Chapter 5: The Institutions of a Modern Market Economy

Objectives of Government Policy

Tax System
Legal System
Financial System
Organization of Business
Labor Market
Trade Policy
Industrial Policy
Developing Human Resources

The Objectives of Government Policy

The government performs three functions:
Allocation making the economy work efficiently, correcting
market failure
Distribution looking after equity, providing safety net.
Stabilization -- growth, inflation.

Comparative Expenditure on Allocation Function

Distribution Function
Income support
Affects incentive in the labor market via
Reservation wages
Search time
Voluntary unemployment

Can both increase and decrease efficiency

Redistribution in-kind
Merit goods
Voucher systems

Comparative Expenditure on Allocation Function

Allocation Function
1. Production of Public and Quasi Public Goods
2. Provision of Information
3. Product Regulation
4. Environmental Regulation
5. Financial market Regulation

Stabilization Function

Accepted really after 1930s

Could do it only after a framework to do it in
Gathering statistics is very important
Improved performance since WWII
Avoided depression
Almost avoided recession

US Real Growth postwar

The Tax System

Direct taxation

Personal income tax

Social security taxes
Corporate taxes
Expenditure taxes
Wealth and estate taxation

Indirect taxation
Taxes on commodities, sales, exchanges
Tariffs: imports, exports,
Real estate

Types:
Progressive
Average rate increases with income

Regressive
Average rate falls with income

Proportional
Rate remains constant with income

The Tax System

The Legal System

Ownership and property Rights

Freedom to engage in economic activity
The enforcement of contracts and compensation
Bankruptcy law
When the business goes wrong, who gets to gnaw on the bones of
the business first?

Accounting and financial disclosure

What companies have to tell you is very important.

Clear definition of governmental responsibility

System of civil compensation (torts)

The Financial System

Central Bank

Used to control and insure the value of the currency

Oversee the banking system
Lender of Last Resort
Clearing Bank

Depository institutions
Banks
Checking and Savings

Non-depository institutions
Market for financial assets
Are markets self-regulating?

Central Banks Functions

Functions
To act as a clearing bank for the banks
To act as the promulgator and enforcer of financial regulation, designed to
enhance the stability and efficiency of the financial system
Recently neglected or given to other agencies
To act as a lender of last resort
To monitor the foreign exchange value of the currency
To control the overall stock of money in the economy, and hence the
interest rate through use of the following tools:
Open-market operations, by which the central bank buys or sells government
bonds to and from the public
Reserve requirements, which constitute controls on the minimum amount of
liquid reserves which banks must hold against the liabilities that it owes its
depositors
The discount rate, which is the interest rate at which the central bank lends
money to banks to provide the reserve base against which banks can lend to
borrowers

Central Bank Independence

The pros and cons of a central banks independence

Pros:
Independence means not beholden to any party or group.
Has the legitimacy of expertise can be given to a real banker who has no
electoral record
Above politics not swayed by interests or obligations of any party.
Takes long view not worried about the next election.
Can make tough decisions that would lose an elected politician his office.

Con:

Undemocratic power not balanced by electoral control.

Isolated can afford to be aloof and uninvolved in important issues.
Politically remote
Responsible to wrong community -- by picking a real banker or academic
he/she might have specific sectoral interests

Depository Institutions

Commercial banks
Savings and Loan Banks
Credit Unions
Postal Savings Banks

Non-depository Institutions
Mutual Funds
Venture Capital Funds
Insurance Companies

The Market for Financial Assets

The Ownership of Stock
Who owns the firms varies from country to country and therefore ability to
control varies too (Table 5.3)

Financial Markets Provide Corporate Governance

The Market for Corporate Control

The Organization of Business

The Corporate Form is the predominant form in most market
economies (vital innovation for the development of modern
capitalism)
Favors risk
Pools capital
Limits liability

The South sea bubble was an early example of perhaps harmful

aspects of corporate form.
The issue of Corporate Responsibility is Corporate
responsibility
Is a corporation a social institution?
What is the Stakeholder society?

The Labor Market

Union form can differ, with impact on performance
Craft
Descendants of guild system

Industry
Covers many occupation in a single industrial grouping (e.g. UAW)

Company
Common in Japan

General
The Teamsters for instance, covers not just wagon drivers and truckers,
but policemen and secretaries as well

Rates of unionization vary widely across nations (see next slide

for table)

Rates of Unionization

Trade Policy
Open versus closed
Trade/GDP ratios

Multilateral
GATT
WTO

Unilateral
Reciprocity

Free Trade areas

Customs Unions
Common Markets

Economic Unions

Industrial Policy
Micro
Picking the winners

Macro
Creating broad structure

Promoting new vs. burying old

Japanese/European models

Developing Human Resources

The Educational System
The Health-Care System
End of Presentation