1EC202 | Public Economics and Finance

Part 1. Introduction

Maria Manuel Pinho

(mpinho@fep.up.pt)
2016/2017
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1EC202 Public Economics and Finance

1. Public economics and Public finance

Organic meaning: the set of public entities responsible for the management

of the economics resources that allow the satisfaction of collective needs

(for instance, the Finance Ministry).

Objective meaning: the activity of allocating the economics resources to

the satisfaction of collective needs by the public sector.

Subjective meaning: the scientific discipline the branch of economic

theory that studies the relationship between the public sector and the
private sector. This is the meaning which interests more for this course unit.

1EC202 Public Economics and Finance

1. Public economics and Public finance

The more consensual approach associates the organic and objective

meanings to Public finance and the subjective meaning to Public
economics.

This reflects the development of Public economics from its initial emphasis
upon the collection and spending of government revenues to its present
concern with all aspects of government economic intervention.

1EC202 Public Economics and Finance

1. Public economics and Public finance

Public finance is a narrower term: it is a field of economics concerned with
the management of public revenues and expenses.

Public economics is a broader term: it is a field of economics concerned

with the interaction between the public sector and the overall economic
activity.

In both cases, the aim should be to maximize social well-being (as for
consumers is to maximize utility and for firms to maximize profit).
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1EC202 Public Economics and Finance

1. Public economics and Public finance

 Collective choices take place in a political and institutional environment.

The Public Choice theory analyses the influence of political and

institutional factors on collective decision-making because it is possible
that decision-makers do not pursue exclusively the public interest.

 Government failures occur when government decisions do not lead to

an improvement of the economic efficiency or of equity.

1EC202 Public Economics and Finance

1. Public economics and Public finance

 So, the normative perspective of seeking to maximize social welfare is

complemented with a positive perspective in which the behaviour of the

decision-makers is conditioned by their own preferences (opportunistic or
ideological) and by the political and institutional context in which those
decisions take place (government, parliament and voters fragmentation,
budget procedures, agenda setting, political regime, electoral system,
central bank independence, etc.).

1EC202 Public Economics and Finance

1. Public economics and Public finance

Public economics focus on the interaction between the government and

the economy in an attempt to understand:


how the government makes decisions (positive perspective);

how those decisions affect the economy (positive perspective);

which are the best policies (normative perspective).

1EC202 Public Economics and Finance

1. Public economics and Public finance

Positive analysis is about explaining why there is a public sector, how

government policies are chosen and how these policies affect the economy.
Analysing the voting of the monetary policy committee of a central bank
over the level of the interest rate and analysing the effect of the corporate
tax on inward investment are examples of positive analysis.

Normative analysis investigates which are the best policies, and aims to
provide a guide to good government. Examples of normative analysis are
whether the level of pensions should be indexed to average wages or
whether a minimum income guarantee should be provided.
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2. Forms of public intervention

The basic structure of a market economy is conveniently represented by the

economic circular flow. Households on the one hand and business firms
on the other are considered to have each their specific individual private
activities, namely consumption of goods and services and supply of factor
resources (labour, capital) for the former, production of goods and services
by means of factors of production for the latter. In addition, these two
categories of agents interact through private exchanges on product and
factor markets, by demanding the goods and/or factors they need against
supplying the goods and/or factors they are willing to offer.
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1EC202 Public Economics and Finance

2. Forms of public intervention

Goods and services
markets

Consumers

State
(Public sector)

Producers
Firms

Households

Factor
markets

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1EC202 Public Economics and Finance

2. Forms of public intervention

In all market economies of the world, the state is present in almost all
components of the economic circular flow, regulating it, supplementing it,
and redistributing its outcome. This is why, it is located in the middle of the
picture.

There three main ways (plus one) of how the public sector intervenes in the
private initiative:

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1EC202 Public Economics and Finance

2. Forms of public intervention

[1]

Economic regulation

The basic argument is that the settlement of the social and legal framework
in which the economic activity takes place provides a justification for at least
a minimal state. This results from the observation that unregulated
economic activity does not lead to a socially optimum outcome.
 An economy could not function effectively if there were no property rights (the

rules defining the ownership of property).

 Contract laws exist to ensure that the participants to a trade receive what they

agreed or, if they do not, they can be compensated.

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2. Forms of public intervention

[2]

Economic intervention

Economic intervention is an action taken by a government in a market

economy or market-oriented mixed economy, beyond the basic regulation,
in an effort to affect the economy that is, the behaviour of consumers and
firms.
 Economic intervention can be aimed at a variety of political or economic objectives,

such as promoting economic growth, increasing employment, raising wages,

raising or reducing prices, promoting equality, managing the money supply and
interest rates, increasing profits, or addressing market failures it reflects both the
economic policy, specific measures and persuasion.
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1EC202 Public Economics and Finance

2. Forms of public intervention

[3]

Economic action

It is the intervention of the public sector as an economic agent making

consumption or investment expenses, managing its assets, getting loans
It may serve as an example of the behaviour that private agents should
have for instance, buying recycled copy paper.

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1EC202 Public Economics and Finance

2. Forms of public intervention

Final notes
 In planned economies, there is a fourth possibility economic planning. An

economic system that is characterized by the primacy of economic planning over

the market is referred to as a Planned economy, where resource allocation and
the quantity produced is allocated by the public sector and not by the market.
 These forms of intervention are not mutually exclusive! For instance, economic

regulation may be seen as economic intervention: tax collection can be seen as

economic intervention (when it aims at reducing the consumption of certain
goods) or economic action (when it just aims at collecting revenues).
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1EC202 Public Economics and Finance

3. Government theories
There are a wide range of theories about the reasons for establishing
governments. The four major ones are briefly described below. Note that
they do not always fully oppose each other.

1) Force theory
Governments originated from the authority of warlords and despots who took,
by force, certain patches of land as their own (and began exercising authority
over the people living on that land). Thus, it is argued that governments
emerged by the enforcement of the will of the strong and oppress the weak,
maintaining and protecting the privilege of a ruling class negative perspective.
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1EC202 Public Economics and Finance

3. Government theories
2) Natural rights theory
Natural rights are the basis for the theory of government shared by most
branches of liberalism. In this view, human beings are born with certain natural
rights, and governments are established strictly for the purpose of protecting
those rights liberal perspective.

3) Order and tradition theory

The various forms of conservatism generally see the government as a positive
force that: brings order out of chaos, establishes laws, encourages moral virtue
and respects tradition conservative perspective.
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1EC202 Public Economics and Finance

3. Government theories
4) Social contract theory
The social contract theory holds that governments are created by the people in
order to provide for collective needs (such as safety from crime, invasion,
natural disasters) that cannot be properly satisfied using purely individual
means. Governments thus exist for the purpose of serving the needs and
wishes of the people, and their relationship with the people is clearly stipulated
in a "social contract" (a constitution and a set of laws) which both the
government and the people must abide by democratic perspective.

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1EC202 Public Economics and Finance

3. Government theories
Final notes


Historically, it is not possible to identify societies with no public sector (or

another supra-individual entity) but is possible to identify societies with no
private society. Naturally, the importance of public sector depends on the
limits of its intervention, which will be developed in the next section. It is up
to the public sector to balance individual freedom with collective needs.

Public intervention has evolved in two ways: with the private sector (on the
basis of new forms of relationship) and with the territory abroad (in a
context of globalization, through the regulation of markets).

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1EC202 Public Economics and Finance

4. Public sector functions

Normally, competitive private markets provide efficient outcomes for the
economy. Generally, it is hard to justify government intervention in markets
but there are four main roles of the public sector regarding economic
intervention:
1) Allocation of resources
2) Redistribution of income
3) Macroeconomic stabilization
4) Promotion of economic development

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1EC202 Public Economics and Finance

4. Public sector functions

1)

Allocation of resources

The basic principle underlying this function is efficiency.

The allocation function aims at promoting the efficient allocation of

resources through a corrective measure undertaken by the government
that might be a Pareto movement or not. It is preferable that it is a
Pareto-movement (without sacrifices associated) and that it leads the
economy closer to its Frontier of Possibilities of Utility. In order to
achieve this outcome, the government has to:
identify the market failures that place the economy in a inefficient situation;
undertake the appropriate corrective measure.
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1EC202 Public Economics and Finance

4. Public sector functions

1)

Allocation of resources

The government intervenes in the economy in order to promote an efficient

allocation of resources, in the presence of market failures:


imperfect competition (the extreme situation is the natural monopoly)

public goods provision: non-rival and non-excludable goods

externalities: external effects of the production or consumption of market

goods which are not signalled by the price, leading to a bias between
the individual / market optimum and the social optimum

imperfect information (incomplete or asymmetric) and, as a

consequence, uncertainty and risk
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1EC202 Public Economics and Finance

4. Public sector functions

2)

Redistribution of income

 The basic principle underlying this function is equity.

 Efficient markets may not produce an equitable distribution of well-being

(usually assessed by income).

 Public economics also investigates the extent to which it is possible, or

desirable, for the government to influence the distribution of income and

wealth, aiming at equity.

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1EC202 Public Economics and Finance

4. Public sector functions

2)

Redistribution of income

 Even if the market situation is efficient, the market distribution of

economic resources (primary distribution), as a function of the stock of

inputs owned by the families and the corresponding remuneration, may
not be consistent with the social idea of a fair distribution. However, the
notion of equity is far more subjective than the notion of efficiency.
Note: The 'S80/S20 income quintile share ratio' is the ratio of the sum of equivalised
disposable income received by the 20% of the countrys population with the highest
equivalised disposable income (top inter-quintile interval) to that received by the 20% of the
countrys population with the lowest equivalised disposable income (lowest inter-quintile
interval), although it is easily understandable by the general population by extreme values of
the income distribution, is the richest and poorest population.
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1EC202 Public Economics and Finance

Inequality of income distribution S80/S20 income quintile share ratio, 2014

10
9
8
7
6

5,2

5
4
3
2

Source: Eurostat.

Serbia

FYR of Macedonia

Spain

Romania

Latvia

Bulgaria

Greece

Estonia

Portugal

Italy

Lithuania

Cyprus

Euro area (19)

European Union (28)

Croatia

United Kingdom

Germany

Ireland

Poland

Switzerland

Luxembourg

France

Hungary

Austria

Malta

Denmark

Sweden

Slovakia

Belgium

Netherlands

Finland

Slovenia

Czech Republic

Iceland

Norway

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1EC202 Public Economics and Finance

4. Public sector functions

2)

Redistribution of income

The public sector must promote social justice:



through the secondary distribution of income (redistribution) there is a

consensus about the need to correct the primary distribution of income (the
one that is the outcome of the free market activity) for distributive justice
purposes.

through the provision of primary and merit goods (those which have
positive externalities on society), in order to promote equal opportunities for
everybody regarding those goods.

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1EC202 Public Economics and Finance

4. Public sector functions

2)

Redistribution of income

Trade-off between efficiency and equity



equity-led measures may lead to more inefficiency

for example, the unemployment transfer may change the choice between
labour and leisure

the efficiency regards the size of the cake (the wealth created) and equity
regards its distribution

a public intervention aiming at changing the cakes distribution may shrink

the cake

the equity criteria reflect the States structure (socialist, communist, etc.)
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1EC202 Public Economics and Finance

4. Public sector functions

3)

Macroeconomic stabilization

This function consists in the use of economic policy to achieve the main
macroeconomic goals:


sustainable economic growth;

high levels of employment of resources;

prices stability;

external accounts balance and consequent national independence.

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1EC202 Public Economics and Finance

4. Public sector functions

3)

Macroeconomic stabilization

These goals are not consistent in the sense that giving priority to one of

them may have negative consequences in terms of efficiency or equity.

In the context of the European economic and monetary union (EMU),

member-states no longer can use monetary and exchange policies,

depending exclusively on fiscal policy.

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1EC202 Public Economics and Finance

4. Public sector functions

4)

Promotion of economic development

Not all the authors consider this as a role to be carried on by the public
sector. However, some consider the need:

to guarantee a balanced growth in order to avoid spatial fluctuations,

fostering the growth of lagging regions and reducing the congestion in

developed regions,

aiming at sustainable territorial cohesion.

The idea is that the market does not ensure the investment and planning
conducing to long term economic, social, environmental and territorial
sustainability.
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1EC202 Public Economics and Finance

4. Public sector functions

Final notes


Allocation, redistribution and stabilization are the classic functions of the

public sector.

While redistribution problems are more associated to equity goals,

allocation and stabilization problems are more associated to efficiency
goals.

While allocation and redistribution problems are more associated to

microeconomic goals, stabilization problems are more associated to
macroeconomic goals.

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