Introduction
The economy of India is neither public nor private but involves a blend of both these sectors. The public sector or the government is required to guide, correct and supplement the private sector. The private sector or market system cannot accomplish all economic functions alone, and hence, public policy is formulated.
Public finance deals with the financial happenings of governments and public authorities. It describes and analyses the expenses of the government and the techniques used by them to finance these expenditures.
The public policy of the government is concerned with the problems of resource allocation, the distribution of income, full employment and price-level stability and growth.
Need for Public Policy
- To provide a perfectly competitive factor and product market for the private sector to attain efficient resource use.
- In the case of imperfect markets also, government intervention is required.
- The government also provides a legal structure that helps in the protection and enforcement of market arrangements and exchanges.
- Certain goods, such as public goods, cannot be provided for through the market system and require government intervention.
- To secure objectives such as high employment, price stability and economic growth, public policy is needed.
Functions of Public Policy
- Allocation Function– The Allocation function of budget policy is concerned with the provision for public goods or the process by which entire resources are divided between private and public goods and by which the mix of public goods is chosen.
- Distribution Function– Distribution function means equitable and fair distribution of income and wealth.
- Stabilization Function– Stabilization function implies maintaining high employment, price stability and an appropriate rate of economic growth.
Public Goods
Definition of Public Goods
Public good, also known as collective or social good is a good that is both non-excludable and non-rival in consumption, i.e., individuals cannot be successfully excluded from its use, and the use by one individual does not reduce its availability to others.
National defence, air, fireworks displays, knowledge, street lighting, etc, are all examples of public goods.
A fireworks display is a public good because it is non-excludable (impossible to prevent people from using it) and non-rival (one individual’s use does not reduce accessibility to others).
Private goods, on the other hand, are both rival in consumption and excludable, and use by one individual reduces its availability for the other individual.
Examples of private goods are apples, loaves of bread, personal cars, houses, etc.
If X is a private good and there are two individuals, A and B, then total consumption Xc is the sum of each individual’s consumption.
Xc = Xa+Xb
In the case of Public good (G), each individual A and B may consume all of the good. So, the total amount consumed is the same for each individual.
Gc = Ga = Gb
Characteristics of Public Goods
(i) Non-rival Consumption: Non-rival consumption means the consumption of one individual does not reduce the benefits derived by all other individuals. It implies that to derive the aggregate demand for the public good, an individual’s demand curve must be added vertically rather than horizontally.
(ii) Non-excludability: It implies that if the good is provided, one individual cannot deny another individual’s consumption of the good.
Need for Public Provision of Public Goods
Public goods cannot be provided through the market system, that is, by transactions between individual consumers and producers. Public policy or budget policy of the government is required to produce these goods.
There are two reasons why the government is required for the allocation of resources in providing public goods:
- Market Failure
- Free-Rider Problem
1. Market Failure
Market failure describes a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers.
The allocation of public goods by a free market is not efficient and thus leads to market failure.
The existence of a market failure is often the reason for government intervention in a particular market. The basic reason for market failure in the provision of public goods is that the benefits that public goods give rise to are not limited to one particular consumer who purchases the good but becomes available to others as well.
The market economy, under certain conditions, helps to secure an efficient use of resources in providing for private goods. But in the case of public goods, it cannot function effectively since public goods have two main features: non-rival and non-excludable consumption.
i. Market Failure Due to Non-rival Consumption
Social goods are those goods for which consumption is non-rival. That is, they are goods where the consumption benefits do not reduce the benefits derived by all others. The same benefits are available to all and without mutual interference. Efficient resource use requires that price equals marginal cost, but in this case, marginal cost is zero, and so should be the price.
In the case of a public good like a bridge which is not crowded, individual A’s crossing will not interfere with that of B. Charging a toll would be quite feasible, but so long as the bridge is not heavily used, the charge would be inefficient since it would reduce the use of the bridge, the marginal cost of which is zero.
But though the marginal cost of admitting additional users is zero, the cost of providing the facility is not. This cost must be covered somehow, and it must be determined how large a facility should be provided. So, provision of such a public good cannot be provided through the market and government intervention is required.
ii. Market Failure Due to Non-excludability Consumption
A second case of market failure arises where consumption is non-excludable. A good or service is non-excludable if consumers who do not pay for it cannot be prevented from accessing it.
Non-excludable goods will generally be under-produced and under-supplied in the absence of government intervention. This is due to the fact that potential producers will not be able to realize a profit (since the good can be obtained for free) sufficient enough to justify the costs of production.
2. Free-Rider Problem
The free-rider problem emerges in the case of public goods, where some individuals either consume more than their fair share or pay less than their fair share or pay less than their fair share of the cost of the public good.
This happens because consumers cannot be excluded from consumption benefits due to the non-excludability characteristics of public goods.
If everyone attempts to free-ride, nothing will be provided, and a free ride for anyone becomes impossible. This requires government intervention and a rationale for public policy.
A commonly used example of the free-rider problem is found in National Defence. All citizens of a country benefit from being defended; however, individuals who evade taxes are still protected even though they did not pay for their fair share of the public good.
Provision of Public Goods
The provision of public goods for consumption depends on:
- Efficient resource allocation is to produce at least cost what consumers want most and at a price also.
- The procedure by which their provision is to be achieved.
Comparison with Private Goods
To analyze the problem, it is necessary to compare the demand and supply diagram for public goods and private goods. Consider the following Figure 1; the left side shows the market for a private good.
DA and DB are normal demand curves for two individuals, A and B. The aggregate market demand curve DA+B is obtained by horizontal summation of DA and DB, adding the quantities that individuals A and B purchase at any given price.
SS is the supply curve, and equilibrium is at point E, where the market demand and supply curve intersect. Price equals OC and output OH, with OF purchased by A and OG by B where OF+OG=OH.
The right side of the figure shows a similar pattern for a public good. With the assumption that consumers are ready to reveal their preferences for the public good, respective demand curves for A and B are drawn.
But the difference is that the market demand curve DA+B for the public good is obtained by vertical summation of DA and DB, showing the sum of the prices which A and B are willing to pay for any given amount. This happens because both consume the same amount, and the price is equal to the marginal preference. The total price includes the sum of prices paid by each to cover the cost of the service.
SS is the supply schedule showing the marginal cost for various outputs of the public good. ON is the total quantity consumed by both A and B. The combined price equals OK, but the price paid by A is OM while that paid by B is OL, where OM+OL=OK.
Public or Budgetary Provision
The above figure suggests that the provision of public goods might be implemented by the private sector through market forces as in the situation of private goods.
However, this interpretation is misleading as the public goods are provided without exclusion, and consumer preferences will not be revealed voluntarily.
To overcome this problem, economists have defined the efficient allocation of social goods in terms of a model. The model explains how a budget policy can reveal consumers’ preferences (that is, to tell the government what social goods should be provided) and mobilize resources to pay for them. This requires tax and expenditure decisions to be taken also. Voters are confronted with a choice among budget proposals which carry a price in terms of their own tax contributions.
Read More in: Theory of Public Finance
- Public Finance: Meaning, Nature & Scope
- Role of Government in Economy
- Role of Government in Mixed Economy: Public & Private Sector
- Role of Government under Cooperation and Competition
- Role of Government in Economic Development and Planning
- Concept of Public Goods, Private Goods, and Merit Goods
- Concept of Market Failure and Functions of Government
- Market Failure and Functions of Government: Decreasing Costs
- Market Failure and Functions of Government: Externalities
- Market Failure and Functions of Government: Public Goods
- Future Market: Meaning, Role & Uncertainty
- Concept of Information Asymmetry
- Theory of Second Best: Concept & Explanation
- Problem of Allocation of Resources: Public & Private Mechanisms
- Preferences: Meaning, Types & Problems of Preference Revelation
- Preference Aggregation & Its Mechanism
- Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
- Economic Theory of Democracy: Concept & Explanation
- Politico Eco Bureaucracy: Concept & Explanation
- Rent-Seeking and Directly Unproductive Profit-Seeking Activities
- Rationale for Public Goods: Concept & Explanation
- Benefit Theory or Voluntary Exchange Theory
- Lindahl Model: Concept, Equilibrium & Limitations
- Bowen Model: Concept, Advantages & Limitations
- Samuelson’s Model of Public Expenditure
- Musgrave’s Model of Public Expenditures
- Demand Revealing Schemes for Public Goods
- Vickery-Clarke-Groves Mechanism
- Groves-Ledyard Mechanism
- Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
- Theory of Club Goods
- Keynesian Principles of Stabilization Policy
- Difference Between Keynesian Economic Thought and Others
- Role of Expectations and Uncertainty in Formulating Stabilization Policy
- Intertemporal Markets Efficiency & Failure
- Liquidity Preference Theory
- Diamond-Dybvig Banking Model
- Preference Shocks, Adverse Selection & Central Bank
- Equilibrium Deposit Contract
- Social Goods and Its Effect on Stabilization Policy
- Effect of Infrastructural Facilities on Stabilization Policy
- Effect of Distributional Inequality on Stabilization Policy
- Effect of Regional Imbalances on Stabilization Policy
- Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
- Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
- Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
- Pure Theory of Public Expenditure
- Structure & Growth of Public Expenditure in India
- Trends, Lessons & Priorities in Public Expenditure in India
- Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
- Performance Based Budgeting and Zero Based Budgeting
- Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
- Tax System and Its Principles
- Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
- Ability to Pay and Benefits Received Principle of Taxation
- Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
- Deadweight Loss of Taxation: Causes, Measurement & Example
- Concept of Equity & Efficiency in Economics
- Trade-Off Between Equity and Efficiency: Meaning & Example
- Theory of Measurement of Dead Weight Loss
- Double Taxation: Meaning, Desirability, Forms & Solution
- Solution to Problem of Double Taxation: Intra-Country & International
- Double Taxation Avoidance Agreement (DTAA) and Indian Policy
- Classical View on Public Debt
- Compensatory Aspect of Public Debt Policy
- Public Debt or Borrowings: Concept, Need, Sources & Types
- Concept of Public Debt or Public Borrowings
- Need for Public Debt or Public Borrowing
- Sources of Public Debt
- Classification of Public Debt
- Burden of Public Debt: Meaning, Types & Explanation
- Debt Through Created Money or Deficit Financing
- Public Debt (Public Borrowings) and Inflation (Price Level)
- Crowding Out of Private Investment and Activity
- Principle of Public Debt Management and Debt Repayment