Theme 2 – Public Sector and Mixed Economy

Public Economics

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Public Sector and the Economy

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The Size of Government

• How to measure the size of government– Number of workers– Annual expenditures

• Types of government expenditure– Purchases of goods and services– Transfers of income– Interest payments

• Budget documents– Unified budget– Regulatory budget

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Government spending, % of GDP

1870 1913 1920 1937 1960 1980 1990 1996  

Austria - - 14.7 15.2 35.7 48.1 48.6 51.7  

Belgium - - - 21.8 30.3 58.6 54.8 54.3  

Canada - - 13.3 18.6 28.6 38.8 46.0 44.7  

France 12.6 17.0 27.6 29.0 34.6 46.1 49.8 54.5  

Germany 10.0 14.8 25.0 42.4 32.4 47.9 45.1 49.0  

Italy 11.9 11.1 22.5 24.5 30.1 41.9 53.2 52.9  

Japan 8.8 8.3 14.8 25.4 17.5 32.0 31.7 36.2  

Netherlands 9.1 9.0 13.5 19.0 33.7 55.2 54.0 49.9  

Norway 3.7 8.3 13.7 - 29.9 37.5 53.8 45.5  

Spain - 8.3 9.3 18.4 18.8 32.2 42.0 43.3  

Sweden 5.7 6.3 8.1 10.4 31.0 60.1 59.1 64.7  

Switzerland - 2.7 4.6 6.1 17.2 32.8 33.5 37.6  

Britain 9.4 12.7 26.2 30.0 32.2 43.0 39.9 41.9  

United States 3.9 1.8 7.0 8.6 27.0 31.8 33.3 33.3  

AVERAGE 8.3 9.1 15.4 18.3* 28.5 43.3 46.1 47.1  

Australia - - - - 21.2 31.6 34.7 36.6  

Ireland - - - - 28.0 48.9 41.2 37.6  

New Zealand - - - - 26.9 38.1 41.3 47.1  

AVERAGE - - - - 25.4 39.5 39.1 40.4  

TOTAL AVERAGE 8.3 9.1 15.4 20.7 27.9 42.6 44.8 45.9  

Source: IMF *Average without Germany, Japan and Spain undergoing war or war preparations at his time  

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The future The future of the of the state...state...

Reasons for government growth

• Macro models

– Wagner and the stages of development

– Peacock and Wiseman’s displacement effect

• Micro models

– Baumol’s unbalanced productivity growth

– Brown and Jackson’s microeconomic model

– Role of politicians, bureaucrats and interest groups.

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Depends on chosen economic system…

What are the Legitimate Economic Functions of a Government?

Least

individual

freedom

Most

individual

freedom

• Centrally Planned Socialism: Government owns all resources and makes all important economic decisions

• Decentralized Capitalist Economy: Limited government; individuals and firms make all important economic decisions

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1. Public expenditure theory

– What government expenditures do we expect, and why?

– How should government carry out its desired functions?

2. Theory of taxation

– What principles should guide design of government tax policy

3. Theory of fiscal federalism

Three Normative Aspects of Public Sector Economics

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• Efficiency is mainly a positive concept• Economists measure efficiency as Pareto Optimality

• Definition: An economy-wide allocation of resources is efficient if in order to increase one person’s utility at least one other person’s utility must be decreased

Example

• An allocation in which I have everything and you have nothing is an ‘efficient’ allocation (Pareto Optimal)

– The only way to make you better off is to take some away from me

Two Goals of Economies1: EFFICIENCY

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Consider all ‘efficient’ points given our existing resources• Called the Utility Possibility Frontier

(Efficiency continued…)

1. Must be downward sloping• To increase 1’s utility we must

take utility away from 2

2. Points below line are attainable but not efficient

• Could give some to both 1 and 2 and make them both better off (Pareto Superior moves)

3. Points beyond line are unattainable• Would require giving more

utility to both 1 and 2 which is impossible

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Equity is mainly a normative concept

End-results equity

• Asks whether outcomes are fair.

– For example: Is it fair that over half of income in the country goes to 20% of households? If not, what should be done to correct it?

Process equity

• Asks whether rules determining process are fair, regardless of allocation.

– For example: Do children of wealthy families start with an advantage due to their family’s wealth? If so, then what should be done to level the playing field?

2: EQUITY (FAIRNESS)

Allocative function

– Market failures distort the allocation of resources in the economy

– Incomplete markets

• Characteristics of goods and services prevent efficient supply

• Existence of externalities.

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Distributive function

– Fairness

– Inequality in income distribution

– Criteria for evaluation.

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Stabilisation function– Macro-economic objectives

– 3 premises of stabilisation (Keynes):

• The market economy is inherently unstable

• Macroeconomic instability is a form of market failure that is highly costly to an economy

• Governments are able to stabilise the economy by means of appropriate macroeconomic policies.

– New Classical Macroeconomics

– Neo-Keynesian theory.

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Direct versus indirect government intervention

•Direct government intervention refers to the actual participation of government in the economy.

•Indirect government intervention to the regulatory function of government.

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Direct versus indirect government intervention

Direct intervention– Actual participation in the

economy

– Tax individuals and companies

– Borrow on financial markets

– Execute budgeted spending

– Examples:• National defence

• Electricity

• Infrastructure

• Provision of school text books

Indirect intervention– Regulatory function

– Enacting law or proclaiming legally binding rule

– Indirect taxes and subsidies

– Examples:• Labour laws

• Anti-tobacco laws

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