BINDURA UNIVERSITY OF SCIENCE EDUCATION

FACULTY OF COMMERCE
DEPARTMENT OF ECONOMICS
PUBLIC FINANCE I: EC218

In-Class Test: Marking Guide

Question 1

(a) State four factors that explain the under-supply of merit goods in a free market economy.
[4 marks]
 There is a significant level of information failure, in terms of both the private and the
external benefits resulting from consumption of merit goods. For example, there is likely
to be considerable information failure in terms of recognising the benefit to themselves,
and to others, of regular health checks, eye tests, or visits to the dentist.
 There may also be considerable time lags in deriving the benefit of a merit good. This is
clearly the case with education, where the private benefits may not occur for ten or
twenty years after consumption.
 Given that individuals are driven largely by self-interest, the external benefit of
consuming a merit good is not likely to be included in the private calculation of buyers
and sellers.
 Individuals and families on low incomes are not likely to be able to pay the full market
price of merit goods and will under-consume. For example, to continue to supply private
education, tuition fees must be set to cover the full costs of supply. However, private fees
are likely to be well in excess of what many low income families could afford to pay.

(b) List three policies that the Government of Zimbabwe can adopt to increase the supply of
merit goods. [3 marks]
There are two basic options that the government can adopt: measures that increase consumer
demand or measures that increase supply.
Measures to increase supply of merit goods
 Government could create a market of merit goods by allowing a rise in price, which
provides an incentive for private firms to enter the market or by a subsidy, which reduces
costs of supply. While a higher price encourages supply, it also discourages demand and
results in less demand for a merit good. Hence, a subsidy would encourage both supply
and demand.
 Government could choose to by-pass the market and take over responsibility for
supplying the socially efficient quantity of merit goods. This is what happens with state
education, healthcare and national insurance.
 Government could pay the cost of supplying a merit good and request that the individual
consumer makes an out-of-pocket contribution to these costs, such as with prescription
charges.
 Government could cover some of the costs of private sector provision, such as providing
free training for doctors, nurses and teachers, who may then work in private hospitals and
schools.

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  Government could encourage private firms to enter the market by offering incentives. For
example, private schools could be given grants to take state school pupils and private
hospitals could be given cash incentives to increase the number of hospital beds available
to patients on social welfare.
Measures to increase demand of merit goods
 Demand for merit goods can be increased either through lowering price which would
expand demand or by shifting the position of the demand curve. What price to set for a
merit good is an issue facing policy makers. One option is to provide the service free at
the point of consumption. This would expand demand to its maximum, but it may
encourage over-consumption, with the system becoming clogged-up with free riders and
malingerers, diverting resources from the genuinely sick and needy. With education, a
voucher system is a frequently proposed option to encourage demand for merit goods
provided by the private sector. This system can be used to create a quasi market. Typical
voucher schemes involve parents being allocated education vouchers, which they are then
free to spend on any school of their choice. Parents are free to combine the vouchers with
their own finance to pay for a place at any school – either state or private.
 Demand for a merit good could be increased by providing knowledge, so that the
consumer can make a more informed appraisal about the benefits of consuming merit
goods.

Question 2

(a) Use clearly labelled diagram(s) to explain how a negative externality can result in an
inefficient provision of goods in a competitive market. [10 marks]
When a negative externality exists, the price of the good or service does not reflect the
full MSC of resources allocated to its production. Figure 2.1 shows the production
decisions of firms (producing steel and dumping sludge in rivers) in a competitive
market. Recall that each point on the market supply curve for a good represents the
market’s marginal cost of producing that unit of the good, that is, the MPC of that unit of
good. MPC is the direct cost to producers of producing an additional unit of a good. What
determines the welfare consequences of production is the MSC which equals the MPC to
the producers of producing that next unit of a good plus any extra costs associated with
the production of that good that are imposed on others. Any extra cost associated with the
production of a good that is imposed on others is called marginal damage or marginal
external cost (MEC). That is,
MSC=MPC + MEC
Although MEC is part of MSC, it is not reflected in the price of the good. MEC curve is
upward sloping for most forms of pollution: As firms produce additional output and
dump additional effluent, the incremental harm/damage increases.

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Price, Cost MSC

P⃰ E
S=MPC

P1 A
B

MEC

D=MSB

Q⃰ Q1 Output
Figure 2.1: Negative externality and production inefficiency
Is industry output efficient when there are negative externalities? Figure 2.1 shows the
efficient industry output level is Q⃰ where, MSB=MSC . The competitive industry output
however is at Q1 where MSB=MPC. The economic inefficiency is the excess production (Q 1
-Q⃰ ) that results in too much effluent being dumped in the river. The source of the
inefficiency is the incorrect pricing of the product. The market price, P 1 in Figure 3.3 is too
low: it reflects the firms’ marginal private cost of production but not the marginal social cost.
The firms will produce the efficient level of output if price is P⃰. Thus, when a negative
externality exists, too much output is produced and sold in a competitive market relative to
the efficient output. The social cost of the inefficiency is shown by the difference between
MSC and MSB. In Figure 2.1, the social cost or deadweight loss is shown by triangle ABE.

(b) With the aid of clearly labelled diagram(s), explain how a Pigouvian tax can be used to
internalise negative externalities. [10 marks]

A corrective or Pigouvian tax is designed to adjust the marginal private cost of a good or service
in such a way as to internalise the externality. The tax must equal the MEC per unit of output to
achieve this objective. It is designed to internalise a negative externality by making producers of
the product pay a fee equal to the MEC per unit of output sold. Figure 2.2 shows the impact of a
corrective tax, T.
T =MEC
Price,
Benefits & SꞋ
Costs, $
F S=MPC
Tax
P1 B

P2 A

H G
D=MSB

Output

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 Q1 Q2
Figure 2.2: A corrective tax on a negative externality
The tax is levied on each unit produced and will be treated by producers as an increase in the
marginal private cost of production. The supply curve consequently shifts from S (=MPC) to S Ꞌ
where SꞋ reflects the full marginal social cost of producing the product:
S1 =MPC+ T= MSC
The increase in cost caused by the tax changes the point corresponding to the market equilibrium
from A to B. The market price increases to P 1 and the equilibrium quantity declines from Q 2 to
the efficient level Q1 where MSC=MSB of the product. The tax allows net gains in well-being
(or efficiency gains) equal to the area ABF. The tax will result in income redistributive effects
which would benefit consumers (assuming that the revenue so generated is used to improve
government services). The tax revenue to the government is shown by P1BGH.

Question 3
(a) Use clearly labelled diagram(s) to describe Pigouvian Approach to resource allocation.
[10 marks]

Optimal intersectoral resource allocation takes place at the equilibrium point where marginal
utility attained in the public sector as well as in the private sector by the use of the last unit of
resources becomes equal. Optimal resource allocation is attained at the equilibrium point where
the marginal utility rendered by public expenditure (MU P) equals the marginal sacrifice or
disutility borne in the payment of tax (MDUT), just as optimal allocation in the private sector
takes place where MU =MC ).
MU P=MDU T

MU of A
public exp.
Y

B MUP>MDUT
A

O E Budget size, $

C MUP<MDUT
YꞋ B
MDU of
tax
payments

C
Figure 3.1: Pigouvian Approach to Resource Allocation

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 (b) State four major shortcomings of Pigou’s Approach to resource allocation.
[4 marks]
 Pigou’s analysis is based on the concept of cardinal utility. How do we measure utility
and disutility in an objective manner?
 Approach uses normative concept and value judgement (which is subjective) regarding
the proper distribution of utilities and disutilities among different consumers.
 Inability to make interpersonal utility comparisons.
 The extent of progressiveness of taxes is refuted. The philosophy of egalitarianism lying
behind the ability to pay approach that individuals are equal in some sense is rejected by
new welfare economists who do not accept interpersonal utility comparisons.
 Approach does not provide mechanism for aggregating individual allocation, so it may be
possible to attain individual equilibrium but not societal equilibrium.

Question 4
(a) State four stages in a government budget process. [4 marks]
 Stage 1: Budget Drafting
 Stage 2: Legislative Approval
 Stage 3: Budget Implementation
 Stage 4: Audit and Evaluation

(b) Outline any five key factors which perpetuate government expenditure growth in
Zimbabwe. [5 marks]
 The traditional functions of Government such as defence, maintenance of law and
order, are becoming extensive and cumbersome. Defence is becoming expensive
more than ever before. The country's administrative set up is increasing both in
coverage and intensity. For example, Government machinery has to be manned by
experts in their respective fields. In addition, various complexities of economic and
social measures develop which make efficient administration complex and expensive.
 Apart from the traditional functions of the State, there is the growing
awareness of additional responsibilities. Government is expanding its activities in
various areas which include the need to enrich the cultural life of the society and
those designed to provide social securities to the people, such as pensions and old
peoples' homes.
 Increasing population is also a determinant of public expenditure growth. The scale
of various public goods and services has to rise in conformity with the growth of the
population. The need for more schools, hospitals, security etc cannot be over-
emphasized in the light of increasing population.
 It has been suggested that urbanisation and the resulting congestion have increased
the need for more infrastructure, public goods and services. Moreover, quite a
number of incidental services as those connected with traffic, roads, pedestrian
bridge have to be provided.

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 The tendency for prices to go up has equally contributed to the growth of
public expenditure. The increase in the prices of inputs and other goods purchased
by the public has resulted in an increase in public expenditure. It is the responsibility
of Government to protect the citizenry against the evils of price mechanism.
Consequently, anti-cyclical and other regulatory measures are put in place. Efforts
are made to reduce income and wealth inequalities and bring about social and
economic justice.
 Increasing public expenditure can also be explained in terms of increasing cost of
debt servicing. Since States are related to one another through various economic
transactions, there are tendencies to run into debts which have to be settled.
 Efforts of Government to reduce income and wealth inequalities, bring about
social and economic justice and protect the economy from market failures entail the
adoption of anti- cyclical and other regulatory measures which invariably increase
public expenditure.
 Subsidies a n d o t h e r avoidable c o m m i t m e n t s a l s o c o n t r i b u t e t o
i n c r e a s e i n p u b l i c expenditure.
 In view of the size and nature of public services increasing specializations are
required.
 Improved quality services and higher qualified administrators, \engineers,
technicians, teachers, medical personnel, etc, imply higher cost of public services
which will also bring about increased public expenditure.