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Economics is the science of rational allocation of resources. This allocation, however, involves redistribution (in particular by the state). Almost half the income in the advanced economies is redistributed. The proportion of redistributed income has been rising fairly rapidly (along with the tax rate) since the start of the 20 th century owing to the constantly rising importance of public goods and social services.

Consequently, public goods (positive externalities) and social services are not and cannot be the result of market forces and decisions alone. For example, vital social services may fail to be provided because the low income of those who receive them makes them unprofitable. Likewise, a shortage of public goods can represent a bottleneck in an economy and thwart profitable activity. For example, an inability to stop free riders consuming public goods makes it impossible to cover the costs by collecting payments from users (people don't normally pay if they don't have to). As a result, it is the state that always takes responsibility for public goods and social services. This does not mean, however, that the state provides these services directly itself—it has proven more efficient to provide state subsidies to private providers of such goods.

The inclusion of redistribution does not mean we have to abandon the idea of assessing the economic rationality of resource allocation. As we argued in the introduction to this section, the fact that social services and public goods are not fully determined by market forces does not mean we are getting outside the realm of economics. Even state subsidies can be provided economically rationally and economically irrationally. State subsidy allocation rules may or may not create bottlenecks, unnecessary expenses, scope for corruption and so on. An economically rational state (with sensible rules) can achieve the same effect at lower cost than an irrational state.

The issue of providing support is unquestionably an economic problem, even if in some cases (the hard-core altruism of a private donor) it lies outside the homo economicus paradigm. Yet although the motives of a private donor can be either (economically irrationally) altruistic or self-interested (e.g. corporate image building), a donor that is part of the public economy acts in the public interest (provided he stays within the bounds of the law). Such a donor is most often the state, but it can also be a local authority or an international organization providing aid to developing or third world economies. We limit ourselves here to the case where the state is the guardian of the public interest.

The motive of the state in the role of donor for public service providers is itself a problem. One possible approach is to assume that the state minimizes the amount of public funds it needs to provide in order to ensure that its citizenslive a dignified life and in order to safeguard the economic survival of the sector of the economy which provides public goods and services. It redistributes funds, primarily from taxes, to the needy and the dependent and to selected firms. In the case of firms, however, there are two problems. The state does not know the threshold (different for different firms) below which a subsidized entity will collapse. It is also debatable to assume that the state prefers a situation where all public service providers scrape along at the very edge of survival and a high percentage of them go under.[2]

If the donor (state) is to distribute subsidies in an economically rational way, it must try to secure the maximum possible return on the funds provided for the public or social services or other activities per formed by the recipient. It can distribute funds among the recipients in basically two ways. The first is to provide funds in proportion to the proven (justified) needs of providers of public goods, social services or other activities worth supporting. The second is to set eligibility conditions for the subsidy and check compliance with them.

The first way is analogous to the centrally planned economy with all its problems (inefficiency, information asymmetry, incentives for recipients to distort information, corruption climate, moral hazard).

The second way is the subject of many theoretical and empirical analyses, for example in the context of conditionality and fungibility.

Subsidy conditionality influences the recipient's behaviour in such a way as to make it comply with the ideas of the donor as far as possible. Sachs and Svensson have developed microeconomic models[3] in which conditionality improves the outcome from the donor's perspective when services are provided through an agency that does not entirely share the donor's preferences (in this case the government, which can implement re for ms that improve the outcome from the subsidy provider's perspective; however, the ef for t to implement re for ms enters its utility function with a negative sign). Ranaweera studies the relationship between conditionality and the necessary amount of aid on the basis of the Harrod-Domar macroeconomic model.[4] Ellerman discusses conditionality of aid in the light of various models based on social learning and change.[5] Killick discusses the potential costs of conditionality in the sense of reduced effectiveness of aid.[6] Cordelia and Dellaricia construct a microeconomic optimization model for the case where the donor and the recipient have different criteria.[7]

Fungibility refers to the fact that a subsidized entity can avoid conditionality if it is funded from multiple uncoordinated sources. If, for example, a donor makes aid conditional on its being used for educational programmes rather than arms projects, the recipient may accept the subsidy but then reduce spending on education and increase arms expenditure by the same amount, thereby bypassing the conditionality.[8]

In the following text we draw attention to another risk limiting the rules for receiving aid. These rules can have such a limiting effect that they prevent the optimal allocation of resources, since they can imply, for example, the needless demise of too many social service providers or public goods producers. Their previously incurred costs and their tangible and intangible assets can also be rendered worthless.

Although a donor may have good reasons for making a subsidy conditional (influencing the behaviour of recipients, limiting the misuse of subsidies for the benefit of public goods and services providers, or complying with budget regulations), doing so can lead to lower spending efficiency. We will show this using two simple models based on generalized microeconomics in which economic agents maximize the Pareto probability of their economic survival. In the first model, we examine the consequences of the donor prohibiting the carry-over of unused subsidies to the next period. The second model analyses a rule limiting the overhead costs of a subsidized social services provider, motivated, for example, by a lack of trust or by concerns about the misuse of the subsidy at the expense of service recipients. We will show that such restrictions can be counterproductive from the donor's perspective, i.e. they can contradict the purpose of the subsidy.

In our models, we assume that the donor's criterion when deciding on the allocation of a subsidy is to achieve the maximum possible return on his money in favour of public or social service recipients.

Let us start by assuming that the donor (state) has decided on the total amount of the subsidy granted to providers of a particular public service. Its objective function when seeking the optimal allocation of funds involves maximizing the volume of services provided[9] (obviously to an acceptable/prescribed standard, with the donor checking compliance with this condition).[10] An economically rational donor with such an objective function allocates its limited resources among the subsidy recipients in such a way as to ensure that as many as possible of them (of the prescribed standard) survive. Accordingly, it tries to ensure the highest possible probability of economic survival of the subsidized entities.

The donor (state) does not interfere in the recipient's routine decisionmaking, but sets conditions or rules for the ongoing provision of the subsidy.

Such conditions need not be limited to service quality. The donor does not have to (but can) allow the carry-over of unused portions of the subsidy to the next period, and can (but does not have to) prescribe allocation of the subsidy by purpose (for example it can prescribe a maximum permissible ratio for overhead or wage costs).

Here, however, we need to make a distinction. Although a specific recipient that provides a low-quality public service is disqualified from receiving a subsidy in accordance with the objective function of the economically rational donor, restrictive rules for receiving a subsidy can contradict the purpose of the subsidy — they can lead ceteris paribus to a lower volume of service provision. If a donor (for example a grant agency) announces such a rule, it is being economically irrational, as it is — with a high probability (bordering on certainty) — deliberately excluding its own optimum from the set of feasible solutions.

Just as in the rest of this book, we adopt a microeconomic approach to the analysis and description of economic phenomena. We focus on themes that pertain to the allocation of public funds, but we refrain from investigating the macroeconomic context and only assess the rationality of the rules for allocating public funds among individual subsidy recipients.

In the following section, we will show that a microeconomic model[1] constructed on the principles of generalized microeconomics can help to provide answers to questions concerning the rationality of allocation of public funds.

  • [1] See Hlaváček, J., Hlaváček, M.: Ekonomická iracionalita donátora plynoucí z nedůvěry k příjemci dotace. Finance a úvěr 54, 3–4(2004): 138–54.
  • [2] This would be economically rational only in a deterministic decision-making situation. In such case it would indeed be optimal (economically rational) for the donor to provide the minimum amount needed to ensure the survival of a sufficient number of public goods providers. In reality, though, this boundary solution would mean, among other things, a high relative frequency of collapse of subsidized entities and a loss of confidence among recipients of public services. This is something that state decision-mak-ers (politicians and civil servants) usually go to great lengths to avoid, as otherwise they would lose the political support of a large fraction of the electorate.
  • [3] See Sachs, J.: Conditionality, Debt Relief, and the Developing Country Debt Crisis. In Developing Country Debt and World Economy, edited by J. Sachs, 275–84. Chicago: University of Chicago Press, 1989, or Svensson, J.: When Is Foreign Aid Policy Credible? Aid Dependence and Conditionality. Journal of Devel-opment Economics 61, 1(2000): 61–84.
  • [4] See Ranaweera, T.: Foreign Aid, Conditionality and Ghost of the Financing Gap: A Forgotten Aspect of the Aid Debate. World Bank Policy Research Paper No. 3019, World Bank, 2003.
  • [5] See Ellerman, D.: Hirschmanian Themes of Social Learning and Change. World Bank Policy Research Working Paper, No. 2591, World Bank, 2001.
  • [6] See Killick, T.: Principals, Agents, and the Failings of Conditionality. Journal of Institutional Development 9, 4(1997): 483–95.
  • [7] See Cordella, T. – Dellaricia, G.: Limits of Conditionality in Poverty Reduction Programs. IMF Staff Papers 49(2002): 68–86.
  • [8] This problem is studied at the theoretical level by, for example, Devarajan, S., Swarroop, V.: The Im-plications of Foreign Aid Fungibility for Development Assistance. World Bank Policy Research Working Paper No. 2022, World Bank, 1998. Empirical research has been conducted by, for example, Feyzioglu, T., Swarroop, V., Zhu, M.: A Panel Data Analysis of the Fungibility of Foreign Aid. The World Bank Economic Review 12, 1(1998): 29–58.
  • [9] This problem is the reciprocal of the maximization of productivity subject to technical feasibility. This relationship is analogous to the reciprocal problems of maximizing profit and minimizing costs at a given level of output in the theory of the firm.
  • [10] This subsidy strategy applies solely to decision-making on the allocation of the subsidy in question. Both state and private donors naturally also have their own broader criterion within which their sub-sidy strategy runs.
  • [11] See Hlaváček, J., Hlaváček, M.: Ekonomická iracionalita donátora plynoucí z nedůvěry k příjemci dotace. Finance a úvěr 54, 3–4(2004): 138–54.
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