Government and the market economy

The limits of markets

Free market does not always achieve the most desirable economic and social outcomes
Under a completely free market (laissez-faire) system, some important community needs and wants may not be
satisfied
Market failure occurs when the price mechanism takes into account private benefits and costs of production to
consumers and producers, but if fails to take into account indirect costs such as environmental damage

Market failure in the provision of goods and services

Market fail to provide certain necessary goods and services or it may be more desirable that they are not
provided by the private sector
Public goods are an area of market failure
o Good that, once provided, is difficult to prevent anyone from using regardless of whether they pay for it
o E.g. Street lighting, national defence, public parks
o They are non-excludable and will attract free riders who will benefit from them with contributing for the
costs so there is no incentive for producers to produce them
o As a result, free market would results in an undersupply of the goods so the government provides them
o They are non-rival as one persons enjoyments of a public good does not diminish the potential for others to
enjoy the good
o E.g. If government reduces pollution, everyone will enjoy cleaner air and one persons enjoyment will not
diminish another persons. Other examples include lighting and public broadcasting
Merit goods may be under produced
o Goods that have benefits that go beyond the individual who enjoys them directly
o E.g. Health care and Opera house are considered to be merit goods that benefit the whole society
o Government can provide good directly (by operating or providing the good) or in directly (through funding)
Demerit goods may be over produced
o Items that bring harm to community e.g. Alcohol, addictive drugs and gambling
o Their sale is restricted, heavily taxed or completely prohibited
Collective goods benefit the whole community
o Provided by the government because they would not be provided otherwise or they may not be desirable in
the hands of the private sector
o E.g. Defence force and public transport
Natural monopolies may be operate by government
o When goods can only be efficiently provided by one supplier, usually because an enormous investment
infrastructure is required and only occurs when it is inefficient for competition to operate
o E.g. Rail networks, Water and electricity distribution networks
o Governments operate natural monopolies as private companies would take advantage of consumers

Market failure in income distribution

Free markets creates income inequality which will widen over time as wealth generates more wealth
Disadvantages groups are susceptible to income inequality and relative poverty
o E.g. Low education levels, Indigenous Australians and single parent families
Almost no people in absolute poverty
Inequality can become entrenched in an economy as it create cycle of poverty
o E.g. Children is low-income families receive less opportunities and become low income earners themselves
Government cannot remove all factors that contribute to inequality but can improve opportunities for
disadvantaged groups
o E.g. Universal access to free education until completion of high school, living allowances for students
o These measures improve social mobility
After WW2 Australia developed welfare state- comprehensive system of welfare benefits such as aged pension,
unemployment benefits, free health care and subsidised access to other government services
Increased in second half of 20th century due to ageing population however by 1980s public backlash. Saying that
people who make no contribution deserve no government benefits. led to reduction in welfare benefits
Market failure in externalities
Free market does not take into account for any side-effects that are not directly reflected in the price mechanism
Externalities are external costs and benefits thats private agents in a market do not consider in their decision
making process
Externalities are a form of market failure as they occur when the price mechanism fails to represent the true
social costs or benefits of production
Positive externalities
o Deliver benefits to third parties
o E.g. Increased labour productivity from increased university completion rates benefits whole economy
Negative externalities
o Have negative impact on the economy and on society
o Common form is pollution when natural environment is degraded
E.g. Manufacturers may dump chemical waste illegally as it is cheaper but do not take into account
harmful effects on environment
o Environmental damage is one of the most important negative externalities of the operation of the free market

Market failure in abuse of market power

Due to high cost in producing, distributing and marketing goods and services in some markets, only a few firms
can survive
Leads to market structure with imperfect competition - Monopoly, Oligopoly and Monopolistic competition
Firms in highly concentrated markers possess substantial market power and can exploit consumers
o Monopolisation occurs when firms use their dominant market power position to eliminate existing
competition or prevent new firms from entering the market
E.g. A firm might engage in temporary price cutting to eliminate competition rather than benefiting
consumers
o Price discrimination occurs when a firm sells the same type of good or service in different markets at
different prices
E.g. peak and off peak pricing for telephone calls and early bird prices for airline ticket
Firms will attempt to charge higher prices to those who are more willing and able to pay and vice versa
o Exclusive dealing occurs when a firms sets conditions for supply that exclude retailers from dealing with
other competitors
Under Competition and Consumers Act 2010 exclusive dealing is prohibited
o Collusion and market sharing occurs when firms get together and agree on a pricing and market sharing
arrangement (often known as a cartel) that reduces effective competition between them and tends to inhibit
the entry of new competition into the market

Market instability: the business cycle

Business cycle describes tendency of economic growth rates to fluctuate between boom and bust periods
Without government intervention, free market economy is likely to experience severe fluctuations
Boom periods can create high inflation which can distort business decisions, reduce purchasing power and force
increase in interest rates
Which leads to recessions which increase unemployment, business failures and other problems
These fluctuations make it difficult for government to achieve sustained economic growth
In order to achieve sustained economic growth without high inflation or unemployment, government uses
economic stabilisation or macroeconomic policies including fiscal and monetary policy
Aim is to provide counter balance to business cycle to stabilise economic growth
During periods of excessive growth with risk of inflation
o Government tries to reduce economic growth by spending less, increase taxation or raising interest rates
o Government slows down a fast growth rate to keep it growing for longer
During recession,
o Government tries to stimulate growth with increased government spending, tax cuts and lower interest rates
By doing this government smooths fluctuations in business cycle and promotes long term sustainable growth
Government also uses microeconomic policies to improve work practices and productivity levels at the level of
individual firms and industries
The role of government in Australia
The structure of government
Commonwealth (or federal) government has overall responsibility for economy and largest influence on
economic performance
State governments which play important roles in developing infrastructure, delivering government services (such
as health and education) and fostering regional development
Local governments which play relatively minor role, mainly relating to local community facilities and roads
Under Australian constitution, Federal and State government are independent of each other but often work
together while state governments further delegate powers to local government
Australia constitution sets out law-making powers of the Commonwealth and State governments
o Sets out absolute limits on what governments are able to do
o Commonwealth government can only act of constitutional heads of power including power to make laws
relating to foreign affairs, defence and currency
o State government holds all other powers that are not indicated as belonging to federal government
o State responsible for public order and safety but main role is to provide government services such as health
care, school education and roads and also responsible for events with specific regional focus
o Commonwealth and state share responsibilities for most economic matters e.g. business regulation, health,
education and taxation
Commonwealth government powers has gradually increase over years
o Reflects evolution of Australia into single national economy with national approach to economic issues such
as business regulation and taxation
o High courts expansive interpretation of heads of power allows Commonwealth to become more powerful
Over time states have handed power over to commonwealth
o State government still play important roles as for economic reform to occurs, commonwealth needs support
of six state governments which leads to extensive negotiations
State governments have more limited role and their importance to the economy has decline over time
o Remain important as they understand specific needs of cities and regions and have responsibility to provide
government services
o Main constraint is limited access to funds
Rely of patchwork of payroll tax, stamp duty, licenses, taxes on gambling and land ownership
Revenue from direct grants given from Commonwealth government e.g. redistribution of GST revenue
o Commonwealth is commonly providing funding for services in areas that have traditionally belonged to state
governments such as education, health services and roads
o Commonwealth has increased involvement in these areas through Council of Australian Governments (COAG)
Local governments are responsible:
o Local planning and development decisions
o Providing local services such as rubbish collection and road building and maintenance
o Providing community facilities such as parks and libraries
o Main source of revenue is rates levied of local property owners
o Grants from state and federal government make up quarters of their funding
o Funds also raised by fees, licences and fines imposed by council

Size of public sector

Public sector refers to the parts of the economy that are owned or controlled by the government. It includes all tiers
of the economy and government business enterprises
Total public sector outlay shows the proportion of total annual expenditure by all levels of government
compared with expenditure for the economy as a whole
o Total public sector outlay as a percentage of GDP has increased steadily since 1949-50
o Public sector outlay has remained in range of 35-42% of GDP since 1979-80
o Public sector is relatively small compared with other industrialised economies, especially Europe
o Public sector outlay increased sharply in 2007-08 and 2009-10 in response to GFC
Reflects fact that public sector outlay increase in response to downturns in economic activity
o Government spending has shifted from infrastructure to social welfare payments and community services
Social welfare payments make up 1/3 of Commonwealth government expenditure
 Proportion of Australian employees who work in public sector is another measure of public sector size
o Employment in public sector grew with public sector outlay, peaking at 25.5% in 1985
o Since 1985, Employment in public sector has declined despite public sector outlay remaining similar
Due to government contracting out many of their activities to private sector
Change in approach to economic management
o Keynesian theory argued government spending could accelerate economic activity and achieve full
employment and was dominant in 1940s -1970s after WW2
o Though became unpopular in 1980 so government started reducing spending as high government spending
required high taxation levels and excessive borrowing from private sector
o However Keynesian theory was used again in 2007-08 GFC as governments tried to use increase government
spending to stabilise business cycle and support financial institutions that were at risk of collapse
o Rapid increase helped Australia avoid recession however fall in taxation revenue has led to budget deficits
Provision of government services
o As economy has grown and living standards have improved, community has higher expectations of
government to provide improved health care, educations and other government services
o Increased concentration of population in large cities have increased demand for community services
o Government also has to deal with problems of economic activity such as pollution and depletion of resources
Growth of social security
o After establishment, Commonwealth government introduced welfare and social security programs
o People wanted to create welfare state where welfare would support people from childhood to old age
o Cost of programs increased as unemployment rate rise and population aged so government started reducing
welfare benefits by giving benefits who need it most
o Growth in welfare stopped in 1980s and since there has been tighter government spending due to pressures
to eliminate budget deficits and decrease taxation levels
o As a results government has tightened access to welfare payments and introduced superannuation to reduce
retirees reliance on aged pension
o However public sector may grow due to pressures to spends on health care, defence and economic crises

Reallocation of resources

Government can affect the allocation of resources in two main ways:

By influencing the way businesses and consumers behave in the market through taxation or spending measures
By producing goods and services itself (e.g. public goods)

Taxation
As taxes add to cost of goods and services, they divert resources away
While reducing rate of tax or tax concession can attract resources
Direct taxes
o Those that are paid the individual or firm on which they are levied i.e. they cannot be passed on to someone
o E.g. Personal Income tax, company tax and capital gains tax
Indirect taxes
o Those that are levied on individuals and business firms but can be passed on to someone else
o Indirect taxes are attach to good or service rather than individual or company
o E.g. Goods and services tax (GST)
Government uses indirect taxes on items such as tobacco and petrol to divert resources away from them

Spending
Can be used to directly reallocate resources to a particular sector of the economy
Can influence the decisions of consumers and business
Government pay provide:
o Funding for the arts, which otherwise may be unprofitable
o Grants for start-up businesses or new growth industries may lack access to finance
o Subsidies for telecommunication companies such as Telstra to provide broadband service in regional areas
where those service would not be profitable
o Cash payments to private employment search business which find jobs for unemployed people
Government provision of goods and services
Governments involve themselves directly in the production process to achieve a better allocation of resources
Attitudes that government could operate businesses better than private sector have shifted to attitudes that
government were inefficient in operating their enterprises
o As a result, government has largely privatises GBEs and reduced direct involvement in production process

Redistribution of income
Taxation
A tax is a compulsory levy imposed by the government. By taxing individuals and businesses and using some or
all of these funds to provide welfare payments, government is redistributing income and in doing so reducing
income inequality
Types of taxes
o PAYG (pay as you go) tax - Income tax levied on individuals
o Company tax - Income tax levied on companies
o Excise duty - tax on manufacturing of tobacco, alcohol and fuel
o GST (goods and services tax) - levied on the consumption of goods and services
o Capital gains tax - tax on the profit resulting in the sale of certain assets such as investment property
o Stamp duty - tax on the purchase of certain assets such as property
o Fringe benefits tax - tax applied to non-cash benefits paid to employees such as company cars
Tax base refers to items that are taxed
o Income based on an individuals businesss income e.g. PAYG (income) tax
o Consumption based on the purchase of goods and services e.g. GST
o Wealth based on an increase in an individuals wealth e.g. Capital gains tax
A specific tax is a tax based on the volume of good regardless of its price e.g. $0.2026 per stick tax on cigarettes
An ad valorem tax is expressed as a % of the price of a good e.g. GST of 10%
A direct tax is paid directly by the tax payer to the government e.g. income tax
An indirect tax is paid indirectly through retailers and passed on to consumers e.g. Excise tax is initially imposed
on manufacturers who pass it on to retailers who then pass it on to consumer
The impact of a tax is the person or business on whom it was initially levied
The incidence of a tax is who ends up paying it e.g.
o For income tax, the impact and incidence is the same as the income taxpayer cannot pass it on
o For GST, the impact is on the seller but the incidence is the consumer it is passed on in higher prices
The average rate of tax (ART) is the proportion of total income earned that is paid in the form of tax
The marginal rate of tax (MRT) is the proportion (the number of cents in the dollar) that must be paid in tax on
the next dollar earned
The tax free threshold is the income level below which no tax is paid (currently $18,200 for PAYG)
A progressive tax claims and increasing proportion of income and income rises (ART rises) e.g. PAYG
A proportional tax claims a constant proportion of income as income rises (ART constant) e.g. Company tax 30%
A regressive tax claims a decreasing proportion of income as income rises (ART falls) e.g. GST

Calculating PAYG tax

Calculating taxable income
o Income earned - work related expenses = Taxable income
Calculating tax payable
o Find tax bracket for income, apply rule then add 2% of income for Medicare levy
Calculating tax refund or difference
o Tax paid - tax payable, if positive - tax refund, if negative - difference owed

Social welfare payments

Major policy instrument for reducing inequality, 1/3 of government expenditure each year
Payments are often means tested so high income earners may be ineligible to receive specific benefits
o Includes employment benefits, family benefits and various pensions
Largest area is aged pension which is increasing due to ageing population
Superannuation was introduced to stop retirees from becoming dependent on pensions
Impacts
 o Positives
Fairer distribution of income
Decreased income inequality
Provides a basic standard of living for disadvantaged people e.g. disabled, unemployed etc.
Decreases relative poverty
Increases government expenditure during low economic activity i.e. automatic stabilisers
Cushions downswing in the business cycle
Increases consumption
o Negative
Promotes welfare dependence
Issued of becoming intergenerational e.g. culture of welfare dependence
Lower socioeconomic group
Disincentive to attain further education skills
In long term, decrease labour productivity
Increases budget deficit or decrease budget surplus
Increase level of government borrowing
Increases public sector debt
Funds could have been spent elsewhere
Opportunity cost

Stabilisation of Economic activity

Policies designed to smooth fluctuations in the business cycle are called macroeconomic policies

Monetary policy
Main stabilising policy
Tightening monetary policy
o Puts upward pressure on interest rates
o interest rates = demand for money = consumer and investment spending = economic activity
o Aggregate demand = Inflationary pressures and cyclical unemployment
Loosening monetary policy
o Puts downward pressure on interest rates
o interest rates = demand for money = consumer and investment spending = economic activity
o Aggregate demand = Inflationary pressures and cyclical unemployment

Fiscal policy
Plays an important role through the direct effect of the governments overall level of spending, taxing and
borrowing in a year

Government business enterprises (GBEs)

Also known as public trading enterprises (PTEs)
Most have been sold off including Commonwealth Bank, Qantas, Federal airports, Medibank private etc.
o In these cases government has felt they would run more efficiently as private business enterprises
Many GBEs that have not been corporatized have been corporatized
o Despite being owned by government, they are run as private businesses with no government interference by
making managers independent and responsible for performance
Remaining GBEs include Australia Post, Australia Rail Track Corporation, utilities, CSIRO etc.
National Broadband Network is unusual example of a new large GBE
Reform the GBEs in past 15 years have significant improvement is prices and productivity in many industries
Other roles in the economy

Competition policy
o Government aims to promote workable competition in Australian Industry
Maximum level of competition compatible with the market structure and specific conditions of an industry
o Goal of increasing competition must be balanced against the goal of achieving economies of scale
So it may be necessary to reduce number of firms in an industry so remaining firms can produce on a
larger scale and enjoy the lowest possible long run average costs of production
o Workable competition policies aim to achieve situation where markers are contestable
Entry barriers to industries are minimal by eliminating business practices that reduce competition
o Competition and Consumer Act 2010 sets our code of behaviour for firms, that outlaws practices that reduce
competition and act is administrated by the Australian Competition and Consumer Commission (ACCC)
Consumer protection
o Consumer protection law prohibits anti-competitive practices and fines firms that break those laws
o Most consumer protection laws were grouped together in 2011 into Australian Consumer Law
o ACCC roles include:
Conducting inquiries into pricing structures
Recommending changes to industries
Giving a firm or industry negative publicity where it finds there is overcharging
o ACCC has hands off attitude where it only monitors industries prices unless there is evidence that the
industry lacks adequate competition
Environmental protection
o Deals with impacts of economic activity on environment to ensure environmental sustainability
o Government can support alternative energy resources by giving incentives to reduce use of fossil fuels
o Increasing awareness of climate change and long-term environmental impacts of economic development

Federal budget

Fiscal policy is a macroeconomic policy that can influence resource allocation, redistribute income and reduce the
fluctuations of the business cycle

Budget is tool of the government for the implementation of fiscal policy. Its shows the governments planned
expenditure and revenue for the next financial year

Revenue
Tax revenue (94%)
o Personal Income tax
Paid through PAYG
Progressive tax
o Company tax
Flat rate of 30% for net profit of private and public corporations
Proportional tax
o Tax on superannuation
Collected as a tax on superannuation on contributions
Like to grow substantially in the future
o Goods and services tax (GST)
Main indirect tax
10% on most items sold in Australia though basic food is exempt from GST
oExcise and customs duty (imposed on the producers of certain goods)
Based on quantity of product
Mainly placed on alcohol, petrol, diesel and tobacco as they have inelastic demand
o Other tax revenue
Mainly miscellaneous taxes, charges, fees and fines
Non-tax revenue (6%)
o Profit from GBEs and interest, dividends & royalties paid to government
Expenditure
Social security and welfare
o Largest portion of expenditure
o Transfer payments (payments aimed at redistributing income from tax payers to welfare recipients)
Education
o Funding to universities, vocational education and training providers as well as primary and secondary schools
Health
o Funds Medicare and pharmaceutical benefits scheme as well as contributes to funding for public hospitals
Provision of infrastructure or social overhead capital
o E.g. roads, rail, ports and communications networks
Protecting the environment and promoting ecologically sustainable development
o Small area of expenditure which includes investment in clean energy and low carbon emission technologies,
energy efficiency and better management of water resources

Impacts of budget

Budget/Fiscal Outcome
Balanced budget (revenue = expenditure)
Budget surplus (revenue > expenditure)
Budget deficit (revenue < expenditure)

Fiscal policy stance

Expansionary fiscal policy stance
o Larger budget deficit or smaller budget surplus
o Aims to increase level of economic activity by stimulating aggregate demand
o Should reduce unemployment but excessive growth leads to increase inflation
Contractionary fiscal policy stance
o Smaller budget deficit or larger budget surplus
o Should decrease economic activity by dampening aggregate demand
o Will reduce inflation but risks increasing unemployment if demand is reduced too much
Neutral fiscal policy stance
o Budget outcome remains unchanged i.e. no effect on economic activity or aggregate demand

Automatic stabilisers (PAYG income tax and social welfare payments)

Economic activity
o Income levels = Tax Revenue and Unemployment = Social welfare
o Leads to bigger surplus or smaller deficit = contraction in aggregate demand
Economic activity
o Income levels = Tax Revenue and Unemployment = Social welfare
o Leads to smaller surplus or larger deficit = Expansion in aggregate demand
Cyclical component of budget (Non-discretionary measures)
o Changes in budget outcomes are due to changes in level of economic activity
Structural component of budget (Discretionary measures)
o Key driver of fiscal policy stance is deliberate revenue and expenditure changes from government

Influences on government policies in Australia

Political parties
o For a bill to be passed through parliament it must be supported by a majority in both houses which includes
both government and opposition
Business
o Business groups have significant influence as successful and growing business are essential for prosperity in a
market economy
Unions
o Largest organisations by membership
o Represent members in consultations with governments on many policy issues
 Environmental groups/organisations
o Interest groups that advocated for environmental protection and involves themselves in debate for
environmental policy
Welfare agencies
o Seek to represent most disadvantaged people in the community in the form of lobby groups
Media
o Determine which issues receive coverage and how they are presented to public
o Government may pursue policies that will have positive media coverage or change policies that are likely to
face heavy criticism
Other interest groups
o People with common interest or concerns group together and raise issues
International
o Policies unpopular with international financial markets would cause a loss in confidence in government
Could lead to a fall in their exchange rates and then higher interest rates on government borrowing.
o International markets may force a change in government policies as seen in the 2008 GFC
o International policy trends affect Australian government policy