BINDURA UNIVERSITY OF SCIENCE EDUCATION

FACULTY OF COMMERCE
DEPARTMENT OF ECONOMICS
PUBLIC FINANCE I: EC218

TUTORIAL I DISCUSSION
Question 1
Distinguish between partial equilibrium analysis and general equilibrium analysis.

Partial equilibrium analysis

In partial equilibrium analysis, the determination of the price of a good is simplified by just
looking at the price of one good (single market) and assuming that the prices of all other goods
remain constant e.g. the Marshallian theory of supply and demand. Partial equilibrium analysis is
adequate when the first-order effects of a shift in the demand curve do not shift the supply curve
that is activity in one market has little or no effect on other markets. However, market
interrelationships can be important. Price plays the role of equilibrating demand and supply so
that all buyers who want to buy at the going price can and do and similarly all sellers who want
to sell at the going price also can and do-with no excess or shortages on either side.

We assume that both buyers and sellers seek to maximise their gains from trading in a market

system. That is, buyers maximise their satisfaction from exchanging their money for goods and

services while sellers maximise profits from making goods and services available to consumers.

The market prices that emerge reflect the free interplay of supply and demand. This is the

hallmark of the first theorem of welfare economics which states that a competitive system,

building on the self-interested goals of consumers and producers and on the ability of market

prices to convey information to both parties will achieve an efficient allocation of resources.

Buyers consider their own marginal private benefit when deciding how much of a good to

purchase. Marginal private benefit (MPB) is the dollar value placed on additional units of the

good by individual consumers. When confronted with market prices, consumers trade until they

adjust the MPB received from consuming a good per month to what they must forgo to purchase

one more unit of the good per any given period of time. What they forgo is measured by the price
1
of one more unit, that is, the amount of money they give up (the price) that could have been

spent on other items. If the value of the money they give up exceeds the MPB of that last unit,

they would be made worse off by trading those dollars for the good. Thus, they maximise their

gains from trading the amount of any good they consume per any given period until the MPB is

equal to price (P).

P=MPB=MSB

The MPB received by consumers purchasing the good is also equal to the marginal social benefit

(MSB) of the good provided that no one except the buyer receives any satisfaction when the

good is consumed. MSB is the market demand.

The firm would increase profits whenever the revenue obtained from selling additional unit

exceeds the cost of producing and selling that extra unit. The marginal private cost (MPC) of

output is the cost incurred by sellers to make an additional unit of output available for sale. The

extra revenue obtained from selling one more unit is its price, assuming that the firm can sell as

much as it likes at the going market price. The firm will maximise profits when it adjusts its

output sold per any given period to the point at which price is equal to the MPC of output.

P=MPC=MSC

If MPC exceeds price, the gains from trade (profit) would decline. The MPC of output incurred

by sellers is the marginal social cost (MSC) provided that opportunity cost of all resources used

in making the product available is included in the sellers’ total costs. MSC is the industry’s

supply curve.

Combining Equations 3.1 and 3.2 would yield:

2
 P=MPB i=MPC=MSB=MSC

where
MPBi is the marginal private benefit received by any given consumer.

If consumers are the only recipients of benefits when the good is sold and sellers bear all the cost

of making that good available, Equation 3.3 implies that MSB=MSC for the good. A system of

competitive markets achieves an efficient allocation of resources when Equation 3.3 is satisfied

in each market and all goods and services are sold in markets.

General equilibrium analysis

Anglo-American economists became more interested in general equilibrium in the late 1920s and
1930s after Piero Sraffa's demonstration that Marshallian economists cannot account for the
forces thought to account for the upward-slope of the supply curve for a consumer good. General
equilibrium tries to give an understanding of the whole economy using a "bottom-up" approach,
starting with individual markets and agents. On the other hand, macroeconomics, as developed
by the Keynesian economists, focused on a "top-down" approach, where the analysis starts with
larger aggregates (the "big picture"). Therefore, general equilibrium theory is classified as part of
microeconomics.
The difference is not as clear as it used to be, since much of modern macroeconomics has
emphasised microeconomic foundations and has constructed general equilibrium models of
macroeconomic fluctuations. General equilibrium macroeconomic models usually have a
simplified structure that only incorporates a few markets, like a "goods market" and a "financial
market". In contrast, general equilibrium models in the microeconomic theory involve a
multitude of different goods markets and hence are usually complex.

Unlike partial equilibrium analysis, general equilibrium analysis determines prices and quantities
in all markets simultaneously and it takes feedback effects into account. A feed back effect is a
price or quantity adjustment in one market caused by price and quantity adjustments in related
markets. Please note that in practice a complete general equilibrium analysis which evaluates the
effects of a change in one market on all other markets is not feasible. General equilibrium
analysis is concerned with the conditions under which equilibrium will be efficient, which
efficient equilibria can be achieved, when equilibrium is guaranteed to exist and when the
equilibrium will be unique and stable.

With consumer preferences that are convex, any efficient allocation of resources can be achieved

by a competitive process with a suitable redistribution of those resources. The second theorem of

3
welfare economics tells us that under certain (ideal) conditions, issues of equity and efficiency

can be treated distinctly from one another. Both theorems of welfare economics depend on the

cardinal assumption that markets are competitive.

Efficiency of competitive markets

A recurring t h e m e in general equilibrium analysis and economic theory in general, h a s

been the idea that the competitive price mechanism l e a d s to outcomes that are efficient
in a way that outcomes under other systems such as planned economies are not. The concept
of efficient was formalised by Vilfredo Pareto (1909) and Abram Bergson (1938). This line of
inquiry culminated in the Theorems of Welfare Economics by Arrow (1951) and Debreu
(1951). These theorems state that there is in essence equivalence between Pareto efficient
outcomes and competitive price equilibria.

The notion of Pareto optimality does not have anything to do with equilibrium per se (although
you will see the close connection in the Appendix notes). Instead it considers the set of feasible
allocations and identifies those allocations at which no consumer could be made better off
without another being made worse off. Pareto efficiency says nothing about distributional
justice or equity. For example, it can be Pareto efficient for one person to have everything and
everyone else has nothing. Pareto optimality just says that there are no “win-win” changes
around: it is quiet on how social trade-offs should be resolved.
i. Efficiency in exchange: All allocations must lie on an exchange contract curve so
that every consumer’s marginal rate of substitution (MRS) of good x for good y is
MRS 1=MRS 2
the same: xy xy
A competitive market achieves this efficient outcome because for consumers the

tangency of the budget line and the highest attainable indifference curve assure that;

Px
MRS = =MRS 2
xy 1 Py xy

ii. Efficiency in the use of inputs in production: All input combinations must lie on
the production contract curve so that every producer’s marginal rate of technical
substitution (MRTS) of labour for capital is equal in the production of good x and
MRTS LK x =MRTS
good y . LK
y

4
 A competitive market achieves this efficient outcome because each producer

maximises profit by choosing labour and capital inputs so that the ratio of the input

prices is equal to the marginal rate of technical substitution.

w
MRTS LK x = =MRTS y
r LK

iii. Efficiency in output market: The mix of outputs must be chosen so that the
marginal rate of transformation (MRT) between outputs is equal to consumers’
marginal rates of substitution. A competitive market achieves this efficient outcome
because profit-maximising producers increase their output to the point at which
marginal cost equals price:
P x=MC x ; P y=MC y

MC x P x
MRT xy = =
As a result, MC y P y

But consumers maximise their satisfaction in competitive markets only if

Px
=MRS xy
Py (for all consumers)

Therefore,
MRT xy =MRS xy (for all consumers)

The above equation shows that efficiency requires that goods are produced in

combinations and at cost that match people’s willingness to pay.

Question 2
(a) Discuss three views of a government.
(b) In your view which of the three views of government is relevant to Zimbabwe?
See lecture notes.
Question 3
(a) What are the likely problems faced by the government when providing public goods.

 Public provision of public goods faces three problems:

o Crowding out of private provision. That is, as the government provides more of a
public good, the private sector will provide less.
o How to determine the costs and benefits of public projects. This is addressed by the
field of cost-benefit analysis.

5
 o Effectively reflecting the public’s demand for public goods, that is, measuring
preferences for the public good;
Preference revelation: individual may not be willing to tell the government their true
valuation because presumably the government might charge them more for the good;
Preference knowledge: individuals may not know what their valuation is since they
do not have experience valuing public goods;
Preference aggregation: how can the government put together preferences of
millions of citizens in order to decide on the value of a public project?

(b) Using insurance industry as an example, explain three market failures caused by
information asymmetry.
(i) Adverse selection
Adverse selection arises when products of different qualities are sold at a single price because
buyers or sellers are not sufficiently informed to determine the true quality at the time of
purchase. As a result, too much of the low quality product and too little of the high quality
product are sold on the market. In the insurance market adverse selection occurs if insurance
companies must charge a single premium because they cannot distinguish between high risk and
low risk individuals such that more high risk individuals will insure making it unprofitable to sell
insurance.
(ii) Moral hazard
Moral hazard refers to adverse actions taken by individuals or producers in response to insurance
against adverse outcomes. It occurs when an insured party takes less care to avoid losses after
insuring. The extent of moral hazard varies with two factors:
o how easy it is to observe whether the adverse event has happened
o how easy it is to change behaviour in order to establish the adverse event
Moral hazard does not only alter behaviour, it also creates economic inefficiency. Figure 3.8
shows how moral hazard leads to inefficient resource allocation.

Cost/km D

$1.50 MC

$1.00 MCꞋ

$0.50

50 100 155 Km per week

Figure 3.1: Effects of moral hazard on resource allocation
D gives the demand for automobile driving. With no moral hazard, the marginal cost of
transportation, MC is $1.50 per kilometre; the driver drives 100 kilometres which is the efficient

6
amount. With moral hazard, the driver perceives the cost per kilometre to be MC Ꞌ=$1.00 and
drives 155 kilometres.
Moral hazard can arise along many dimensions:
 Reduced precaution against entering the adverse state: e.g. because you have medical
insurance that covers illness, you reduce preventive activities to protect your health.
 Increased odds of entering the adverse state: e.g. because you have workers’
compensation claim that you were injured on the job.
 Increased expenditure when in the adverse state: e.g. because you have medical
insurance, you use more medical care than you otherwise would.
 Supplier response to insurance against the adverse state: e.g. because you have
medical insurance, physicians provide too much care to you.
(iii) Principal-agent problem
Principal-agent problem arises when managers (agents) pursue their own goals even when doing
so entails lower profits for the firm’s owners (the principals). In the insurance market, sometimes
insured parties may be seen as agents and insurance companies as principals. Incomplete
information and costly monitoring often affect the way agents act.

Question 4
Discuss ways that can be used to correct negative externalities.
See lecture notes.
Question 5
(a) Identify three forms of government expenditure.
Three forms of government expenditure are recurrent expenditure (consumption);
capital/investment expenditure and transfer payments.
(b) Explain three ways of financing government expenditures.
Proposed Answer

(i) Taxes
Taxation is the central part of modern public finance. Its significance arises not only from the
fact that it is by far the most important of all revenues but also because of the gravity of the
problems created by the present day tax burden. The main objective of taxation is raising
revenue. A high level of taxation is necessary in a welfare State to fulfill its obligations.
Taxation is used as an instrument of attaining certain social objectives i.e. as a means of
redistribution of wealth and thereby reducing inequalities. Taxation in a modern Government
is thus needed not merely to raise the revenue required to meet its ever-growing expenditure
on administration and social services but also to reduce the inequalities of income and wealth.
Taxation is also needed to draw away money that would otherwise go into consumption and
cause inflation to rise.

A tax is a financial charge or other levy imposed on an individual or a legal entity by a state
or a functional equivalent of a state. A tax "is not a voluntary payment or donation, but an
enforced contribution, exacted pursuant to legislative authority" and is "any contribution
imposed by government whether under the name of toll, tribute, impost, duty, custom, excise,

7
subsidy, aid, supply, or other name." There are various types of taxes, broadly divided into
two heads: direct (which is proportional) e.g. personal income tax and indirect tax (which is
differential in nature) e.g. sales tax.

(ii) Debt
Governments, like any other legal entity, can take out loans, issue bonds and make financial
investments. Government debt (also known as public debt or national debt) is money (or
credit) owed by any level of government; either central, municipal government or local
government. Government debt can be categorized as internal debt, owed to lenders within the
country, and external debt, owed to foreign lenders. Governments usually borrow by issuing
securities such as government bonds and bills. Less creditworthy countries such as
Zimbabwe sometimes borrow directly from commercial banks or international financial
institutions such as the International Monetary Fund or the World Bank.

(iii) Public finance through state enterprise

Public finance in centrally planned economies has differed in fundamental ways from that in
market economies. Some state-owned enterprises generated profits that helped finance
government activities. The government entities that operate for profit are usually
manufacturing and financial institutions, services such as nationalized healthcare do not
operate for a profit to keep costs low for consumers. The Soviet Union relied heavily on
turnover taxes on retail sales. Sales of natural resources, and especially petroleum products,
were an important source of revenue for the Soviet Union.

In market-oriented economies with substantial state enterprise, such as in Venezuela, the

state-run oil company PSDVA provides revenue for the government to fund its operations
and programs that would otherwise be profit for private owners. In various mixed
economies, the revenue generated by state-run or state-owned enterprises are used for
various state endeavours; typically the revenue generated by state and government agencies
goes into a sovereign wealth fund. An example of this is the Alaska Permanent Fund and
Singapore's Temasek Holdings.
(iv) Grants
Developing countries often receive grants which could be in monetary form or goods and
services in order to finance development programmes or government operations.

(c) In your view, what factors can militate against efficient and effective budget
implementation in the public sector in Zimbabwe?

Proposed Answer
(i) Human Element

8
Top management members see budgeting as restraining and challenging. They tend to develop a
lot of apathy towards its adoption and implementation. The lack of probity and accountability of
some operatives affect successful budgeting.

(ii) Uncertainties Underlying Data Inputs

There is a lot of uncertainties in the data used for the budget preparation. The projections in
revenue accruing from oil may not be forthcoming in view of the vagaries in the world market.
Lack of efficient data base also hamstrings reliable forecasts.

(iii) The Type of Project for which Budget is Prepared

How successful a budget will be depends on the type of project to which it relates. Some projects
are popular while others are not. Those which are not popular may face stiff implementation
problems.

(iv) The Problem of Inflation

Inflation tends to reduce the purchasing power of money. When the value of money is falling,
budget implementation may run into problems. The revenue available will not be able to cover
the expenditure.

(v) Political, Social and Cultural Elements.

Each segment of the country has its own cultural beliefs and taboos which may take time to
change. Introducing innovation may be met with stiff opposition. For example, a section of the
country may not be willing to provide land for development purposes. Secondly, where there is
political instability, budget implementation is at risk.

(vi) Changing Government Policies.

To implement a budget, a lot depends on the policy of Government. For effective budget
implementation, Government policies have to be harmonized and consistent. Frequent changes
of government policies affect budget implementation.

(vii) The Problem of Debt Management and Optimal Use of Limited Resources.
There is the challenge of striking a balance between what part of the nation's resources should be
used for servicing/repaying debts and the amount that should be utilized for economic
development.

(viii) Low Agricultural Output.

Agricultural output is fast dwindling because the method of farming is outdated and the younger
population is not attracted. The resources that should be used for economic development are
therefore being diverted to the importation of food items.

(ix) Fiscal Indiscipline.

9
 Most spending Accounting Officers/Permanent Secretaries are budget maximizers. Under the
incremental budgeting system, they tend to expend the last dollar available in a year's budget in
order to justify the demand for increased allocation in the subsequent year, with little or nothing
to show under the current dispensation.

Question 6
Using specific examples, discuss five sources of government failure.
Proposed Answer

Causes of Government Failure

Government intervention can prove to be ineffective, inequitable and misplaced.
(a) Political self-interest

 The pursuit of self-interest amongst politicians and civil servants can often lead to a
misallocation of resources. For example decisions about where to build new roads, schools and
hospitals may be decided with at least one eye to the political consequences.

 The pressures of a looming election or the influence exerted by special interest groups can
foster an environment in which inappropriate spending and tax decisions are made e.g. boosting
welfare spending in the run up to an election, or bringing forward major items of capital
spending on infrastructural projects without the projects being subjected to a full and proper
cost-benefit analysis to determine the likely social costs and benefits. Critics of current
government policy towards tobacco taxation and advertising, and the controversial issue of
genetically modified foods argue that government departments are too sensitive to political
lobbying from the major corporations.

(b) Policy myopia

 Critics of government intervention in the economy argue that politicians have a tendency to look
for short term solutions or "quick fixes" to difficult economic problems rather than making
considered analysis of long term considerations.
 For example, a decision to build more roads might simply add to the problems of traffic
congestion in the long run encouraging an increase in the total number of cars on the roads.
 The risk is that myopic decision-making will only provide short term relief to particular
problems but does little to address structural economic problems.
 Critics of government subsidies to particular industries also claim that they distort the proper
functioning of markets and lead to inefficiencies in the economy.

(c) Regulatory Capture

 This is when the industries under the control of a regulatory body (i.e. a government agency)
appear to operate in favour of the vested interest of producers rather can consumers

10
 Some economists argue that regulators can prevent the ability of the market to operate freely. We
might find examples of this in agriculture, telecommunications, the main household utilities and
in transport regulation.

(d) Disincentive effects

 Free market economists who fear government failure at every turn argue that attempts to reduce
income and wealth inequalities can worsen incentives and productivity. They would argue
against the national minimum wage because they believe that it artificially raises wages above
their true free-market level and can lead to real-wage unemployment.
 They would argue against raising the higher rates of income tax because it is deemed to have a
negative effect on the incentives of wealth-creators in the economy and generally acts as a
disincentive to work longer hours or take a better paid job.

(e) Government intervention and evasion

 A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to
an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey
markets where trade takes place between consumers and suppliers without paying tax.
A decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of
drugs and a substantial loss of social welfare arising from over consumption.

(f) Policy decisions based on imperfect information

 How does the government establish what citizens want it to do in their name? Can the
government ever really know the true revealed preferences of so many people?
 Often a government will choose to go ahead with a project or policy without having the full
amount of information required for a proper cost-benefit analysis. The result can be misguided
policies and damaging long-term consequences.

 How does the government know how many extra houses need to be built in the Zimbabwe over
the next twenty years? Is building thousands of extra homes in an already congested Mbare High
Density Suburb in Harare the right option? Are there better solutions? There have been plenty of
instances of government housing policy having failed in previous decades!

(g) The Law of Unintended Consequences

 The law of unintended consequences is that actions of consumer and producers and especially of
government always have effects that are unanticipated or "unintended."
 The law of unintended consequences is often used to criticise the effects of government
legislation, taxation and regulation. People find ways to circumvent laws; shadow markets
develop to undermine an official policy; people act in unexpected ways because of ignorance and
/ or error. Unintended consequences can add hugely to the financial costs of some government
programmes so that they make them extremely expensive when set against their original goals
and objectives.
(h) Costs of administration and enforcement

11
Government intervention can prove costly to administer and enforce. The estimated social
benefits of a particular policy might be largely swamped by the administrative costs of
introducing it.

12