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to
intervene
in
the
economy
or
in
Societys Goal
To produce an optimal
mix of output.
Optimal
mix
of
output:
the
most
desirable combination
of output attainable
using
existing
resources, technology,
and social values.
Market Failure
Society wants the
combination
at
point X.
The
market
mechanism would
lead us to point M.
Market failure: an
imperfection in the
market mechanism
that
prevents
optimal outcomes.
Market Failure
Market Failure can occur from any of the
following:
Market Power
Inequity in Income Distribution
Externalities
Public Goods
Market Power
Market power: A company's ability
to manipulate price by influencing an
item's supply, demand or both.
Thus, the firm can restrict supply in
order to maximize profits rather than
produce societys desired mix of output.
Government role:
Restrict market power.
Promote more competition.
M a r k e t
P o w e r
S2(restricted supply)
Price
S1(competitive supply)
P2
P1
D
Q2
Q1
Quantity/time
Income Inequity
Income Inequity:
The gap between individuals or households making most of the
income in a given country and those making very little.
Transfer payments.
Provide payments to individuals for which no current goods
and services are exchanged.
Externalities / Spillovers
Externalities
An externality is an effect of a purchase or
use decision by one set of parties on others
who did not have a choice and whose
interests were not taken into account.
The difference between the social and
private costs (benefits) of a market activity.
Third
parties
benefit
because of a market
transaction.
Not enough is produced
and sold at price p1
because
societys
benefits are greater than
market benefits.
Government steps in to
generate benefits for
society.
Government
action
causes more to be
produced by subsidizing
production or purchase.
Product is sold at price
p3.
Price of
vaccines
Social demand
Market demand
p2
p1
Subsidy
p3
Market
output
q1
q2
Quantity
of
Optimal output vaccines
Price of
polluting good D
Social
supply
Market
supply
p2
p1
Quantity
Optimal q2 q1
output
Market output
Price
Market demand
Social demand
p2
p1
External cost
p3
Optimal
output
q1
q2
Quantity
of
Market output cigarettes
Summary: Externalities
Positive externality
Societys benefit > market benefit.
The market underproduces.
The government subsidizes.
Negative externality
Societys benefit < market benefit, or
Societys cost > market cost.
The market overproduces.
The government restricts consumption or
production.
Taxation
Establish
Property
Rights
Public Provision
Types of
Government
Intervention
Subsidies
Transfer
Payments
Education and
social
marketing
campaigns
Regulation
Public Goods
Private good: a good or service
whose consumption by one person
excludes consumption by others.
A burger
Public Goods
The free-rider dilemma:
The free rider problem refers to a situation where some
individuals in a population either consume more than
their fair share of a common resource, or pay less than
their fair share of the cost of a common resource.
Free rider:
A commonly used example of the economic notion of
the free rider problem is found in national defense. All
citizens of a country benefit from being defended;
however, individuals who evade taxes (free riders) are
still protected by the same public resource of
national defense, even though they did not pay for
their fair share of the resource.
Sales Tax
Income Tax
Regulations
Transfer
Payments
Public
Ownership/
Provision
Macro Instability
The goal of macro intervention is to foster
economic growth and to move towards a
more allocatively efficient position
Move out of inefficiency and/or push the PPC
outward.
Reduce unemployment.
Avoid inflation.
Stable prices.
Growth of Government
When society perceives a problem, it
looks to government to fix the problem,
which
provides
justification
for
government intervention in the economy.
As a result, government has grown over
the last century:
Over 10 times more employees since 1900.
A budget 6,000 times larger since 1900.
Growth of Government
Government Finances
Each level of government (federal, state,
and local) creates a budget of fund inflows
and outflows.
Inflows (sources of funds).
Taxes (and fees/user charges).
Borrowing.
payments,
defense
Taxation
Taxes pay for government spending.
There is a change in the output mix as
more government spending absorbs factors
of production that could be used to produce
consumer goods.
The opportunity cost of taxation is
measured by the private-sector output
sacrificed when government employs
scarce factors of production.
Taxation
The primary function of taxes is to
transfer command over resources
(purchasing power) from the private
sector to the public sector.
Federal Taxes
Income Tax
Income taxes: the largest single
source of government revenue.
It is a progressive tax system.
As income rises, the tax rate also rises.
Compared to those with lower incomes,
those with higher incomes:
Pay more taxes.
Pay a greater fraction of their income in
taxes.
Other Taxes
Corporate taxes.
Usually passed on to the customer in higher
prices.
It is a progressive tax system to the
corporation.
Excise taxes.
Imposed on a specific good or service.
Some are imposed to discourage production
and consumption of these goods.
Other Taxes
Property tax.
A major source of local taxes.
It is a regressive tax, since poorer people devote
a larger portion of their income to housing costs.
Sales tax.
Another major source of local taxes.
It is also a regressive tax, since poorer people
tend to spend all of their income while richer
people do not.
Government Failure
Government
intervention should
move the mix of
output
closer
to
societys
desired
mix.
Government
failure: government
intervention fails to
improve
economic
outcomes and may
worsen outcomes.
Perceptions of Waste
Public perception is that the government
isnt producing as many services as it
could with the resources at its disposal.
This inefficiency pushes the economy inside
the PPC.
Government
Benefits and costs usually
accrue to different groups.
Makes it more difficult for
the decision maker.
Politics enter into the
decision.
The decision maker may
have no stake in the
outcome.
In
the
government
sector, the beneficiaries
see only the benefits
and the payers see only
the costs. The decision
maker may not see
either.