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MEC-106: Public Economics

MEC-106: Public Economics

IGNOU Solved Assignment Solution for 2021-22

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Assignment Code: MEC-106/AST/2021-22

Course Code: MEC-106

Assignment Name: Public Economics

Year: 2021-2022 (July 2021 and January 2022)

Verification Status: Verified by Professor

Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each). In the case of numerical questions word limits do not apply.



Section A


1) Show that the welfare foundations of economic policies in a competitive market is guided by Pareto Criterion.

Ans) The Pareto Criterion, which states that the most efficient solution in any economy is offered by a Pareto optimal condition, clearly guides the welfare foundation of economic policies in a competitive market economy. This leads to the first welfare economics theorem.

Welfare Theorem 1: In a competitive market economy where individuals are free to trade, any mutually beneficial trading will result in optimal resource distribution (or goods).

According to the aforementioned theorem, the market itself directs individuals to the greatest viable option. As previously stated, if individuals could achieve their optimum utility levels, social welfare would be maximised as well. The welfare economics theorem forbids government intervention because it assumptions away difficulties that hinder people from achieving their utility maximisation goals. Thus, the theorem demonstrates that if individuals do not have 'external' effects (i.e., my neighbour’s consumption affects my utility, goods that are not divisible and jointly consumed do not exist, markets do not fail due to the existence of a single buyer and seller with complete market power, etc. ), the economy will automatically arrive at the most efficient solution. This can be demonstrated using the Edgeworth-Bowley Box approach (Fig below).


In a competitive market economy, the welfare theorem 1 leads to the Pareto optimal outcome, as shown in the box in Fig above (called after Edgeworth and Bowley). The box has two beginnings, one for individual and the other for individual b at the northeast corner. As a result, it's a two-person, two-commodity simplified SWF based on individual decisions made by only two people. The two persons' indifference curves are based on the quantities consumed of the two goods, with the first good measured on the horizontal axis for both and the second good measured on the vertical axis for both. The distance between the origins of the horizontal and vertical axes (drawn identically for both) represents the given endowment of the two goods. Note that, because we're assuming no manufacturing, we'll have to talk about initial endowments of the two items to have a better understanding of consumer behaviour.

The two utility levels Ua0 and Ub0 are similar to sustenance level indifference curves, below which people will not choose any utility level.

To grasp the significance of free trade among individuals, consider the initial solution at point L, which depicts individual an at the subsistence level. Allowing trading at current prices is always beneficial to society, as it allows individuals to get at point F. Individual b benefits while individual a does not. This meets the Pareto Criterion (i.e. suffer any loss). As a result, it is a Pareto optimal location in terms of welfare theorem 1. In fact, all of the tangency points of the two individuals' indifference curves satisfy the Pareto Criterion and are better than any position outside of the tangency points. The contract curve is the location of these tangency points within the sustenance levels of the two individuals (i.e. FGH). The curve indicates that individuals' optimal trading for the available endowment of the two items should always be on this locus. Individuals will never stray from this curve because every point is Pareto optimum. The points on the contract curve should, in general, satisfy the equivalence MRSa,12 = MRSb,12, i.e. they should be equal to the current price ratio.

The Pareto optimality principle states that the most efficient economic solution is one in which all persons benefit. This also demonstrates that economic policies have little impact because the market alone leads the economy to the best option. However, the challenge arises when one wants to know which of the infinite number of possible combinations on the contract curve is the best among the optimal points. This raises the issue of societal equality, imposing additional value judgments on people' relative positions in society. This also highlights Welfare Theorem 2, which emphasises the critical importance of economic policy in achieving the best of many possible optimal outcomes in the economy. To understand more about this, we must first define the Utility Possibility Frontier notion (UPF).


2) Discuss the ‘spill over effects’ of ‘international policy coordination’ in the context of fiscal and monetary policies.

Ans) The impact of seemingly unrelated events in one country on the economies of other countries is referred to as spillover effects. National economic policies of any single country have international spillover consequences in a globally integrated economy. The greater the impact, the stronger the country's standing in the international commercial arena. Not only from an academic standpoint, but also for policymaking, knowing the transmission pathways of spillovers has become critical. Without international policy coordination, each country will overlook externalities and pursue policies that maximise its own well-being. When all of these countries operate independently, the result is an equilibrium that is not Pareto efficient when externalities are taken into account.

Fiscal and monetary policy are intertwined.

Consider  a scenario in which the United States adopts contractionary fiscal policies to combat inflationary pressures, such as raising taxes and cutting government spending. As a result, there would be a slowdown in the economy. As consumer spending in the United States slows, so does demand for imports. Let's say 'X' is a major import that the United States buys from the European Union (EU) [with the assumption that the US buys 50% of the entire amount of 'X' produced in the EU]. Exports of the EU fall as demand for 'X' (and associated items) falls, setting in motion a chain of events that leads to a weakening of the EU economy. Stock values in the EU's financial markets would plummet. As a result, it is obvious that a country's internal fiscal policy has an impact on its trading partners. Similarly, a country's monetary policy can have an impact on its trading partners. The three ways in which one country's monetary policy might have spillover effects on another are as follows.

Real Income Effects: A change in national income of one country affects its demand for imports from other countries. The impact of this spill over effect depends on its marginal propensity to import (MPM), i.e., change in imports caused by a change in income/disposable income (Fig above). An economy with a positive marginal propensity to consume is likely to have a positive marginal propensity to import. Thus, the effect of economic policies of countries whose imports constitute a significant part of their consumption pattern are higher on their trade partners compared to countries with low MPM.

Monetary Effects: Monetary effects occur when a country’s government or central bank intervenes in the foreign exchange market (by selling or buying foreign exchange) to influence the value of their exchange rates. An increase in money supply of a country, say A, may increase its imports. When the exchange rates are not perfectly flexible, this will lead to improvement in the balance of payments of a country B with whom A is having trading links. This leads to appreciation of the value of currency of country B (foreign currency) with respect to country A (domestic currency). In such a scenario, the government/central bank of country B may choose to intervene in its foreign exchange market by selling its own currency and buying country A’s currency. This would result in expansion of its own money supply.

Relative Price Effects: Relative price effects occur when the exchange rates are flexible i.e. when the currencies can appreciate or depreciate leading to change in relative prices of goods and services. Thus, imports may become cheaper or more expensive resulting in change in demand for imports or exports.

Section B



3) Distinguish between ‘merit goods’ and ‘demerit goods’. Explain briefly why consumption of merit goods are encouraged and those of demerit goods are discouraged.

Ans) Merit Goods and De-Merit Goods

In economics, products are goods because their use or consumption makes customers feel happy, even if they aren't always useful. Consumers may be unappreciative of what they are buying. For example, one may dislike medicines yet find them useful; on the other side, one may enjoy smoking but find it ineffective. Similarly, while children may dislike going to school, it benefits them in the long run. Children, once again, have little understanding of the value of vaccination, but the government frequently encourages parents to have their children vaccinated in order to prevent potential disabilities and deadly diseases.

Richard Musgrave put words to the things that deserve to be said. Consumers are forced to purchase such things, and the government pays for them out of the general fund, in addition to what is available on the market. As a result, it interferes with the concept of consumer sovereignty by imposing a paternalistic imposition. In the eyes of society or government, however, consumption of merit products (such as elementary education, public health, public libraries, and museums) is beneficial to both the consumer and society over time. Such things are private goods, but the market cannot supply them to the amount that society requires. Markets are not nonexistent in such circumstances, but they are incomplete. As a result, the government (or another communal arm) steps in to help.

The consumption of merit products by individuals has numerous beneficial externalities for the rest of society. A well-educated individual is expected to act more correctly, and a vaccinated person is unlikely to damage other passengers. As a result, it has two advantages: it is useful to the consumer (who may overlook its benefits) and it is beneficial to society (though consumed only by some persons). Economists value this quality so highly that they believe merit goods to be subsidizable. Others say that government subsidies should only be used as a temporary solution since people will eventually recognise their relevance and demand them for their intrinsic worth. The government also runs a public awareness campaign to promote their usage. By extension, there may be items that are hazardous, but people consume them because they enjoy them. Smoking, drugs, gambling, and alcohol are examples of de-merit goods. Some term them merit bads, which is incorrect because the people who eat them think they're good!

Aside from being harmful to the consumer, such items have negative externalities. A smoker, for example, produces passive smoking, and an intoxicated person may be a public nuisance. As a result, they have two flaws: one, they injure consumers, and two, they produce negative externality. Taxes are frequently imposed by governments in order to discourage consumption and to promote social campaigns against their use.


4) Outline the issues involved in allocating resources for production in public sector.

Ans) The allocation of resources in public sector is different from that of private sector. Citizens vote for elected representatives and the elected representatives, in turn, vote for a public budget which is spent by many public agencies. Thus, there is a considerable difference in the nature of spending of a private agent and how the government spends public funds. A member of assembly or parliament, when he votes or spends public funds, is supposed to reflect the views of his constituents, not just his own views. In deciding where to spend the money allocated to his constituency or department, he must ascertain the views of his constituents. Since these views may differ, he must decide on weights to be given to the positions adopted by different constituents.

An individual may express his/her preference for one private good versus another either by buying it or not buying it. But there is no practical way by which a person can compare a public good with another. By voting a party, a voter can express his/her view towards more or less of a public good to be provided. Unless and until there is a trade-off between two goods, it is challenging to get them to think hard about their choices. Again, free-riding problem restricts individuals in revealing their preferences regarding public goods truthfully. Usually, as long as the individual does not have to pay for the public good, individual likes more of the public good. However, if the preference for the public good is related to the amount the individual has to pay for the good, then, usually the individual reveals less than what he/she prefers. The critical difference between public and private resource allocation is that in case of private good the decision maker knows his preferences, but for a public good, the decision maker has to ascertain the preferences of those on whose behalf he is making a decision.

A public good is a good of collective consumption. As different individuals have different preference for a public good, decision making for collective consumption of a public good is not so easy. Demand for public good differs in terms of preference, income and taxes. Wealthier individuals consume more public and private goods, but if more provision of public good increases the tax liability of the rich people, then they would want a lower level of public expenditure.

Resources for Public Goods

Suppose there are N people and each pays same amount to finance public expenditure/good regardless of income. If G is the level of expenditure on public good then each pays G/N. Thus, in case of uniform taxation, price paid for the public good is 1/N. But with proportional taxes, if ‘t’ is the tax rate and Y is the average income, then total tax collection is: tNY . Thus, under a balanced budget:

an individual’s preferred level of public good can be illustrated as in Fig below

Utility depends on the level of public expenditure and in case of an individual, utility is maximised at a point where the indifference curve is tangent to the budget constraint. Larger the gap between actual expenditure and preferred expenditure, lower is the level of utility. Fig below depicts utility as a function of public expenditure for three different classes of people: the poor, the middle and the rich. Suppose they reach their maximum utility at Gp Gm and Gr respectively. Since utility varies with the actual level of public expenditure, the rich prefer the highest level of public expenditure followed by the middle and then by the poor.


In a private market, whoever pays the price for the good will get the good. There is thus no need to balance the claims and interest of one group against those of others. The problem of reconciling the decisions however arise when there is a need for collective decision. While in a dictatorship, the dictator's preference dominate, there is no such easy resolution in a democracy. This leads us to the consideration of voting methods for collective decision making.


5) Explain briefly how the size of public expenditure is determined under the Niskanen’s ‘budget maximisation approach’.

Ans) Budget Maximisation

The other strand is about how the size of public expenditure is determined. Public choice theory does not accept the government as a benevolent despot. People are as rational in political processes as they are in the market. Their actions in both the arenas, economic and political, are motivated by self-interest. In the budget maximising processes, there are three varieties of actors: voters, legislators and executives who are basically bureaucrats. William Arthur Niskanen, an American economist, with experience in US administration, proposed (in 1971) the ‘budget maximising model’ of bureaucracy, by adopting the public choice approach. According to Niskanen, rational bureaucrats will always and everywhere seek to increase the budget of the department they are in, in order to increase their power. Thus, they will contribute to the growth of State at the cost of society. It is very similar to Parkinson’s law (popular in Public Administration), which says that ‘work expands to fill the time available for its completion’ much the same way as ‘gas expands to fit the volume’.

A department comes into existence because there is demand for its services by the voters or electors. It offers the services to the voters-electors through the legislature in a democracy. The legislature defines the budget of a department depending on the quantity it supplies. The more the services, the higher the budget. The model assumes that the department’s (bureau) policies and programmes are set by bureaucrats by considering the costs and benefits associated within a given range of output. It also assumes that bureaucrats attempt to maximise their personal utilities by satisfying ‘self-regarding preferences and that top bureaucrat decides the agenda to sell to the legislature. In a parliamentary democracy, political executives partly share the ‘self-regarding’ characteristic.

 Usually, there are two kinds of departments: one earning revenue and the other spending revenue. The model proposes that the top bureaucrat in a spending department will try to maximise the department’s expenditure budget and thus ensuring better pay packet and prestige. The department will propose to the legislature the services it will dispense to the public (which approves and authorises it to carry out the agenda). In Economics, maximisation is constrained maximisation. This maximisation, according to Niskanen, is subject to social welfare break-even constraint. There is social benefit from the services (schemes) and there are associated social costs (sacrifice) of dispensation. Instead of equating Marginal Social Benefit (MSB) with Marginal Social Cost (MSC), the department equates Average Social Benefit (ASB) with Average Social Cost (ASC). Thus, bureaucracy tries to push the production/provision of services up to the level where citizens’ (consumer’s) surplus is ‘nil’. Thus, the deadweight loss will be equivalent to total surplus it could generate by equating MSC with MSB (Fig. below). Instead of attempting to produce at Qo level it prefers to go to Q1 level. This oversupply generates allocative inefficiency.

Niskanen adds that it also generates x-inefficiency by producing services inefficiently in the sense that the actual cost curve will be higher than warranted by technical considerations. Thus, the actual ASC and MSC curves would be higher than they ought to be.

Why does the service not go beyond Q1 level? It is quite likely that the excess is discovered by the legislators and the quantum of services is drastically reduced. In India, this tendency is found to be very eloquent in the case of centrally sponsored schemes which kept proliferating. Review committees cut them down but they again surfaced since the political executives found them to be good vote catching devices. It could be seen that Niskanen is addressing the American context. British reaction was that Niskanen is too harsh on the bureaucracy. Largely agreeing with many of Niskanen’s assumptions, Patrick Dunleavy, a British economist, discards the assumption that bureau’s behaviour coincides with preferences of the senior-most bureaucrat. In his view, no individual has complete hegemony or autonomy. The interaction of self-regarding maximising individuals may not necessarily lead to budget maximising.

An alternative model, known as the ‘budget-shaping model’, was proposed by Patrick Dunleavy in 1991. This model admitted that bureaucracy might also work in small bureaus with lean staff and recommending ‘agencification’ or off-loading functions to private contractors or outright privatisation. Whether as a reaction to Niskanen’s negative caricature of bureaucracy or as a response to Dunleavy’s positive view or general refrain to minimal government, proliferation of government seems to be halting and many public-private partnerships are now happening all over the globe. In fact, both the tendencies i.e. proliferating departmental budget and magnification have been witnessed in last few decades.

6) Contrast the nature of ‘fiscal federalism’ as it exists in India with those in some other countries.

Ans) Fiscal Federalism in India

The Indian Constitution divides tax bases between the Union and the States, which are listed in the Union List and the State List, respectively (as provided in the Seventh Schedule under Art 246). In the Concurrent List, there was/is no provision for taxation. When GST was established, however, it was necessary to provide for a concurrent base, for which Article 246A was inserted (as 101st Amendment in August 2016). This allowed the Union to enact CGST (central GST) and IGST (integrated GST) legislation, while the States could enact SGST legislation. The Constitution lays out a complex system for levying, collecting, and allocating taxes and duties between the federal and state governments. States levy, collect, and appropriate all taxes for which they have legislative authority. Certain taxes are imposed by the Union, but they are collected and appropriated by the states in their jurisdictions. There were some taxes that were to be levied and collected by the Union, but they were to be assigned to the states where they were collected (for example, interstate sales and consignment of products). This became part of IGST after the establishment of GST, and the state's portion is to be assigned. Except for a few taxes, duties, surcharges, and cesses, all taxes and duties levied and collected by the Union are to be split between the Union and the States according to the Finance Commission's recommendations.

States also have similar enabling measures in place for their municipal administrations. To begin with, the Union was meant to be required to share some taxes. However, since 2000, the Union and the States have had to share the majority of taxes and duties. The divisible pool, on the other hand, excludes earnings from cesses and surcharges collected in addition to taxes. According to estimates, the exempted portion of the Union's gross tax collection climbed from 7.5 percent in 2000-01 to over 13.0 percent in 2013-14. The Union argues that 'cesses and surcharges' are charged for specific objectives and are not included in the divisible pool under the Constitution. The Union currently collects and distributes income (personal and corporate), excise (on petroleum and petroleum products), customs, and CGST taxes to the states. SGST, VAT (on alcoholic beverages and petroleum and petroleum goods), Motor Vehicle Tax, Stamp Duty, and other taxes and charges are collected by states. Taxes on agricultural income are minimal, and land revenue yields are insignificant. Under Articles 275 and 282, the Union is supposed to pay grants-in-aid to the States in addition to sharing tax revenues. There is also a provision for 'grant-in-lieu-of-tax' for states exporting jute and jute products, such as Assam, Bihar, Odisha, and West Bengal.

Non-tax revenue sources include dividends from public corporations, fees or royalties on the use of natural resources such as spectrum, mineral deposits, and so on. Fees and fines are collected by all departments. Governments also get interest on loans granted to other governments, state companies, and employees (when they pay it out). It was expected that there would be both vertical and horizontal fiscal resource imbalances. To deal with this, Article 280 establishes a Finance Commission (FC) [to be appointed by the President every five years] to decide on resource sharing between the Union and the States. Furthermore, following the advent of Parts IX and IXA, which deal with Panchayats and Municipalities, the Finance Commission is entrusted with recommending steps to supplement States' resources in order to assist them in supplementing the resources of their local governments. The FC is specifically asked to make recommendations on: I the distribution of net tax proceeds between the Union and the States, as well as the allocation of States' share among States; (ii) the principles that should govern grants-in-aid to the States from the Consolidated Fund of India, both before and after 1994; and (iii) the measures needed to augment the Consolidated Fund of a State in order to supplement the resources of the Panchayats/Municipalities in the State on In the sake of states' financial stability, the President can refer any other topic to the Commission.

Every five years, comprehensive Terms of Reference (ToR) are handed over together with the nomination of the Commission (Chairman and Members), with catastrophe management reoccurring in the ToR. The Finance Commission considers various submissions, consults State governments, meets with academics, calculates revenues and expenditures on a normative basis, develops criteria for inter-se distribution of States' share of taxes among states (usually in percentage terms), and recommends grants-in-aid to those States in need of assistance, local government grants, disaster management grants, and, on occasion, sector-specific grants. However, the Finance Commission's recommendations must be implemented by the government, which has largely done so.

The States are required to: I authorise their respective Panchayats and Municipalities to levy, collect, and appropriate such taxes, duties, tolls, and fees as they deem fit, (ii) assign such taxes, duties, tolls, and cess as they deem fit, and (c) provide for making grants-in-aid from the State's Consolidated Fund through an Amendment (under Articles 243H and 243X). Furthermore, under Articles 243I and 243Y, every State is required to establish a Finance Commission every five years to recommend, among other things, taxes that may be assigned to and divided with Panchayats and Municipalities, as well as grants-in-aid to be paid to them.


7) Delineate the two applications of Engel curve.

Ans) Applications of Engel curve:

  1. In microeconomics Engel curves are used for equivalence scale calculations and related welfare comparisons and determine properties of demand systems such as aggregability and rank.

  2. Engel curves have also been used to study how the changing industrial composition of growing economies are linked to the changes in the composition of household demand.

  3. In trade theory, one explanation of inter-industry trade has been the hypothesis that countries with similar income levels possess similar preferences for goods and services (the Lindner hypothesis), which suggests that understanding how the composition of household demand changes with income may play an important role in determining global trade patterns.

  4. Engel curves are also of great relevance in the measurement of inflation, and tax policy.

  5. The Engel curve allows estimating the consumer price index deviation for old age.

  6. The Engel curve method is used to study the improvement of farmers' welfare by comparing food consumption and income growth. What is more, it infers the cost of living of households. Additionally, it also studies the impact of the sources of household consumption diversity on welfare.

  7. The Engel curve estimates the collective household model.

  8. Engel curves assess whether outdoor leisure is a luxury or a necessity.

  9. The deflator of the Engel curve is not sufficiently representative of the deflator obtained from the multilateral price index. It is not appropriate to use only the Engel method in some regions, the changes in poverty and inequality, the estimated locations and levels will be greatly distorted, which will result in wrong conclusions.

  10. Engel curves have found a wide range of applications, including assessing policies related to agriculture, taxation, trade, industrial organization, housing, and the measurement of poverty and inequality.

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