MEC 106
Public Economics
IGNOU MEC 106 Solved Free Assignment
MEC 106 Solved Free Assignment July 2023 & January 2024
Section A
Q. 1. Define Externalities. Present a brief about types of externalities. Explain how internalisation of negative externalities could be a solution to externalities through the instruments of taxation and property rights.
Ans. Externalities refer to the costs borne by or benefits accrued to third parties who are neither consumers nor producers. Externalities occur from both production and consumption activities.
If a flyover is built opposite to a house, valuation of the house will fall. This is an example of negative externality. A lot of commuters will get the benefits of flyover. So for the commuters, this is a positive externality.
If we get vaccinated against Covid, people who come into contact with us would have smaller chance of getting infected with the disease.
This is positive externality. But if we smoke, we will make many people smoke passively. This is a negative externality.
Since most of the analysis is conducted in marginal terms, it can be said that Marginal Social Cost (MSC) and Marginal Social Benefit (MSB) diverge from their private counterparts (i.e. MPC and MPB).
The difference between them is accounted for by marginal external cost/benefit (MEC/MEB).
Thus:
MSC = MPC + MEC
and
MSB MPB + MEB
When goods produced are private, perfectly competitive markets are found to allocated resources efficiently. However, markets usually do not capture MEC.
It tends to equate MPB with MPC and end up either over produce when MSC is greater than marginal private cost (i.e. MSC > MPC) or under-produce when MSB is greater than MPB (i.e. MSB > MPB).
Negative Externalities
When a negative externality exists, too much output is produced and sold in a competitive market as compared to efficient quantity.
A paper mill effluents emptying into a water stream affecting the people who live nearby, low flying aircrafts cause a lot of noise to those living near the airport and disturb their sleep, new railway lines disturbing the buildings nearby and people may lose their earlier quietness are some of the examples of negative externality.
Positive Externalities
An apple orchard may be helping neighbouring bee-keepers, one person getting vaccinated against Covid may be helping others, installation of a smoke detector or fire proofing in a building are cases of positive externalities as the third party do not share the cost but receive benefit.
When there is positive externality, too little output is produced and sold in a competitive market against efficient quantity.
Internalisation of externalities refers to adding external cost (benefit) to the private cost (benefit) to get social cost (benefit).
However, it is not that easy. In most cases, it is difficult to identify people who bear the cost and who get benefits. For example, a car emitting smoke and polluting different areas.
It is also difficult to assign monetary value to the external cost. Negative Externality and Taxation Economist Arthur Pigou suggested imposition of a tax, called corrective tax or Pigovian Tax.
A Pigovian tax is a tax assessed against private individuals or businesses for engaging in activities that create adverse side effects for society.
Adverse side effects are those costs that are not included as a part of the product’s market price.
These include environ-mental pollution, strains on public healthcare from the sale of tobacco products, and any other side effects that have an external, negative impact. It is explained further in Q&A section.
Negative Externality and Property Rights
Ronald Coase suggested a solution to negative externalities. He proposed that the government should assign property rights and reduce transaction costs.
Market outcome of a firm which generates negative externality would be efficient if the property rights are clearly assigned. Property is not necessarily physical.
Property rights and transaction cost are important. Transaction cost includes every other cost other than production cost and transportation cost.
For example, a railway line passing through clove fields. Railway company uses steam engines which emit sparks that burn clove crop.
The railway company should be assigned the right to continue using spark emitting engines but it should trade its right. Clove farmers would bargain with the railway firm to operate fewer trips.
Clove farmers should be assigned the rights to have spark-free running of trains but they should be allowed to trade their right with the railway line. Railway firm would bargain with the farmers to allow some trains to run.
Less the number of the trains, less the marginal revenue to the railway firm. More the trains, more the marginal damage to the crops.
Exact number of trains would be decided by equality (i.e. by equalising the marginal loss to the party who has to limit the activity with the marginal gain to the party who has to get that activity cut).
This solution has limitations. Transaction cost rises when the number of parties rises. Parties involved may be organisations which have internal transaction costs.
Last party to bargain, once he comes to know that all others have agreed, may demand a very high compensation.
Assigning the right arbitrarily by government may not be viewed right by the judiciary. A polluter and a victim do not form the market.
Q. 2. (a) Explain the scope of mechanism design relating it to implementation theory and game theory.
Ans. The fundamental building blocks in the theory of ‘mechanism design’ are: (i) A setting, situations of in-complete information, in which the theory of mecha-nism design works.
(ii) A finite number of different types of agents like voters, bidders, citizens.
(iii) A pro-bability distribution of the agents across types. The outcome depends on highest votes polled or the highest bidder getting the resource.
The mechanism designer selects among the existing mechanisms or designs a new one. The mechanism designer has to first select the social objective function to be maximised.
It may be net welfare, maximum revenue, minimum user fees for commuters. A desirable mechanism is one in which the results of the game meets the social objective.
In the Vickery auction scenario, truthful bidding emerges as the dominant strategy i.e. an agent will gain most by honest bidding.
Two complications may be there: (i) Honesty may not be the dominant strategy, or (ii) There may not be any dominant strategy. In the latter case, the equilibrium outcome is achieved by using ‘Bayesian Nash Equilibrium’ concept.
Asymmetric information occurs when one party has greater material knowledge than the other party. In cases of information asymmetry, Mechanism design can be used. In this context, understanding the games of incomplete information will help.
Such games are based on contract theory which covers games of hidden information and games of hidden action. Hidden information occurs when one party has superior information.
For example, the insured is better aware of his health condition than the insurer and the voters are better aware of their own preference than the government.
Hidden action occurs when one party is not able to observe the actions of the other party.
For example, the insurer may not be able to observe whether the insured takes reasonable precautions and the employer may not know when the employee is lax.
Hidden Action Contracts
The hidden action contracts or mechanisms address the two key issues of incentivisation and participation to solve for the difficulties arising out of hidden action.
For example, if a firm is hiring a manager, there is always some chance that the enterprise may fail. But if the manager puts in the right effort, the chances of success increases.
For this, the firm has to draw up a contract – a bilateral mechanism – which would make the manger put-in the extra effort in his own interest.
The owner can incentivise the extra effort by giving a bonus if the project succeeds. The firm can also decide how much should the bonus be for the manager to put in the extra effort on his own.
China can also be taken as an example. Before the introduction of reforms in China, the peasants had a fixed salary and no bonus. Chinese agriculture had no incentives and production was adversely affected.
Deng introduced a system of a fixed tax/rent/payment to higher governments, which was a negative wage.
A bonus incentive was introduced in which whatever output was produced over and above the fixed payment could be kept by the peasants.
Such an incentive led to rapid increase in agricultural output and it became one of the most outstanding turnarounds.
Hidden Information Mechanisms
Another type of ‘hidden’ or ‘asymmetric’ infor-mation is one where one party has information which the other does not have access to. For example, when a company is hiring a person, the firm has less information compared to the person about his abilities and motivation.
The person taking the insurance has better information about his health than the insurance company.
If the first party (the company hiring) is taking the initiative to distinguish between the desirable and not so desirable second party (e.g. between the capable workers and less capable workers), it is called ‘screening games’.
If the second party moves first, the games are called ‘signalling games’. In screening mechanism, the hiring firm screen between capable’ and non- capable people (called ‘lemons’).
For this it may introduce a criterion that only candidates from the best universities with first division masters’ degree can apply. The insurance company often mandates a medical check-up before insuring a person.
The key feature of these games is that one party does not have all the information. The party with less information must proceed with some beliefs, which can be updated depending on the experience.
If the employer believes that all prospective candidates are of the capable type, screening is not needed.
For screening, the critical elements are ‘information’, ‘types’ with their preferences, beliefs about types and the various ‘messages’ that each type would give under different game settings.
(b) Illustrate some applications of ‘mechanism design’ with an identification of their attendant problems.
Ans. Some of the policy areas in which mechanism design has been used are:
(i) Auctions: Auctions are one of the early applications of mechanism design theory.
The problem here is to decide how to allocate some object(s) among potential bidders when the value of the object(s) to a bidder is only known to that bidder.
The objective can be to maximize the revenue raised from the sale, or to ensure that the objects go to those who value them the most (achieving the goal of efficiency). Today, governments use auctions to allocate spectrum, airport slots, oil drilling rights, timber or land.
They also use reverse auctions to procure goods and services from the private sector. In each case, mechanism design theory has successfully been applied to give recommendations on how to best set the rules of the auction as a function of the government’s objective and the nature of private information.
(ii) Regulation: Regulation too has been revolutionized by mechanism design. In work with David Baron, Myerson was the first to abandon the conventional assumption that regulators “know everything” and to use mechanism design to derive optimal regulatory schemes insuring the provision of public services at least cost.
Other researchers later showed that, if cost realizations are observable, simple schemes like cost-plus contracts (where the firm is paid a fixed reimbursement plus the difference between a cost target and the cost realization) can achieve this objective.
Such results have had a profound influence on actual regulatory schemes and on the design of contracts between international institutions and infrastructure providers in developing countries.
(iii) Environmental Policy: Environmental policy has also benefited from the insights of mechanism design theory. The theory tells us that cap-and-trade systems, such as the system put in place by the Kyoto Protocol, are more cost- effective ways to reduce carbon dioxide emissions than command-and-control mechanisms.
mechanisms design theory also tells us how to design environmentally sustainable fishing and hunting schemes in natural reserves.
A few years ago, the UK government called on Maskin to help design a scheme that would maximize the corporate sector’s commitment to carbon dioxide emissions reduction for a given budget. Mechanism design theory was again put at work to provide a solution.
(iv) Development: Mechanism design theory has also had a big effect on our thinking about development problems in poor countries. Today’s focus is on fostering institutions and individual initiative.
Traditional solutions to community problems such as access to credit, land sharing arrangements and natural resources management have been revisited and improved in light of mechanism design theory, and new solutions have been pro-posed.
For example, the current success of micro-finance is due in large part to a good understanding not only of the needs and objectives of small borrowers but also of the severe incentive problems faced by these borrowers.
Mechanism design helps evaluate the relative performance of different micro-finance arrangements.
Section-B
Q. 3. Explain how by redistribution, a socially more desired welfare level can be attained by considering the Utility Possibility Frontier.
Ans. The utility possibility frontier is the upper frontier of the utility possibilities set, which is the set of utility levels of agents possible for a given amount of output, and thus the utility levels possible in a given consumer Edgeworth box.
Utility Possibility Frontier (UPF) is the locus of all possible optimal combinations of Ua and Ub lying on the contract locus.
Since the total endowment of goods is given, an increase in one individual’s utility can only come at the expense of utility of another individual.
In the figure below, any movement from point A to any point in the north east quadrant to point A, is welfare improving in Pareto sense. So points B, C and D are all improvements over A as they satisfy the Pareto Criterion.
But which of these points B, D and C is the most desirable point to the society is clear as one moves from point B to point C (where utility of individual a is reduced but that of b is increased).
Generally, UPF is concave to the origin implying that if one takes away some utility from an individual a, then one has to compensate that loss by an increasing amount of utility given to another individual b.
This becomes clear with the statement of the second welfare theorem which says in a competitive market economy, given that the indifference curves of individuals satisfy the standard properties, for any initial distribution of goods among the individuals, any point on the utility possibility frontier is a point of equilibrium.
This implies that if the existing equilibrium point is not the one which is desirable from society’s point of view, then a re- distribution of income can lead to a more desirable outcome at some other Pareto optimal point.
Thus, if point B is a Pareto optimal efficient equilibrium point, but at that point individual b gets more utility than individual a, and the society wants a better deal for a since a happens to be poorer than b, it requires a policy intervention so that the richer individual can be suitably taxed and the poorer individual subsidised so that the resulting re-distribution of income leads to a new Pareto optimal equilibrium D with better distribution of utility.
Welfare Theorem 1 suggests competitive market economy can generate Pareto optimal situation without any external policy intervention.
However, all Pareto optimal situations may not be desirable since additional value judgements may place one Pareto optimal situation better than the others.
This brings the Welfare Theorem 2 into limelight for suggesting that starting from any initial distribution of income (or goods), policy induced re-distribution can bring the desired Pareto optimal situation based on some value judge-ment of the society.
Q. 4. Outline how imperfect competition leads to welfare loss stating he policy options open to government to rectify the situation.
Ans. In imperfect competition, regulation is necessary because markets fail to achieve maximum welfare on their own in such condition. For example, under monopoly, the industry has one firm and a large number of buyers.
The demand curve for the good is the demand curve facing the product of the firm. The market demand curve can be taken as the AR curve of the firm (AR is the constant price at which the monopolist can supply any quantity).
The firm will optimize profits when MR equals MC. Since the MR curve must lie below the AR curve, the profit optimizing output is lower than under perfect competition (where MC = Price) and the price charged by the monopolist firm is higher (Pm > Pc).
The profit maximising output would be at quantity OQm (MR = MC), which is lower as compared to the perfect competition output of OQ. The monopolist’s price (OP) is higher relative to perfect competition price (OP).
The welfare loss is the area TSR. If output is increased from Q to Qe the WTP of society for this extra output would become greater than its cost of production.
If the government decides to keep the price controlled at OP, the monopolist can sell any amount at this constant price. It means PC, becomes its new MR curve.
Under price control, it will produce till MR = MC (the output OQ). Thus, regulation can remove the inefficiency.
Therefore, the key to welfare maximi-sation lies in the fact that the output should be so fixed that at this level of output, Price = MC.
In case of imperfect competition where only few firms enjoy the situation of concentrated power, the government prefer to either: (i) Promote competition, or (ii) Run the monopoly as a state-owned enterprise. For this, anti-trust and anti-restrictive laws or nationalisation of monopolies are required.
Q. 5. Describe the Nozick’s ‘entitlement theory’ and the theory of ‘justice in distribution’.
Ans. Nozick’s entitlement theory comprises three main principles:
(i) A Principle of Justice in Acquisition: This principle deals with the initial acquisition of holdings. It is an account of how people first come to own unowned and natural world property, what types of things can be held, and so forth.
(ii) A Principle of Justice in Transfer: This principle explains how one person can acquire holdings from another, including voluntary exchange and gifts.
(iii) A Principle of Rectification of Injustice: how to deal with holdings that are unjustly acquired or transferred, whether and how much victims can be compensated, how to deal with long past transgressions or injustices done by a government, and so on.
Nozick believes that if the world were wholly just, only the first two principles would be needed, as “The following inductive definition would exhaustively cover the subject of justice in holdings”:
(i) A person who acquires a holding in accordance with the principle of justice in acquisition is entitled to that holding.
(ii) A person who acquires a holding in accordance with the principle of justice in transfer, from someone else entitled to the holding, is entitled to the holding.
Thus, entitlement theory would imply “A distribution is just if everyone is entitled to the holdings they possess under the distribution”.
However, not everyone follows these rules: “Some people steal from others, or defraud them, or enslave them, seizing their product and preventing them from living as they choose, or forcibly exclude others from competing in exchanges”. Thus, the third principle of rectification is needed.
Nozick’s Theory of Justice in Distribution is againt the re-distributive activity of the state.
Re-distributive taxation, from the talented to the disadvantaged, violates self-ownership in two ways – First, the conditions under which the use of my talents (and their products) will lead to a just allocation of resources are specified by three principles of justice viz. the principle of initial acquisition, the principle of transfer and the principle of rectification.
Thus, the Rawlsian principle of justice is a failure to treat people as equals, since the disadvantaged have partial property rights in other people.
Second, self-ownership and property rights are necessary to enable an individual to pursue his conception of the good and his self-determined way of life.
Taking away one’s property decreases his options and limits his possibilities. It is morally unjustified because it violates his freedom.
Q. 6. Discuss the public debt situation of India. Is there a way to finance the deficit in the government budget? How?
Ans. In India, state governments issue State Develop-ment Loans to collect debt. The central government issues treasury bills and bonds. Treasury Bills are of three types based on duration: 91-days, 182-days and 364-days.
Dated securities have fixed or floating coupon rate, with half yearly interest payment. Maturity period ranges from 5 years to 40 years. These are now auctioned at E-Kuber platform and primary members can take part.
The primary members include: urban cooperative banks, commercial banks, insurance companies and provident fund organisations.
Government debt instruments such as: T-Bills, Bonds (G-Sec) and SDLs are popular with commercial and cooperative banks.
Dated securities and treasury bills are called as market loans or marketable debt. Their sale/purchase-back is called open market operations.
The 14-day intermediate securities issued to state governments, foreign central bank and other specified bodies, and special securities issued to Small Savings Fund, Public Corporations and International Financial Institutions are called nonmarketable internal debt.
States have deposits of provident funds, pension funds, insurance funds and trusts and endowments. Total public debt is around 50 per cent of GDP. The FRBM Act has set a long term goal of reducing this to 40 per cent.
Besides, RBI provides advances to the central and state governments to tide over cash shortage. This is not debt but a kind of overdraft.
External public debt, raised only by the central government, is about 6 per cent of total debt and less than 3 per cent of GDP.
There are several objectives behind mobili-zation of public debt depending upon the situation of the country.
If the country is enjoying surplus budget or balance budget fiscal policy, then the importance of public debt might not be emphasized. However, in case of deficit budget fiscal policy, role of the public debt would be vital.
The objectives of the public debt broadly coined for: (a) Maintaining balance between expenditure and revenue (income) (for bridging the resource gap); (b) Solving depressionary problem or financial crisis; (c) Curbing inflation; (d) Financing for economic deve-lopment (capital formation); (e) Meeting unprecedented expenses; ( Avoid unpopularity of taxation; (g) Better allocation of resources; (h) Building socio-economic infrastructures; (i) Financing public enterprises; (j) War financing, etc.
Major objectives of the public debt management are:
To help conduct the fiscal policy of the country for attaining desired level of growth (budgetary deficit management); and
2. To help conduct the monetary policy of the country for maintaining stability (liquidity management)If efficiently and effectively used, the role of the public debt in the economy is multifold.
For this reason, it is sometimes advocated that the entire public debts of a country should not be retired (some portion of it should be left for market instruments).
Public Debt, alter-natively termed as National Debt also, refers to loans raised by a government within or outside the country especially when its expenditure exceeds its revenue (resource gap).
Q. 7. Write short notes on the following:
(a) Multi-part Tariff.
Ans. A multi-part tariff is one in which the producer charges separate prices for different elements of the service.
A common multi-part tariff is the two-part tariff in electricity, under which the customer pays a monthly fee for access and a usage fee for consumption of electricity.
Companies often charge price in two or three components when there is some consumer surplus.
Since there exists consumer surplus, it can be extracted by the producer who has no surplus. Regulator could allow this extraction to make the producer stand on his own legs.
While access charge or entry fee can be one, usage charge per unit may vary from slab to slab. For example, there can be two schemes.
In one, higher the slab higher could be the rate (like income tax). Higher the slab lower could be the rates (e.g. as in telephony and internet usage).
Peak Load Pricing
The Peak Load Pricing is the pricing strategy wherein the high price is charged for the goods and services during times when their demand is at peak.
For goods and services, demand peaks at particular times – for roads and public transport during commuter rush hours, for electricity during late afternoon and so on. The diagram is given in Q&A section.
(b) Public Goods.
Ans. Public good in economics are non-rivalrous and non-excludable. Non-rivalrous means goods which does not get diminished or depleted when others consume it simultaneously with us.
Air or sun-shine in the open or bathe in a lake or watch TV show together in our living room are examples.
Non-excludable means no consumers can be excluded from consuming the good. For example, in the case of street light, no passer-by can be excluded from its consumption.
Local Public Goods
Local public goods mean a public good with a local reach. Examples are city parks, scavenging, streetlight and garbage collection. They are like club goods.
In 1950s, Charles Tiebout came with interesting ideas about local public goods and competition between civic jurisdictions to attract residents with revelation of true preference by the consumers through choice of jurisdiction.
Global Public Goods
Global public goods are goods with benefits and/or costs that potentially extend to all countries. Due to globalisation and disintegration of many countries, there has been a rise in global and transnational public goods.
New products and technologies are increasing the number of activities with cross-border or global effects. Chlorofluorocarbons and related compounds were used extensively for refrigeration, propulsion and cleaning.
(c) Median Voter Theorem.
Ans. The median voter theorem states that a majority rule voting system will select the outcome most preferred by the median voter under two assumptions: Voters can place all election alternatives in a one-dimensional spectrum and the voters’ preferences are single-peaked (i.e. voters have one alternative that they favour more than any other).
For example, if there is a voting over the location of a bus stop, the location preferred by the median voter can be chosen where at least half the population will also vote for (or prefer).
In other words, if the number of voters are in odd numbers, and the policy space is one-dimensional (i.e. voters can clearly place political candidates on a left to right continuum which is the same as saying ‘options can be put in a transitive order’), and so long as the voters have single-peaked preferences, then the median of the distribution of voters’ preferred options is a Condorcet winner.
The theorem have some drawbacks. It requires an odd number of voters as this ensures that there is a majority for the median.
When there is an even number of voters, there will be a tie between the two central voters and it is silent on which of these locations will eventually be chosen.
The second drawback is that the theorem is applicable only when the decision over which voting is happening has a single dimension.
In the single crossing version of the median voter theorem, it is assumed that the policy space is transitively ordered (from left to right) and it is also assumed that voters too are transitively ordered (from left to right) of the political spectrum.
This assumption is called the single crossing assumption i.e. half of the voters are to the left of the median voter and the other half is to his right. Suppose, there is an odd number of voters and that the policy space is one-dimensional.
According to the single crossing property, for any two options ‘a’ and ‘b’, with a <b, if a median voter prefers ‘a’, then all the voters to the left of him should prefer ‘a’, and all the voter to the right of him must prefer ‘b’.
Similarly, if a median voter prefers ‘b’ then all the voters to the right of him should prefer ‘b’.
A majority of the voters who agree with the median voter and the option chosen by the median voter is Condorcet winner. Thus, in both single-peaked and unique median voter’s preferred option is Condorcet winner.
Buchanan and Tullock (1965) analysed the costs associated with different voting rules. The community has Nmax population.
The simple majority is 50 per cent of Nmax plus 1. If the costs of voting is represented by E and D as in the figure below. Members of the minority group (by the support of whom, the party with the highest votes can reach the majority mark) represent the ‘external cost’ of winning the majority.
This is dependent on the decisions (sacrifices or costs) of the majority group since the minority group may disagree with the majority group.
It is, therefore, clear that the external cost falls with the rise in the size of the necessary majority i.e. at Nmax the external cost is zero with D as the cost of decision-making.
The decision-making cost is lower if any one person can take the decision and as the proportion of persons needed to agree on any issue rises, the cost of finding agreement between the winning majority would rise.
Since the sum of costs is E+D, the minimum total cost is not necessarily reached at the point of intersection of E and D as it also depends on their rate of change. At the minimum point of E+D curve, the absolute slope of E and D are equal.
The minimum cost is reached at N,. However, the minimum point may not always be at N, in which case it may imply a minority win.
It means, for some issues, it may be easier to attain consensus than in others with some decisions involving lower or higher costs.
IGNOU MEC 07 Solved Free Assignment 2023-24