Public Finance Fundamentals and Market Failure Correction
Public Finance Fundamentals
Meaning of Public Finance
Public finance is concerned with how governments raise money, how that money is utilized (spent), and the effects of these activities on the economy and society.
Definition by Hugh Dalton
“Public finance is concerned with the income and expenditure of public authorities and with the adjustment of one with the other.”
Scope of Public Finance
The scope of public finance traditionally covers several key areas:
Public Revenue
This branch discusses the ways and means of raising funds and their effects on the economy (e.g., taxation).
Public Expenditure
It is an important and effective tool in the hands of the government for executing its welfare programs, growth, and stabilization policies. This branch judges the relative appropriateness of all government expenditure policies, including their advantages and disadvantages.
Public Debt
This branch deals with the causes, consequences, effects, types, and burden of public borrowing.
Financial Administration
This branch exercises control over government expenditure. Financial administration refers to the sanctioning of public expenditure, public accounting, auditing, execution, and the evaluation of the budget, as well as public borrowing.
Stabilization and Economic Growth
This refers to measures taken by the government to avoid economic fluctuations and promote economic stability. It is also concerned with measures to promote growth and development.
Understanding Market Failure
What is Market Failure?
Market failure occurs when markets fail to produce and allocate scarce resources in the most efficient way. That is, the market may not always allocate scarce resources efficiently in a way that achieves the highest total social welfare.
Causes of Market Failure
Public Goods
A public good is a special type of good that can be consumed by everyone, regardless of whether they have paid for it. When goods are available free of charge, the market forces that normally allocate resources in the economy are absent, leading to underproduction or non-provision.
Market Power (Market Control)
Market control arises when buyers or sellers are able to exert influence over the price of a good and/or the quantity exchanged. The ability to control the market, especially the market price, prevents a market from equating demand price and supply price.
- Extreme control on the supply side: Monopoly
- Less extreme but more common example: Oligopoly
- Extreme control on the demand side: Monopsony
- Less extreme example but more common: Oligopsony (Corrected from original text)
Externalities
An externality arises when a person engages in an activity that influences the well-being of a bystander (or third party) and yet neither pays nor receives any compensation for that effect. Third parties are individuals, organizations, or communities indirectly benefiting or suffering as a result of the actions of consumers and producers attempting to pursue their own self-interest.
Asymmetric Information
Asymmetric information is a market situation in which one party in a transaction has more information than the other party. This can affect the firm’s strategy and often leads to market failures.
Inequality
Market failure can also be caused by the existence of inequality throughout the economy. Wide differences in income and wealth between different groups within an economy lead to a wide gap in living standards between wealthy households and those experiencing poverty.
Other Market Failure Factors
Additional factors contributing to market failure include:
- Missing Markets and Incomplete Markets
- Merit Goods
- Unstable Markets
- De-Merit Goods
- Property Rights
Role of Government in Correcting Market Failure
The government plays an important role in correcting market failures and improving economic efficiency. The prevalence of government intervention reflects the fact that the market mechanism alone cannot perform all necessary economic functions.
Securing Conditions for Market Functioning
The government has an important role in correcting market failures arising from imperfect information, imperfect competition, externalities, and public goods. For example, in the case of imperfect competition, firms use their market power to raise prices and reduce output. Policies like the MRTP Act or modern Competition Policy Act address this.
Providing Legal Framework
The contractual arrangements and exchanges needed for market operations cannot exist without the protection and enforcement of a governmentally provided legal framework (e.g., regulatory bodies like SEBI).
Provision of Public Goods and Merit Goods
Even if the legal structure is provided and barriers to competition are removed, the production or consumption characteristics of certain goods, like Public Goods and Merit Goods, are such that they cannot be provided efficiently through the market.
Correcting Problems Arising from Externalities
Externalities lead to market failures, requiring correction by the government either by way of budgetary provisions, subsidies, or taxation.
- Goods with positive externalities (like research, education): Firms produce too little.
- Goods with negative externalities (like pollution): Firms produce too much.
Correcting Unequal Distribution of Income and Wealth
In the market system, individual incomes are related to their ownership of assets and their productivity. Since wealth is often concentrated in the hands of a few, the government must work towards redistribution of income from the rich to the poor through welfare programs and taxation policies.
Provision of Social Security
The market system cannot provide social security to citizens suffering from unemployment, sickness, old age, disability, and so on. The government must step in to provide social security to its citizens.
Securing Important Social Objectives
The market system does not necessarily bring high employment, price level stability, a socially desirable rate of growth, poverty eradication, or economic development. Government policies are needed to secure these objectives.
Guiding the Use of Natural Resources
The government plays a role in ensuring sustainable resource use.
Public Ownership
In certain strategic sectors, public ownership may be necessary to ensure social welfare.