive market economy leads to a Pareto optimum, provided certain conditions are met.
--> about efficiency


Second Fundamental Theorem of Welfare Economics

After a suitable redistribution of initial wealth, any desired Pareto-efficient allocation can be achieved by a perfectly-competitive market economy, provided that certain conditions are met.
--> about efficiency AND equity


Sources of market failure include (3)

1) presence of monopoly power (either for buyers or sellers in a market)
2) incomplete or asymmetric info (some Pareto-improving trades do not take place)
3) absence of markets for certain types of commodity, such as public goods and externalities


Implications of the 2 characteristics of public goods

1) Non-excludability: can't be provided by private sector mechanism, i.e. in exchange for payment
2) Non-rivalry: exclusion is inefficient, even if practicable


Externalities - definition

When the utility of an individual or the production function of a firm is directly affected by the decisions of another agent, without the former's consent.


Coase Theorem

Sometimes, individuals may be able to bargain with polluters and this may correct externalities without the need for public intervention


Why might people care about equity (3)

1) Moral values: a sense of fairness
2) Social cohesion: ensuring that everyone feels they have a stake in society
3) Safety net: anyone could find one day they are poor, sick, old etc. and need help


Limitations of government (4)

1) Informational: doing better than the market may require unrealistic information
2) Decision making: the outcome of majority voting will not please everyone and some might have preferred the non-gov outcome
3) Implementations: voters may not be able to ensure that the gov does what they want (P-A problem from Asymm Info)
4) Financial: distortionary cost of taxes <=> collateral damage (estimated 20-30cts per $)


Baumol's law (4pts)

-> Public s. prod is labour intensive rel. to private sector
-> wage rates must be similar in the two sectors
-> increasing use of capital-intensive tech in private sector means higher Pty of labour and thus higher wages
-> HENCE, maintaining constant level of public sector output requires higher (wage) costs


Ratchet effect

-> Re-election constraint limits politicians' ability to increase spending (by taxes)
-> Citizens consent to higher spending in wartime or other major crises ('slacker' constraint)
-> Expenditure does not fall back after the crisis


Why doesn't expenditure fall back (ratchet effect) (4)?

1) Citizens become accustomed to it
2) Cutting spending is much harder than increasing it
3) Borrowing means higher debt service costs (spending)
4) Promises of a better world


Niskanen model of bureaucracy (3 pts)

-> Bureaucrats want to maximise their agency's budget
-> Monitoring failure (P-A problem) means they can request more funds than they really need (others can't know their true costs and judge efficiency)
-> Absence of competitive pressures mean they don't go out of business


4 conditions for 1FT of Welfare Economics to hold

1) Complete set of markets w/ well-defined and costlessly-enforced property rights
2) producers and consumers maximise their benefits and minimise their costs
3) all markets are perfectly-competitive and prices known by all
4) zero transactions costs