Public Finance
Principle of Maximum Social Benefit
Principle of Maximum Social Advantage:
i.
ii.
iii.
This principle deals with:
Size of public budget
The level at which the state should operate
The boundaries of its activities.
The purpose should be to design the policy and
the operations of the state so as to achieve
maximum possible advantage or welfare as a
whole.
i.
ii.
iii.
Older concepts of public finance made unrealistic
assumptions and reached faulty conclusions
regarding the best possible public finance policy
or the optimum level of budgetary activities of the
state. They assumed thatThe state was an entirely extraneous body to
maintain the economy
It was also an economic burden
Every tax cause a disutility to the society.
J.B Say pointed out in the nineteenth century
that “the very best of all plans to finance is
to spend little and the best of all taxes is
that which is least in amount”. It amounted
to saying that the State activities must be
kept to the minimum possible.”
By agreeing with the unrealistic assumption
which is- “all taxes drain economy’s
resources and that all public expenses
restore these resources to the economy”
we can lay down prescriptions regarding
government's budgetary policy aimed at
achieving maximum net social advantage.
1.
2.
In this view the following assumptions can
be made:
The public revenue consists of only taxes(
and not of gifts, loans and fees etc) and
the State has no surplus or deficit budget.
Public expenditure will be first directed
towards those uses which are most
beneficial to the society and the state taxes
will be paid by withdrawing resources from
the lines where they are least useful.
As the state increases its taxation and
expenditure activities, the social benefit from
each
additional
money
falls,
while
dissatisfaction from each additional money
taxed increases. This way , a stage is
reached
when
the
rising
marginal
dissatisfaction of taxation becomes equal to
the falling marginal benefit of expenditure.
Thus,
At this stage
the
state should stop
expanding its activities. It is no longer
beneficial to further expand state activities
because the social benefit of the marginal
unit of public finance operations is no longer
larger than the corresponding social
dissatisfaction.
The proposition of maximum social advantage
can be depicted graphically.
Through this
Graph the
optimum tax
and
expenditure
activity can be
determined
B
P
N
B’
M
O
D
N’
C
Amount of Taxation
and Public Expenditure
D’
Where,
X- axis the public expenditure and taxation is being
measured
Y-axis social benefit and cost are measured.
-
-
The
Quantity
measured along
Y-axis will be
positive
if
measured above
X-axis
And negative if
measured below
X-axis.
B
P
N
B’
M
O
Amount of Taxation
and Public Expenditure
D
N’
C
D’
So, Marginal social benefit from public expenditure will
lie above X-axis
And Marginal disutility from taxation will lie below X-axis
B
BB’ represents marginal
social benefit accruing to
the
society
from
alternative amount of
public expenditure
DD’ represents marginal
social cost to the society
levied by the State.
N
P
B’
M
O
D
N’
C
Amount of Taxation
and Public Expenditure
D’
The difference between BB’ and DD’
measures the net social benefit or
advantage to the society, and is depicted
by the curve NN’.



When an amount OM
is taxed and spent by
the State,
Marginal
social
benefit=
marginal
social disutility
Or, MP= MC
Till then, gain to the
society is more than
loss.
It is here where the
State should stop
expanding
their
activity.
B
P
N
B’
M
O
Amount of Taxation
and Public Expenditure
D
N’
C
D’


The net gain to the
society is equal to
the area OMN
If the state stops its
public
finance
operations at a level
below
OM,
the
society
forgoes
possible gain.
If the operations are
expanded
beyond
OM, the net benefit
again stats falling.
B
P
N
B’
M
O
Amount of Taxation
and Public Expenditure
D
N’
C
D’
ANALYSIS OF PUBLIC FINANCE: POSITIVE
AND NORMATIVE APPROACH:
POSITIVE APPROACH:
Positive economics deals with refutable
hypothesis about the implementation or effects
of government policies.
Positive approach deals with “What it is".
Positive approach describes the facts of a an
economy. Through this analysis, all questions
can be resolved by reference to analysis and
empirical evidence that puts them in the realm
of positive economics. What is
NORMATIVE APPROACH:
Normative economics deals with the desirability of
government policies (optimal policies) i.e., with
social value judgments. It involves the ethical
precepts and norms of fairness.
This approach deals with “What ought to be". There
are no right and wrong answers to different
questions because they involve ethics and values
rather than facts.
They can be resolved by political debates and
decisions, not by economic analysis alone.
WELFARE ECONOMICS:
Welfare economics is that branch of
economic theory that deals with the social
desirability of alternative economic states.
The theory is used to distinguish the
circumstances under which markets can be
expected to perform well from those under
which market fail to produce desirable
results.
One of the role of the government is public
interest or social welfare. The largest concept
of public finance is “public interest”. Public
utility is ensured by public interest.


Minimalist Approach: Least involvement of
government in social concern.
Public interest: Government’s activity for the
benefit or maximizing public utility. If
government for all he citizen of the country
take any decisions which ensures benefits,
then government serves the maximum public
benefit.
Around 200 years back Jeremy Bentham
define- “ Public goods for the greatest
number of citizen”. The implementation of this
definition is very hard by taking only one
government decision, as public interest is
conflicting factor.
So the definition is weak in the sense of utility
measurement.
i.
ii.
John Stuart Mill another economists also
define public interest like Bentham, but he
also measures the level of utility.
Ordinal Utility: Utility is measured in
absolute term.
Cardinal Utility: Utility can be measured
through pricing.
The government cannot ensure the benefit of
all the people at a time. It can be benefited
for one and also harmful for another.
For example: Giving ‘Old Age pension’ by
redistributing the money from the pocket of
the taxpayer. So, the gainer is the old age
people and the looser is the general people.
The problem of J.Mills definition:
But on the other hand, by other economists
govt. activity is not possible to measure the
level of utility, that is the loss and gain of
utility measurement.
i.
ii.
Finally. The Italian Economist Vilfredo
Pareto develops the concept of “Pareto
Efficiency” which includesPareto optimality (one-sided view)
Pareto Superiority (two-sided view)
The clarification oif Pareto Optimality:
To understand the pareto efficiency, we begin
with the concept of “Edgeworth Exchange
Box” which means the contrast of two parties’
utility which is shown by the edgeworth box
proposed by the economists.
EDGEWORTH EXCHANGE BOX
We begin with the Edgeworth exchange box

Apple
0
Apple
Orange
0
Orange
EDGEWORTH EXCHANGE BOX
(cont)
Apple
Apple
0
Consumer 1 (C1)
Orange
Orange
0
Consumer 2 (C2)
EDGEWORTH EXCHANGE BOX
(cont)
0
Orange
Orange
0
Apple
Apple
DERIVING PARETO OPTIMAL
POINT
As we can see, point A and B
represents same level of
satisfaction for consumer C2
but represents higher level of
satisfaction for Consumer C1.
Hence, we can say point B is
more socially desirable to A.
Apple
A
B
We can also note here that,
given the production
possibility, even better
satisfaction for C1 is
achievable.
0
Orange
DERIVING PARETO OPTIMAL
POINT (cont)
Orange
01
B
A1
C
0
R1
Orange
A2
Apple
Apple
A
R2
Given this situation, we can
see that the satisfaction for C1
would be maximized at point
C where both these two
indifference curves are
tangent.
Hence, if C2 consumes 01A2
unit of Apples and 01R2 unit of
orange then C1 achieves the
highest indifference curve
without hampering C2’s
satisfaction. At this point, C1
will consume 0A1 apples and
0R1 oranges.
DERIVING PARETO OPTIMAL
CURVE/CONTRACT CURVE
Now, if we find out all these
tangents between these two sets
of indifference curves and join
them in free hand, we will get the
Pareto optimal curve which is
better known as contact curve.
Apple
0
Before we describe the
characteristics of contact curve
and Pareto optimal point, let us
briefly refresh our understanding
of the micro-economic concept of
marginal rate of substitution.
Orange
DERIVING PARETO OPTIMAL
CURVE/CONTRACT CURVE
Apple
This is the same indifference
curve that we have used at the
beginning of this session for
consumer 1.
50
Notice that, consumer 1 is willing
to sacrifice 20 apples for 2
oranges, that is if he is asked to
forgo 20 apples he would ask for
2 additional oranges or vice
versa.
30
0
10 12
Orange
Here 20/2=10 is the marginal
substitution rate of Apples for
Oranges or .10 is the MRS of
Oranges for Apples.
DERIVING PARETO OPTIMAL
CURVE/CONTRACT CURVE
Now, given our understanding of
MRS we can see that, at every
point of the contact curve, the
MRS of consumer 1 is the same
as MRS of consumer 2.
Apple
Hence come the first condition of
Pareto optimality. When a
distribution is Pareto optimal, the
MRS of all the consumers will be
equal.
0
Orange
Before we describe the second
condition of Pareto optimality, let
us refresh our understanding of
Marginal Rate of Transformation.
DERIVING PARETO OPTIMAL
CURVE/CONTRACT CURVE
Apple
Given the fixed quantity of
productive resources in a
Economy, suppose, if production
of Apple go to be increased from
70 unit to 90 units, the production
of orange got to be decreased
from 130 units to 100 unit.
90
70
0
100 130
Orange
That is the marginal rate of
transformation (MRT) of Apple
would be 30/20=1.5 Oranges at
this point. In other word, 1.5 unit
of orange got to be sacrificed for
producing another unit of Apple.
DERIVING PARETO OPTIMAL
CURVE/CONTRACT CURVE
Now suppose at point A the MRS apple
for orange is 1/3. That is, one unit of
orange would require 3 units of Apple to
enable the consumers to stay at the
same indifference level.
Apple
However, if at this level the MRT is say
¼ then more apple can be produced by
forgoing 1 orange. That is more efficient
allocation is still possible between the
two consumer.
A
0
Orange
However, according to our definition of
Pareto optimality that should not
happen. Hence, MRT must be equal to
1/3 or MRS. Hence the second
condition, at Pareto optimal point
MRSC1=MRSC2=MRT
SECOND THEOREM OF
WELFARE ECONOMICS

Apple
A
B

C
D
0
Orange
The first theorem tells us that
we should allocate resources
on
the
contact
curve.
However, it tells us nothing
about where in the contact
curve should we make our
allocation.
The
second
theorem
emphasizes this point that,
the society must make explicit
value judgment about which
point is more desirable than
the other. In other words, this
theorem reminds us of the
issue of fairness and social
justice.
The drawbacks or limitations or problems
of pareto optimality:
i.
Applicability: It is very difficult to apply in
the real life situation. In a complex society,
people have the contrasting demand .As
because it is not possible to achieve all the
demands for all of the people of the society,
so the optimality is not achieved.
ii.
Status Quo: Pareto optimality must be
achieved by fair means or in a legitimate
way. If pareto optimality is achieved by
illegal way then the problem of status quo
arrived. The status queo problems arise by
unfair legitimate means.
iii.
Measurement problem:
Public interest is conflicting from the viewpoint of
utility measurement. Utility was regarded as relative
factor and no absolute factor is identified to
determine the level of measuring the public utility.
So the measurement should be taken by comparing
the suitability of the decision taken by the govt. If
the portion of the losers is greater than the
benefited group, govt. should withdraw the
decision. But in optimality there is no consideration
of measurement. Here, micro sense is working by
analyzing one by one. The extent of benefit and
loss may differ from one to one.