Public economics(or economics of thepublic sector) is the study of government policy through the lens ofeconomic efficiency andequity. Public economics builds on the theory ofwelfare economics and is ultimately used as a tool to improvesocial welfare. Welfare can be defined in terms of well-being, prosperity, and overall state of being.
Public economics provides a framework for thinking about whether or not the government should participate in economic markets and if so to what extent it should do so.Microeconomic theory is utilized to assess whether the privatemarket is likely to provide efficient outcomes in the absence of governmental interference; this study involves the analysis of governmenttaxation andexpenditures.
TheJournal of Economic Literature (JEL) classification codes are one way categorizing the range of economics subjects. There, Public Economics, one of 19 primary classifications, has 8 categories. They are listed below with JEL-code links to corresponding available article-preview links ofThe New Palgrave Dictionary of Economics Online (2008) and with similar footnote links for each respectivesubcategory if available:[10]
The role of government in providing efficient and equitable markets is largely underpinned by addressingmarket failures that may arise. Public Economics focuses on when and to what degree the government should intervene in the economy to address market failures.[19] Some examples of government intervention are providing pure public goods such as defense, regulating negative externalities such aspollution and addressing imperfect market conditions such asasymmetric information.
Pure public goods, or collective consumption goods, exhibit two properties; non-rivalry and non-excludability. Something is non-rivaled if one person's consumption of it does not deprive another person, (to a point) a firework display is non-rivaled - since one person watching a firework display does not prevent another person from doing so. Something is non-excludable if its use cannot be limited to a certain group of people. Again, since one cannot prevent people from viewing a firework display it is non-excludable.[9] Due to these constraints, one of few examples of a "pure public good" is national defense - it is both non-rivalry and non-excludable. Another example, of a pure public good is knowledge. Consider a book. The book itself can be destroyed and thus is excludable. However, the knowledge obtained from the book is far more difficult to destroy and is non-rivalrous and non-excludable.[20] In reality, not all public goods can be classed as 'pure' and most display some degree of excludability and rivalrous. These are known asImpure public goods.[21] To visualize the public good's characteristic of non-excludability, it would be the inability to build a fence, barrier or wall that would block the good from consumption. In the modern era, digital replication allows several goods to be non-rivalry; since, people from all over the world can access it if you have access to the internet and a device.
Due to the two unique properties that public goods exhibit, being non-rivalrous & non-excludable, it is unlikely that without intervention markets will produce the efficient amount. It therefore, the role of government to regulate the production of public goods so as to create an efficient market equilibrium.[19]
Externalities arise when consumption by individuals or production by firms affect the utility or production function of other individuals or firms.[22] Positive externalities are education, public health and others while examples of negative externalities are air pollution,noise pollution, non-vaccination and more.[23]
Pigou describes aspositive externalities, examples such as resources invested in private parks that improve the surrounding air, and scientific research from which discoveries of high practical utility often grow. Alternatively, he describesnegative externalities, such as the factory that destroys a great part of the amenities of neighboring sites.
The role of government is to address the negative external effects and societaldeadweight loss created from inefficient markets[19]
Imperfect competition within markets can take many forms and will often depend on the barriers to entry, firms profit and production objectives and the nature of the product and respective market.[21] Imperfect competition will lead to a social cost and it is the role of government to minimize this cost.[24] Some notable imperfections include:
Companies sell differentiated products
There are barriers to exit and entry
Suboptimal output and pricing
In its essence, the role of government is to address the issues that arise from these market failures and decide the optimal degree of intervention necessary.[19]
In 1971,Peter A. Diamond andJames A. Mirrlees published a seminal paper that showed that even whenlump-sum taxation is not available, production efficiency is still desirable. This finding is known as the Diamond–Mirrlees efficiency theorem, and it is widely credited with having modernizedRamsey's analysis by considering the problem ofincome distribution with the problem of raising revenue.Joseph E. Stiglitz andPartha Dasgupta (1971) have criticized this theorem as not being robust on the grounds that production efficiency will not necessarily be desirable if certain tax instruments cannot be used.
One of the achievements for which the great English economistA.C. Pigou is known, was his work on the divergences betweenmarginal private costs and marginalsocial costs (externalities). In his book,The Economics of Welfare (1932), Pigou describes how these divergences come about:
...one person A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons (not producers of like services), of such a sort that payment cannot be extracted from the benefited parties or compensation enforced on behalf of the injured parties (Pigou p. 183).
In particular, Pigou is known for his advocacy of what are known as corrective taxes, orPigouvian taxes:
It is plain that divergences between private and social net product of the kinds we have so far been considering cannot, like divergences due to tenancy laws, be mitigated by a modification of the contractual relation between any two contracting parties, because the divergence arises out of a service or disservice to persons other than the contracting parties. It is, however, possible for the State, if it so chooses, to remove the divergence in any field by "extraordinary encouragements" or "extraordinary restraints" upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes (Pigou p. 192).
Pigou suggested that the market failure of externalities can be overcome by the introduction of taxes. The government can intervene in the market, using an emission tax for example to create a more efficient outcome; this Pigouvian tax is the optimal policy prescription for any aggregate, negative externality.[25]
In 1960, the economistRonald H. Coase proposed an alternative scheme whereby negative externalities are dealt with through the appropriate assignment ofproperty rights. This result is known as theCoase theorem.
While the origins of cost–benefit analysis can be traced back to Jules Dupuit's classic article "On the Measurement of the Utility of Public Works" (1844), much of the subsequent scholarly development occurred in the United States and arose from the challenges of water-resource development. In 1950, the U.S. Federal Interagency River Basin Committee's Subcommittee on Benefits and Costs published a report entitled,Proposed Practices for Economic Analysis of River Basin Projects (also known as theGreen Book), which became noteworthy for bringing in the language of welfare economics.[26] In 1958,Otto Eckstein publishedWater-Resource Development: The Economics of Project Evaluation, andRoland McKean published hisEfficiency in Government Through Systems Analysis: With Emphasis on Water Resources Development. The latter book is also considered a classic in the field ofoperations research. In subsequent years, several other important works appeared:Jack Hirshleifer, James DeHaven, and Jerome W. Milliman published a volume entitledWater Supply: Economics, Technology, and Policy (1960); and a group of Harvard scholars includingRobert Dorfman,Stephen Marglin, and others publishedDesign of Water-Resource Systems: New Techniques for Relating Economic Objectives, Engineering Analysis, and Governmental Planning (1962).[27]
Public economics involvescollective decision making, which can be difficult as individuals in society have different views, including on how much should be spent on public goods. Richer individuals prefer to spend more on both public and private goods than individuals with lower incomes.[28] While both rich and poorer citizens pay the same price for private goods, individuals with higher incomes must pay a relatively higher cost when it comes topublic goods.[28] We can calculate this additional expenditure as the tax price; “the additional amount an individual must pay whengovernment expenditures increase by one dollar”.[28] With a higher tax price wealthier individuals will desire a lower expenditure on public goods.
An important part of collective decision making in ademocracy, and thus public economics, is aggregating preferences of all individuals in society. To aggregate preferences, however, the decision-making body (i.e. the government) must first ascertain the preferences of the citizens. We can call this processpreference revelation, and in terms of public economics, the objective is to determine the “desired level of public goods of each individual”.[28] This can be a very difficult process in practice. In most democratic countries, citizens vote for representatives that best emulate their preferences. This process can be perverted in a number of ways includinglobbying, media biases, political advertising, andspecial interest groups.[28]
Another aspect of this public choice paradigm was identified byAnthony Downs in 1957, when he wrote that “parties formulate policies to win elections, rather than winelections to formulate policies”.[29][30] The argument is thatpolitical parties and candidates are motivated primarily by self-interest, and “the income, prestige and power which come from being in office".[29][30] This can sometimes lead to difficult outcomes and can make it harder to properly aggregate the preferences of the population and can potentially lead to the favouring of the welfare of government officials as opposed to public welfare.
Social Choice Theory
Social choice theory in economics studies how groups end up making decisions as opposed to individuals. One of the central components of social choice theory is that government actions result from individuals acting out of rationalself-interest within the confines of the “rules of the game”.[28] In this sense, the constitution of a given country is a significant factor in what actions a government can take (i.e. limits on deficit spending).[31] One of the pioneers in this field was the American economist James Buchanan, who emphasized the role of the constitution in setting out the rules of the game.[28] The idea is that without restraints in place, there will be natural incentives for the majority to redistribute income in away from the minority in their favour. There is also the threat of special interest groups influencing elected representatives to act in their favour, at the expense of the public interest, and without appropriate rules in place these temptations will naturally be capitalized on.[28]
^•Richard A. Musgrave, 2008. "public finance,"The New Palgrave Dictionary of Economics, 2nd Edition.Abstract. • _____, 1959.The Theory of Public Finance: A Study in Public Economy.J. M. Buchanan review,1st page.
^• Sharun W. Mukand, 2008. "policy reform, political economy of,"The New Palgrave Dictionary of Economics 2nd Edition.Abstract. •James M. Buchanan, 2008. "public debt,"The New Palgrave Dictionary of Economics 2nd Edition.Abstract. • Mrinal Datta-Chaudhuri, 1990. "Market Failure and Government Failure,"Journal of Economic Perspectives, 4(3), pp.25-39.. •Kenneth J. Arrow, 1969. "The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Non-market Allocations," inAnalysis and Evaluation of Public Expenditures: The PPP System. Washington, D.C., Joint Economic Committee of Congress. PDF reprint as pp.1-16 (press+). •Joseph E. Stiglitz, 2009. "Regulation and Failure," in David Moss and John Cisternino (eds.),New Perspectives on Regulation, ch. 1, pp.11-23.Archived February 14, 2010, at theWayback Machine Cambridge: The Tobin Project.
^Gilbert E. Metcalf, 2008. "tax incidence,"The New Palgrave Dictionary of Economics, 2nd Edition.Abstract.
^Louis Kaplow, 2008. "optimal taxation,"The New Palgrave Dictionary of Economics, 2nd Edition.Abstract.
^ab•Agnar Sandmo, 2008."public goods,"The New Palgrave Dictionary of Economics, 2nd Edition.Abstract. • Serge-Christophe Kolm, 1987. "public economics,"TheNew Palgrave: A Dictionary of Economics, v. 3, pp. 1047-48. •Anthony B. Atkinson and Joseph E. Stiglitz, 1980.Lectures in Public Economics, McGraw-Hill, pp. vii-xi. •Mancur Olson, 1971, 2nd ed.The Logic of Collective Action: Public Goods and the Theory of Groups, Harvard University Press,Description and chapter-previews links, pp.ix-x.
^JEL: H51 – Government Expenditures and Health JEL: H52 – Government Expenditures and Education JEL: H53 – Government Expenditures andWelfare Programs JEL: H54 – Infrastructures; Other Public Investment and Capital Stock JEL: H55 –Social security and PublicPensions JEL: H56 – National Security and War JEL: H57 – Procurement
^JEL: H71 – State and Local Taxation, Subsidies, and Revenue JEL: H72 – State and Local Budget and Expenditures JEL: H73 – Interjurisdictional Differentials and Their Effects JEL: H74 – State and Local Borrowing JEL: H75 - State and Local Government: Health; Education; Welfare; PublicPensions JEL: H76 - State and Local Government: Other Expenditure Categories JEL: H77 - Intergovernmental Relations;Federalism;Secession
_____ andMusgrave, Richard A., 1999.Public Finance and Public Choice: Two Contrasting Visions of the State. MIT Press.Description and scrollable previewlinks.
Diamond, Peter A. and James A. Mirrlees. "Optimal Taxation and Public Production I: Production Efficiency"The American Economic Review Vol. 61 No. 1 (Mar. 1971) 8-27
Diamond, Peter A. and James A. Mirrlees. "Optimal Taxation and Public Production II: Tax Rules"The American Economic Review Vol. 61 No. 3 (Jun. 1971) 261-278
Drèze Jacques H., 1995. "Forty Years of Public Economics: A Personal Perspective,"Journal of Economic Perspectives, 9(2), pp.111-130.
Dupuit, Jules. "On the Measurement of the Utility of Public Works" inReadings in Welfare Economics, ed. Kenneth J. Arrow and Tibor Scitovsky (1969)
Haveman, Robert 1976.The Economics of the Public Sector.
Myles, Gareth D., 1995.Public Economics, Cambridge.Description and scroll to chapter-previewlinks.
Oates, Wallace E., 1972.Fiscal Federalism, Harcourt Brace Jovanovich, Inc.
Pigou, A.C. "Divergences Between Marginal Social Net Product and Marginal Private Net Product" inThe Economics of Welfare, A.C. Pigou (1932)
Ramsey, Frank P. "A Contribution to the Theory of Taxation" inClassics in the Theory of Public Finance, ed. R.A. Musgrave and A.T. Peacock (1958)
Stigler, George J. andPaul A. Samuelson, 1963. "A Dialogue on the Proper Economic Role of the State."Selected Papers, No.7. Chicago: University of Chicago Graduate School of Business.
Starrett, David A., 1988.Foundations of Public Economics, Cambridge.Description. Scroll to chapter-previewlinks.
_____, 1998. "The Role of Government in the Contemporary World," in Vito Tanzi and Ke-Young Chu,Income Distribution and High-Quality Growth, pp.211-54.
_____, 2000.Economics of the Public Sector, 3rd ed., Norton.
