University of Maastricht

Faculty of Economics and Business Administration

ANSWER FORMAT TO EXAM QUESTIONS

COURSE Public Finance and Public Choice (IES/AE)

CODE 1316

EXAM DATE 19-12-1997

PROFESSOR Dr J.G.A. van Mierlo

Question 1:

Because of several technical problems with the classical Pareto-criterium, economists (e.g., Kaldor, Hicks, Scitovsky) have invented the so-called 'Neo-Paretian criterium' for welfare improvements. This criterium is also known as the 'compensation-principle'.

Please explain this compensation-principle in relation with the concepts of CV (compensating variation) and EV (equivalent variation):

1a. According to Hicks.

1b. According to Kaldor.

1c. According to Scitovsky.

Answer 1: related to Task 2, Welfare criteria

The general argument runs as follows. The main welfare measures are consumer and producer surplus, price-compensating variation (CV) and price-equivalent variation (EV) (see C and J, Sec. 2.2). Welfare is then expressed in money, and it is implicitly assumed that one unit of money (e.g., dollar) has the same (marginal) utility for everybody, irrespectively of income or wealth. This assumption implies an interpersonal comparison of utility and is questionable, especially in the context of underdeveloped countries. Welfare can be measured in a more adequate way (see, e.g., the income evaluation research of Van Praag and Kapteyn c.s.), but this requires survey data and is not generally accepted among economists. Therefore, economists mostly use the deficient welfare measures mentioned above.

1a and b. Kaldor and Hicks are discussed in Cullis and Jones, pp. 34-40. Figure 2-3 (p. 36) actually presents the analysis in terms of EV and CV. In Figure 2-4 (b) (p. 39) the two criteria are presented in combination. See also section 2-3-2 (p. 40), where this combination is labelled as the 'Potential Pareto Criterion'. Present the figures and summarise the argument of Kaldor and Hicks.

Rosen discusses Kaldor and Hicks on pp. 257-258, and the equivalent variation on p. 306.

1b. Present Figure 2-4 (c) of Cullis and Jones (p. 39) and summarise section 2-3-3 (p. 40)!

Question 2:

The 'theory of public/private goods' may serve as the theoretical basis for government intervention in the market system.

2a. Present the two technical characteristics of a pure collective good and explain why market provision of such a pure collective good causes serious problems.

2b. Present a 'taxonomy' (i.e., a 'classification') of (pure and quasi-) collective goods based on these two technical characteristics.

2c. What other economic arguments, in addition to the collective good-problem, which may be applied to defend government intervention in the market system?

Answer 2: related to Task 4, Public goods, and Lectures 1 and 2

2a. Nonrivalness and non-excludability, plus the definitions of both concepts!

2b. The combination of both characteristics results in the following matrix, presenting a typology or taxonomy of collective/public and individual/private goods:

Excludability of consumption

High Low

High 1. 2.

Individual Common pool

goods resources

Bread and butter Water and energy,

nature and environment

Rivalness in

consumption

Low 3. 4.

Club or Toll (Pure) collective

goods goods

Roads and bridges, Defense, dykes,

swimming pools, legal protection

telephone system,

infrastructure

Central problem of pure collective goods: 'free ridership', resulting in under-supply! See Cullis and Jones, section 3-2 (main points in pp. 60-63) and elaboration in sections 3-3 and further (pp. 63-83). See Rosen, Chapter 5, pp. 61-75!

2c. Other arguments are:

-positive or negative externalities, resulting in 'allocative inefficiency';

-(de-)merit wants and goods, resulting in paternalism and in overthrowing individual preferences;

-arguments of distributive justice and equal access (the case for 'equity'!).

Question 3:

Voting is an important mechanism for decision making in the public sector. 'Majority voting rules' are applied most.

3a. Explain the majority voting rule.

3b. Summarise and explain the so-called Arrow-paradox.

3c. Present some solutions to this paradox. What is your own opinion about these solutions and about the relevance of the Arrow-paradox?

Answer 3: Related to Task 5, Majority voting rules

3a. Essence of majority voting rule is: winner is 50% plus 1!

3b. Elements of the Arrow-paradox, to be discussed in your answer, are: the problem of cyclical voting (explain the transitivity-problem!); the five 'conditions of correspondence'; the 'impossibility theorem', collective intransitivity, multi-peakedness as the cause of the problem.

3c. Possible solutions are: enforcing single-peakedness instead of allowing multi-peakedness, logrolling, alternative voting systems: point voting and plurality voting, approval voting, probabilistic voting on the basis of a referendum, voting by veto.

You have to discuss the theoretical significance of the Arrow-paradox as well as the empirical relevance!

Literature:

Cullis and Jones, Chapter 4-3 and 4-4, pp. 93-104.

Rosen, Chapter 7, pp. 120-131.

Question 4:

Taxation induces 'efficiency losses' (distortions, resulting in excess burdens, welfare costs, etc.).

4a. Present a graphical partial equilibrium analysis for an excise tax (tax per unit) and a compensated demand curve.

4b. Explain how price-(in)elasticities of demand and supply determine the quantity-reactions of consumers and producers to such an excise tax.

4c. Explain in four graphical partial equilibrium analyses, representing the extreme cases of inelastic/elastic demand and elastic/inelastic supply, how the tax burden of this excise tax is divided between consumers and producers.

Answer 4: Related to Task 10, Tax incidence

4a. Present a figure, like Figure 7-8 (p. 202) of Cullis and Jones, with a compensated demand curve! Explain with a verbal instruction what is happening in the graphs!

4b. Explain Dalton's Law in this figure and show, how the tax burden is distributed over consumers and producers! A mathematical explanation is also okay, but do not limit yourself by providing just the graphs. Show that you understand what is happening! Rosen, Chapter 13, pp. 279-284, presents the same analysis!

4c. Elaborate on the figure as you have presented under 4a and 4b, by presenting a four-case graphical analysis with price-elastic and price-inelastic demand and price-elastic and price-inelastic supply. Explain in all cases how the tax burden is divided between producers and consumers!

Literature:

Cullis and Jones, Chapter 7-6, pp. 201-203.

Rosen, Chapter 13, pp. 278-284.

Question 5:

The modern public sector consists of more than just one scale-level of government, on which public goods and services are provided. The theory of fiscal federalism provides arguments for the optimal scale-level.

5a. Explain the 'decentralisation theorem' developed by Oates.

5b. Explain the 'economic theory of clubs' developed by Buchanan.

5c. What is the relationship between both theories within the framework of fiscal federalism?

Answer 5: Related to Task 17, Local government

5a, 5b, and 5c taken together.

These different questions are addressed in Chapter 11 of Cullis and Jones, and in Chapter 21 of Rosen!

Please try to summarise the following argument, derived from the tutorial instruction!

In economic theory, the question of how the public sector should be organized and which level of government should perform which task, in order to attain a particular welfare optimum, is the central theme of the theory of 'fiscal federalism'. In case of complete (de)centralization, the (de)central level(s) of government execute(s) all functions of society, i.e. those related to allocation, distribution and stabilization. Both centralization and decentralization have some well known advantages. Oates (1972: 3-11) makes the point that a centralized government has the advantage of being more apt to perform functions related to distribution, stabilization and allocative functions in case of collective goods. An important advantage of decentralization is a quicker response to changing preferences. In this sense, decentralization offers the possibility to respond to spatial patterns and circumstances.

In addition to the advantage of being able to respond to spatial patterns and circumstances, decentralization also has the advantage that competition between different levels of government encourages these levels to adopt the most efficient techniques to produce their goods (i.e. if it is assumed that there are no synergies to be exploited with non-competition). Moreover, an important advantage of decentralization is a more rational weighing of the costs and benefits of a specific government program. It can generally be stated that an optimal organization of the public sector is one which combines the advantages of the two extreme forms and minimizes possible disadvantages, which is what federalism tries to accomplish (see Oates, 1972, p. 14 ff.). From an economic point of view, a federal government can be defined as a public sector which has both decentralized and centralized levels of decision making. A central feature of a federal government is also the fact that choices of the provision of specific government services for each government level are determined by the demand for these services by citizens and others in the jurisdiction in question. The central matter is finding the suitable degree of decentralization for a specific government sector.

In an ideal situation each provision is linked to that jurisdiction of which the spatial range corresponds with the actual use by citizens. From the decentralization theorem it then follows that for a particular collective good, given the afore mentioned conditions and assumptions, it is always more or at least as efficient to let local governments provide efficient levels of output for their jurisdictions than to let the central government provide a specific uniform level of output for all jurisdictions (Oates, 1972, p. 35). In this sense, if the environmental quality in a region within a specific nation can be considered a local public good, under the afore mentioned conditions, it is always more or at least as efficient to let local governments provide the efficient level of environmental quality than to let the central government provide a non regionally differentiated level.

Since centralization offers no benefits of scale, since it is assumed that different levels of government face equal costs, the theorem in fact emphasizes a certain degree of decentralization. The incentive to decentralize increases when there are more different efficient levels of output between jurisdictions. This situation will arise in case the diversity of the individual demand in the entire country increases and if every geographical subset of the population becomes more homogeneous. In a non ideal situation, in which not all conditions of the theorem hold, a determination of the optimal form of the public sector becomes more complicated. Complications may arise in case the consumption of the collective good in question is no longer defined over a specific geographical subset, in case of externalities and in case the population is mobile and can move to other jurisdictions.

One of the central assumptions of the theory of fiscal federalism is that the consumption of a collective good is clearly defined over a specific geographical subset. When the consumption of the good, however, is not clearly defined over this subset, an optimal size of the group which collectively consumes the good has to be determined. This is the central theme of the economic theory of clubs. The basis of this theory was first described by Buchanan (1965). The central theme of the theory is related to the most desirable cost and consumption sharing arrangement for those goods and services for which the optimal sharing group is more than one person or family but smaller than an infinitely large number (see Buchanan, 1965, p. 2). This theory, in other words, is related to the range of goods and services that are neither purely private nor purely collective.

To determine the most desirable cost and consumption sharing arrangements for these goods and services it has to be taken into consideration that the utility which an individual obtains from these goods and services also depends on the number of other persons with whom the benefits of the goods and services have to be shared (i.e. the club size). An individual will attain full equilibrium in club size if the marginal benefits that he secures from having an additional member in the sharing arrangement are equal to the marginal costs that he incurs from adding a member (Buchanan, 1965, p. 5). Increasing the club size by adding an additional member may affect the costs of the good or service in question to any other member. Additional individual benefits, for instance, arise if, due to economies of scale, it becomes cheaper for individuals to consume the good or service together (i.e. if it is assumed that individuals share in the costs of providing the specific goods or services for groups of varying sizes). Increasing the club size, however, also imposes additional individual costs. The latter can be due to congestion and/or due to a decrease in the individual power over consumption levels of the good or service in question. To determine the optimal club size, therefore, both marginal costs and benefits of adding an additional member have to be taken into consideration.

In case there are externalities which go beyond the boundaries of the jurisdiction in question, the probability of which increases according as the size of this jurisdiction is relatively small, it seems desirable to internalize the externalities in such a way that the spatial range is in agreement with the actual use of the good. Among others, this can be achieved by increasing the size of the jurisdiction in question or by using intergovernmental grants for a reduction or abolishment of the inefficiencies associated with externalities. If the costs of collective decision making are also taken into consideration, attention has to be paid to the fact that, other than in the ideal situation, the higher the number of government levels, the higher the costs of creating and operationalising these levels (e.g. more administrative and electoral costs). Again, relevant costs and benefits of alternatives have to be weighed against each other.

From the previous considerations, it can be concluded that, ideally, the responsibility for a particular task or good can best be performed by that level of government of which the spatial range corresponds with the actual use by citizens. In this case, there are different levels of government, ".....each of which determines levels of provision of particular public services in response largely to the interests of its geographical constituency" (Oates, 1972, p. xvi). Secondly, it can be concluded that in a non ideal situation the most suitable organization of the public sector can be determined with great difficulties only. In those situations,".....[T]he gaines from establishing an independent unit or level of government to provide a good must be weighed against the increase in costs due to a larger number of public agencies" (Oates, 1972, p. 49).

Question 6:

Personal income is formed in a dynamic process of market forces and government interventions. In every stage of the so-called 'income formation process', market activities and government measures influence income distribution patterns.

6a. Present a so-called 'balance-sheet' of the income-formation process.

6b. Explain with this balance-sheet how government intervention in the market process induces efficiency-losses, which increase with every subsequent stage of the income formation process.

6c. Explain in more detail the problems which arise from charging 'income-prices' for public goods, and what could be done about them.

Answer 6: related to Task 13, Optimal income distribution, Task 14, Supporting the poor, and Lecture 5

6a. The following 'Balance Sheet of Income Formation' must be presented:

*Start: Factor Incomes

+ Earnings from labour

+ Earnings from entrepreneurship

+ Interests on capital

+ Private pensions

- Private pensions premiums

=PRIMARY INCOME: gross earned income

(the process of income formation on markets!)

- Direct taxes (related to income and wealth)

- Social security premiums

+ Social security benefits (income transfers in cash)

=SECONDARY INCOME: free disposable income

(income redistribution in cash)

- Indirect taxes (related to goods and services)

+ Price subsidies on market goods

+ Price subsidies on public goods (free provision: up to P =0!)

- Transfers in kind to government

=TERTIARY INCOME: income in cash and in kind

(income redistribution in kind)

In your explanation, you should emphasise:

1. the dynamic perspective on the process of income formation;

2. various positive and negative feedback mechanisms;

3. from macro level to micro level.

6b. In the secondary income stage, income and substitution effects between income and leisure are caused by redistribution in cash through income taxes and income transfers. This results in negative incentive effects and allocative inefficiency on the labour market and in poverty traps.

In addition to this, in the tertiary income stage, income and substitution effects between different commodities are caused by redistribution in kind through commodity taxes and price subsidies. This results in allocative inefficiency on commodity markets.

6c. 'Income prices' are prices for public goods which are related with the consumption of the public good, and hence with its technical characteristics, as well as with the income of the consumer. Hence, we have 'double trouble': income prices result in both allocative inefficiencies on the labour market, because of their relation with income, and allocative efficiencies on the commodity market because of their relation with specific goods and services. A well-known example is the so-called 'subject-object subsidy' for housing, which is related with rent prices for houses and with recipients income.

Literature:

Cullis and Jones, Chapter 7 (Tax theory) and Chapter 9 (Income redistribution);

Rosen, Chapters 13 and 14 on Taxation, Chapter 8 (Income redistribution).

Question 7:

Economists also have modelled 'bureaucratic behaviour', i.e. behaviour in bureaucratic organisations.

7a. Explain the Niskanen-model of bureaucracy.

7b. Discuss the two sources of bureaucratic power.

7c. Discuss the three possible solutions to bureaucratic power and explain which solution (and why) might work best.

Answer: related to Task 19, Government failure, and Lecture 6

7a. The Niskanen-model should be presented as it is discussed in Cullis and Jones, pp. 372-374, and in Rosen, pp. 134-137. The two graphical models of bureaucracy should be combined in the way, as has been done in lecture 6!

7b. The two sources of bureaucratic power are the following characteristics of bureaucracy:

1. internal organisation: vertical hierarchy, top down decision-making;

2. external organisation: monopoly.

In connection with this, you may discuss the following topics:

1. the behavioral assumptions: what makes Sammy run?

-budget maximisation;

-maximisation size department;

-mixed motives and utility functions.

2. the incentive structure and the reward/punishment system:

-of the organisation;

-of the bureaucrat;

-fit between the two?

3. the financial structure:

-sponsoring by politicians: budgets;

-income earning by market transactions;

-compliance of conflict between the two?

7c. The following three solutions have been presented in the lecture.

1. Classical solution: more political (external) control.

Problems: -does it really work? -more bureaucracy (fighting bureaucracy with bureaucracy!).

2. Radical solution: privatisation to the market.

Problems: -from public to private monopolies? -market failure around the corner!

3. Modern solutions: putting in competition!

-competition in the public sector, -competition with the private sector, -public entrepreneurship!

Problems: -cream skimming and cherry picking, -cross subsidisation, -unfair competition with the market (level playing field!)

Question 8:

Cullis and Jones end their text book with a chapter on the 'traditional approach' to public finance and the 'public choice approach'.

8a. What are the main differences between both approaches?

8b. What do you think of the contribution of public choice approach to public finance? Give your own personal view!

Answer 8: Related to Task 23 and Task 24, and to Lectures 1 and 6

8a. See the arguments presented and discussed in:

-Chapter 18 of Cullis and Jones;

-the introduction in the block book;

-and lectures 1 and 6!

8b. Every personal opinion is okay, as long as you can present your arguments for that opinion and as long as you have considered the pro's and con's of every argument and of every alternative!