OUTLINE -- Chapter 4 --pp. 71-80

The Role of the Government in Market Economies

Outline

I. Structural Adjustment Policies

1. Privatization
2. Promotion of Competition
3. Limited and Reoriented Role for Government
4. Price Reform: Removing Controls
5. Joining the World Economy
6. Macroeconomic Stability

II. Review: Capitalism, Markets, and Efficiency

A. Capitalism and Limited Government
  1. private property and economic growth
  2. markets and prices
  3. role of self interest
  4. freedom of enterprise and choice
  5. competition = capitalism
  6. limited role for government

B. Why limited government?

I. REVIEW

A. The Market System and Efficiency
See: The supply and demand model and allocative efficiency
1. WHAT WE GET:
a. Goal of businesses: Maximize Profits
b. Therefore,they will produce where:
  • the Market Equilibrium quantity
  • the quantity where Qs=Qd
  • the is "what we get"

 

  • Graphically:

     

c. Assumptions: pure capitalism (for what is capitalism see: chapter 2)

2. WHAT WE WANT: ALLOCATIVE EFFICIENCY

a.. Review :
(1) Allocative Efficiency
definition - using our limited resources to produce:
  • The quantity of goods and services that maximizes society's satisfaction
  • using resources to produce more CDs that people want and fewer cassette tapes that they don't want
  • no shortages and no surpluses

(2) Benefit-Cost Analysis

definition -
the selection of ALL possible alternatives where the marginal benefits are greater than the marginal cost

select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

B. Allocative Efficiency is achieved where:

1. MSB=MSC
a. define Marginal Social Benefits (MSB)

b. define Marginal Social Costs (MSC)

c. therfore if society gets

all quantities where: MSB > MSC
up to where: MSB = MSC
but never where: MSB < MSC

this will be the quantity where society's Satisfaction will be maximized or the allocatively efficient quantity

2. Graphically:

 

 

C. THEREFORE:

1. Businesses will produce the profit maximizing or market equilibrium quantity - the quantity where Qd=Qs

2. Society wants the allocatively efficient quantity - the quantity where MSB=MSC

3. WHAT WE GET = WHAT WE WANT if:

b. Market Demand = Marginal Social Benefits (D=MSB)
1. law of diminishing marginal utility
2. assuming no positive externality (or spillover benefit)s D=MSB

c. Market Supply = Marginal Social Costs (S=MSC)

1. law of increasing costs
2. assuming no negative externality (or spillover cost)s S=MSC

D. Competitive Markets and Allocative Efficiency (MSB=MSC)

1. if there are no negative externality (or spillover cost)s, then S = MSC,

2. if there are no positive externality (or spillover benefit)s, then D = MSB,

3. Graphically:

 

 

4. Then: WHAT WE GET = WHAT WE WANT and market economies achieve allocative efficiency

 

In a market economy with no positive externality (or spillover benefit)s and no negative externality (or spillover cost)s:

the profit maximizing or market equilibrium quantity
(what we get)

WILL BE THE SAME AS

the allocative efficient quantity
(what we want)

III. Economic Functions of Government

A. Five Reasons for Government Involvement
1. legal and social framework
2. maintaining competition
3. redistribution of income
(correcting market failure to achieve equity)
4. reallocation of resources
(correcting market failure to achieve efficiency)
5. stabilizing unemployment and inflation and promoting economic growth

B. Legal and Social Framework

providing the legal foundation and a social environment conducive to the effective operation of the market system

C. Maintaining Competition

1. review competition
a. large numbers
b. free entry and exit

2. the problem with monopolies

a. higher prices
b. smaller quantities
C. allocative and productive inefficiency

3. role of government

a. preventing monopolies -- antitrust laws
b. regulating monopolies -- natural monopolies

D. Correcting Market Failure to Achieve Equity

1. define equity
2. how does equity affect society's satisfaction?
3. examples of income distribution
US:http://www.census.gov/ftp/pub/hhes/income/histinc/h02.html
World:

4. role of government

a. transfer payments
b. market intervention
c. progressive income taxes

E. Correcting Market Failure to Achieve Allocative Efficiency

Three Circumstances when a market economy results in allocative inefficiency
  • Negative Externalities
  • Positicve Externalities
  • Public goods

1. Negative Externality (or spillover costs)

a. definition
TEXTBOOK: A cost imposed without compensation on third parties by the production or consumption of sellers or buyers.

CLASS: A negative externality (or spillover cost) occurs if some of the costs of producing and consuming a product "spillover" onto a third party who does not benefit.

  • not just the buyer
  • not just the seller,
  • but someone else must pay some of the costs of production

Example: A paper manufacturer dumps toxic chemicals into a river killing the fish sport fishers seek.

  • buyer = purchaser of paper
  • seller = paper manufacturer
  • third party = people who fish, or live, downstream

b. examples

a) pollution
b) cigarettes
c) alcohol
d) gasoline and pollution
d) party in dorm room and you're not invited

c. markets and inefficiency:

ON A GRAPH SHOW:

1) S and D for a product

2) MSC when there are NO negative externality (or spillover cost)s (producer pays ALL costs)

  • Show the profit maximizing quantity
  • Show the allocatively efficient quantity
    (assume D=MSB, i.e. no positive externality (or spillover benefit)s)

3) What happens to S if there ARE negative externality (or spillover cost)s (the producer can AVOID some costs)

4) What happens to P, Q, and efficiency WITH negative externality (or spillover cost)s?

  • what happens to the profit maximizing P and Q? (Show on gragh)
  • what is the allocatively efficient quantity? (Show on graph)

5) RESULT:

  • Does the market achieve allocative efficiency when ther are negative externality (or spillover cost)s?
  • Is there an OVERallocation of resources OR an UNDERallocation of resources?
  • without the government would TOO NUCH or TOO LITTLE be produced?

d. correcting for negative externality (or spillover cost)s: What can the government do?

1) GOAL: to reduce production and get closer to the allocatively efficient quantity

2) policies

  • specific (excise) taxes on products with negative externality (or spillover cost)s

 

  • legislation/regulation (Direct Controls)
    • gov't sets the amount
    • gov't decides who

     

e. APPLICATION: SHOULD GAS PRICES BE HIGHER?

2. Positive Externalities (or spillover benefits)

a. definition
TEXTBOOK: A benefit obtained without compensation by third parties from the production or consumption of sellers or buyers.

CLASS: A positive externality (or spillover benefit) occurs if some of the benefits of producing or consuming a product "spillover" onto a third party who does not have to pay

  • not just the buyer
  • not just the seller,
  • but someone else benefits

Example: A beekeeper benefits when a neighboring farmer plants clover.

  • buyer = purchaser of honey
  • seller = beekeeper
  • third party = neighboring farmer

b. examples

a) education
b) Ski Areas and Ski Shops
c) parks

c. markets and inefficiency:

 

ON A GRAPH SHOW:

a) MSB and alloc eff. P and Q with NO positive externality (or spillover benefit)s

  • what is the profit maximizing quantity?
  • what is the allocatively efficient quantity?

b) What happens to D if there are positive externality (or spillover benefit)s and a consumer can benefit without paying?

c) So what happens to P, Q, and efficiency WITH positive externality (or spillover benefit)s?

  • what is the profit maximizing quantity?
  • what is the allocatively efficient quantity?

d) RESULT: an UNDERallocation of resources

  • too little would be produced without the government

d. Correcting for positive externality (or spillover benefit)s - What can the government do?

1) GOAL: increase the quantity

2) HOW?

  • increase demand (subsidize consumers)
  • increase supply (subsidize suppliers)
  • provide goods via the government

3. Public goods and services

a. definition
A good or service which is indivisible (nonrival;) and to which the exclusion principle does not apply

1) exclusion principle does not apply

The exclusion principle is: The ability to exclude those who do not pay for a product from receiving its benefits.

2) free-rider problem

because exclusion principle does not apply

The inability of potential providers of an economically desirable but indivisible good or service to obtain payment from those who benefit because the exclusion principle is not applicable.

3) indivisible good / nonrival

b. examples

1) lighthouse
2) national defense
3) immunizations
4) street lights
5) insect and flood control

c. markets and inefficiency

RESULT:
  • an UNDERallocation of resources
  • too little (none) will be produced without the government

d. role of government:
allocating resources to public goods

e. Are the following public goods? If not why does the government provide them?

1) public education
2) public parks
3) public libraries

 

F. Stabilization

1. unemployment
2. inflation
3. role of government
a. fiscal policy
b. monetary policy

IV. Government Finance

A. Federal Expenditures
1. pensions and income security
2. national defense
3. health
4. interest on the public debt
5. other

B. Federal Tax Revenues

1. personal income tax
2. payroll taxes
3. corporate income tax
4. excise taxes

C. State and Local Finance

1. state expenditures and receipts
2. local expenditures an receipts

D. Personal Income Tax

1. Fed. Income Tax Rates
http://www.irs.gov (search for "tax schedule")
TAX TABLE: http://www.irs.gov/prod/forms_pubs/graphics/10311g75.gif
TAX SCHEDULE: http://www.irs.gov/prod/forms_pubs/graphics/10311g87.gif
  • marginal tax rates
  • average tax rate

2. What is fair?

  • Progressive tax
  • Proportional tax
  • Regressive tax

 

E. Government Growth

1. ways to measure government size
2. purchases vs. transfer payments
(exhaustive and nonexhaustive expenditures)
3. growth of government expenditures
a. correcting for inflation
b. compared to other sectors
c. growth of transfer payments