Paper 4- Money, Banking and Public Finance (Unit 5) D.N. P.G.

College, Gulaothi E-content

UNIT-5

Introduction to Public Finance

Created by

Bhavnit Singh Batra

Assistant Professor (Economics)
Devanagari Post Graduate College, Gulaothi, Bulandshahr (U.P)

Syllabus
➢ Nature and Scope of Public Finance: Meaning and scope of Public Finance
➢ Distinction between Private and Public Finance
➢ Public Goods Vs. Private Goods
➢ The Principle of Maximum Social Advantage
➢ Market Failure and Role of the Government.

Meaning and objectives of public finance

Public finance refers to the study of how governments raise revenue, allocate resources, and manage
expenditures to achieve economic and social objectives. It deals with the financial activities and
policies of governments at various levels, such as central, state, and local governments.

The primary objectives of public finance are to ensure the efficient allocation of resources, promote
economic stability and growth, and enhance the welfare of the population. It encompasses various
aspects of government finances, including taxation, public expenditure, public debt management,
and fiscal policies.

Scope of public finance

Public finance is a multidisciplinary field that combines economics, political science, and public
administration. Its theories and principles guide policymakers in making decisions related to
taxation, public expenditure, debt management, and fiscal policies to achieve the economic and
social goals of a nation.

Here are the key components of public finance:

1. Public Revenue: Public finance examines how governments generate revenue to finance
their activities. This includes the collection of taxes (such as income tax, corporate tax, sales
tax, etc.), non-tax revenue (fees, fines, licenses, etc.), and borrowing through issuance of
government securities.

2. Public Expenditure: Public finance analyzes the government's spending patterns and
priorities. It encompasses expenditures on areas such as infrastructure development,
education, healthcare, defense, social welfare programs, public administration, and
subsidies. Public expenditure aims to address market failures, promote public goods, and
provide essential services to citizens.

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Paper 4- Money, Banking and Public Finance (Unit 5) D.N. P.G. College, Gulaothi E-content

3. Public Debt: Public finance evaluates the borrowing and debt management practices of
governments. Governments may borrow funds through issuing government bonds, treasury
bills, or loans from domestic or international sources. Public debt management involves
strategies to ensure sustainable levels of debt, manage interest costs, and mitigate
associated risks.

4. Fiscal Policy: Public finance examines the formulation and implementation of fiscal policies
by governments. Fiscal policy involves decisions related to taxation, government spending,
and borrowing to influence economic activity, stabilize the economy, and achieve desired
policy objectives. It aims to strike a balance between economic growth, price stability, and
fiscal sustainability.

5. Public Financial Management: Public finance includes the study of the institutional
framework and mechanisms for budgeting, financial planning, accounting, and auditing
within the government. Effective public financial management ensures transparency,
accountability, and efficient use of public resources.

6. Redistribution and Equity: Public finance addresses issues of income distribution and
equity. It examines how fiscal policies and public expenditure programs can be designed to
promote social justice, reduce income inequality, and improve the well-being of
disadvantaged groups.

Difference between private finance and public finance

Private finance and public finance are two distinct areas that deal with the management of financial
resources, but they differ in terms of scope, objectives, sources of funds, and decision-making
authority. Here are the key distinctions between private finance and public finance:

1. Scope and Participants:

- Private Finance: Private finance focuses on the financial activities of individuals, households,
businesses, and non-governmental organizations. It deals with personal financial management,
corporate finance, investments, and financial transactions in the private sector.

- Public Finance: Public finance deals with the financial activities of governments at various levels
(central, state, and local). It involves the management of public revenue, expenditure, and debt,
and it encompasses fiscal policies and decisions made by the government.

2. Objectives:

- Private Finance: The primary objective of private finance is to maximize individual or

organizational wealth and financial well-being. Private finance aims to optimize personal savings,
investments, and financial decisions to meet personal or business objectives, such as profitability,
growth, or wealth accumulation.

- Public Finance: The objectives of public finance are broader and include ensuring economic
stability, promoting equitable distribution of resources, providing public goods and services,
addressing market failures, and enhancing the welfare of the population. Public finance focuses on
achieving collective goals rather than maximizing individual wealth.

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Paper 4- Money, Banking and Public Finance (Unit 5) D.N. P.G. College, Gulaothi E-content

3. Sources of Funds:

- Private Finance: Private finance derives its funds primarily from private sources, such as personal
savings, bank loans, equity investments, bonds, or other forms of private financing. It relies on
voluntary transactions and the participation of private individuals, organizations, and financial
institutions.

- Public Finance: Public finance relies on public sources of funds, mainly derived from taxation,
government revenue, fees, fines, and borrowing from domestic or international sources. Public
finance involves compulsory contributions from the public to finance government activities and the
provision of public goods and services.

4. Decision-Making Authority

- Private Finance: In private finance, individuals and businesses have the autonomy and decision-
making authority to manage their financial resources according to their own preferences and
objectives. They make decisions on savings, investments, borrowing, and financial planning based
on market conditions and personal or business considerations.

- Public Finance: The government has the decision-making authority in public finance. It
formulates and implements fiscal policies, determines tax rates, allocates public expenditure,
manages public debt, and regulates the overall financial activities of the public sector. Public finance
decisions are influenced by public policy objectives, political considerations, and the need to address
collective needs and public interest.

5. Accountability and Transparency

- Private Finance: Accountability and transparency in private finance primarily involve the
obligations of individuals and businesses towards stakeholders, shareholders, and regulatory
authorities. Disclosure requirements, financial reporting, and adherence to legal and ethical
standards are essential aspects of private finance.

- Public Finance: Public finance requires a higher degree of accountability and transparency due
to the involvement of public funds and the responsibility of governments to their citizens.
Governments are accountable to the public and subject to scrutiny and oversight by legislative
bodies, auditors, and citizens. Public financial management systems emphasize transparency, proper
governance, and public accountability.

Principal of maximum social advantage

Financial activities of the government have a significant impact on the production, consumption,
distribution and income pattern of a country. The Principle of Maximum Social Advantage is the
principle that governs the operation of public finance (financial activities of the government) to
maximize the economic welfare of the society as a whole. It was first propounded by British economist,
Hugh Dalton.

According to Hugh Dalton – The best system of Public Finance is that which secures the maximum
social advantage from its fiscal operations. He propounded the Principle of Maximum Social
Advantage and stated the following:

✓ Government should collect money and spend it to maximize the welfare of people
✓ When taxes are imposed, dis-utility is created and when expenditure is done, utility is
created.

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Paper 4- Money, Banking and Public Finance (Unit 5) D.N. P.G. College, Gulaothi E-content

✓ Government must adjust its revenues & expenditures in such a way that the surplus of utility
is maximum and dis-utility is minimum.

Assumptions of Principle of Maximum Social Advantage

✓ All taxes result in sacrifice. All public expenditure lead to benefit.

✓ Public revenue consists of only taxes and government has no other source of income.
✓ Government has no deficit or surplus budget
✓ Public expenditure is subjected to law of diminishing marginal utility therefore Marginal
Social Benefit keeps on diminishing.
✓ Taxes are subjected to increase Marginal Social Sacrifice.

Dalton stated the extent to which public expenditure should be done and taxes should be collected.
According to Dalton, public expenditure should be done till the point where the advantage of a unit
increase public expenditure to the society is counter balanced by the disadvantage of a unit increase
in revenue or taxation.

He gave the following two concepts:

MSS – Marginal Social Sacrifice – It is the amount of sacrifice undergone by public (tax payer)
due to imposition of one additional unit of tax.

MSB – Marginal Social Benefit – Benefits enjoyed by the public by one additional unit of public
expenditure.

The point of maximum social advantage is the point where Marginal Social Sacrifice cuts the Marginal
Social Benefit curve. This is the optimum limit of State’s Public Finance activity.

MSS = MSB

It is the point at which the marginal utility from public expenditure equals marginal dis utility due to
taxation. Hence, at this point the benefit derived from the last unit of money spent on public
expenditure equals the sacrifice imposed in raising that one addition unit of revenue from the public.

Market failure
Market failure refers to a situation where the free market fails to allocate resources efficiently or
produce optimal outcomes. In such cases, the market mechanism, driven by supply and demand
forces, does not lead to the most desirable allocation of goods and services or fails to achieve certain
societal goals. Market failures can occur due to various reasons, including:

1. Externalities: Externalities are the spillover effects of economic activities that impact
parties not directly involved in the market transaction. Positive externalities, such as
education or vaccinations, provide benefits to society beyond the immediate participants.
Negative externalities, such as pollution or congestion, impose costs on society. Market
failures arise when externalities are not internalized, leading to suboptimal resource
allocation.
2. Public Goods: Public goods are non-excludable and non-rivalrous, meaning that once
provided, they are available to all and one person's consumption does not diminish
availability for others. Public goods, such as national defense or street lighting, often suffer
from under-provision in the market because individuals have little incentive to pay for them
voluntarily, leading to a market failure.

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3. Imperfect Competition: Market failures can occur due to imperfect competition, such as
monopolies or oligopolies. In such situations, a lack of competition allows firms to exert
market power, leading to higher prices, reduced output, and inefficient allocation of
resources. Imperfect information, barriers to entry, and anti-competitive practices
contribute to market failure in these cases.
4. Market Power and Inequality: Concentration of market power among a few dominant
firms can lead to unequal distribution of resources and reduced consumer welfare.
Monopolistic or oligopolistic practices can hinder market competition and lead to higher
prices and lower quality goods. Market failure occurs when certain groups or individuals
exploit their market power to the detriment of others.
5. Information Asymmetry: Market failures can arise due to information asymmetry, where
one party in a transaction has more information than the other. This can lead to adverse
selection or moral hazard problems, where one party takes advantage of the knowledge
asymmetry to the detriment of the other party. For example, in the market for used cars,
sellers may possess more information about the car's condition, leading to market failure.

Role of the government in correcting market failures

When market failures occur, governments often intervene to correct or mitigate the inefficiencies.
Public policy tools, such as regulations, taxes, subsidies, and public provision, are employed to
address externalities, provide public goods, promote competition, and ensure fair outcomes. The
goal is to achieve a more efficient and equitable allocation of resources and promote the well-being

Here are some common roles of the government in correcting market failures:

1. Providing Public Goods: The government provides public goods and services that are
necessary for society but unlikely to be adequately provided by the market due to their non-
excludable and non-rivalrous nature. Examples include national defense, public
infrastructure, and basic research. By supplying public goods, the government ensures their
provision for the benefit of all citizens.

2. Regulating Externalities: The government regulates externalities, both positive and

negative, to ensure that the costs or benefits associated with economic activities are properly
accounted for. This can involve imposing taxes or subsidies to internalize the external costs
or benefits, setting emission standards to reduce pollution, or implementing regulations to
address market failures caused by externalities.

3. Promoting Competition: Governments regulate markets to promote competition and

prevent the abuse of market power by monopolies or oligopolies. Antitrust laws and
regulatory bodies are established to prevent anti-competitive practices, promote fair
competition, and protect consumers. By fostering competition, the government aims to
enhance efficiency, innovation, and consumer welfare.

4. Correcting Information Asymmetry: The government addresses market failures arising

from information asymmetry by establishing regulations that require transparency and
disclosure of information. This ensures that consumers have access to accurate and reliable
information to make informed decisions. Examples include mandatory product labeling,
consumer protection laws, and regulations for financial markets.

5. Redistributive Measures: In cases where market outcomes result in significant inequality

or social disparities, the government may implement redistributive measures to promote
social justice. This can involve progressive taxation to redistribute income, social welfare

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programs to provide support for vulnerable populations, or policies aimed at reducing

poverty and inequality.

6. Ensuring Financial Stability: Governments regulate and supervise financial markets to

prevent systemic risks and maintain stability in the financial system. They establish central
banks to manage monetary policy, oversee banking regulations, and provide lender-of-last-
resort facilities during times of financial distress. These measures aim to prevent market
failures that could lead to economic instability.

7. Macroeconomic Stabilization: Governments use fiscal and monetary policies to stabilize

the overall economy and mitigate business cycle fluctuations. They employ measures such
as fiscal stimulus or contraction, interest rate adjustments, and exchange rate policies to
manage inflation, unemployment, and economic growth. These interventions aim to counter
market failures arising from macroeconomic imbalances and external shocks.

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