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Microeconomic

Dr. Karim Kobeissi

Chapter 4: The Role of Government

Why Does the Government


Intervene?
The free market is not always able to achieve
allocative efficiency. Accordingly, we have a Market
Failure.
An allocative efficient point is where
All resources are allocated to their most efficient use
All markets are in equilibrium
The economy is operating on its production possibility curve.
It is not possible to make someone better off without making someone
else worse off (Societys well being is maximised)
This situation is also called Pareto efficiency

Market failure provides governments with the


reason

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.

Government redistributes income using:


A progressive income tax system.
Collect taxes from income earners at a progressive tax rate.

Transfer payments.
Provide payments to individuals for which no current goods
and services are exchanged.

Provides a minimum amount of merit goods.

Merit good: Goods or services (such as education and


vaccination) provided free for the benefit of the entire society
by a government, because they would be under-provided if
left
to
the
market
forces
or
private
enterprise.

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.

When externalities are present, market


prices are not a valid measure of a
goods value to society.

Correcting for Externalities


Positive Externality

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

Correcting for Externalities


Negative Externality
Third parties are hurt
because
of
a
market
transaction.
Too much is produced and
sold at price p1 because
societys costs are greater
than market costs.
Government steps in to
shift costs from society to
the producer and the buyer.
Rising costs cause the
supply curve to shift
left.
Government action causes
less to be produced and
sold at a higher price p2.
Example: pollution.

Price of
polluting good D

Social
supply

Market
supply

p2
p1

Quantity
Optimal q2 q1
output
Market output

Correcting for Externalities


Negative Externality

Third parties suffer


because of a market
transaction.
Too much is produced
and sold at price p2
because
societys
benefits are less than
market benefits.
Government steps in to
reduce benefits for
market .
Government
action
causes less to be
produced by restricting
production
or
purchase.
Example:
cigarette

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 good: a good or service


whose consumption by one person
does not exclude consumption by
others.
A public highway

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.

Range of Government Interventions


Method
Subsidy

Sales Tax

Income Tax
Regulations
Transfer
Payments
Public
Ownership/
Provision

Effect/ what it is Best for:


Lowers the cost of
production
Increases the cost of
production
Reduces Incomes

More direct effect


than taxes or
subsidies
Redistribution of
incomes from rich to
poor
Situations where its not
socially desirable for
provision to be in private
ownership. Providing
G&S not sufficiently
provided by the free

Lowering the price to encourage the


production and use of certain products.
More resources are allocated to a
good/service than would be provided by
the free
market.
Raises
the
price to discourage the
production and use of certain products.
Pay for some of the costs imposed on
society as a result of the product being
consumed
Reduces demand. Progressive taxation
narrows the gap between rich and poor
and reduces inequality of income
Limit or prohibit the production or
consumption of certain products.
Enforce the production or
consumption
of certain
productsin form
Addressing income
inequality
of social welfare benefits and income
support.
Army, Police
Libraries, parks, Rubbish
collection, Education

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.

Increase our capacity to produce.


Economic growth.

Government uses macroeconomic policies


in an attempt to meet these goals.

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.

Outflows (uses of funds).


Purchases of goods and services.
Payments for resources used.
Transfer payments.

Sources of Government Growth


Most of the growth is due to
transfer

payments,

defense

spending, and health programs.

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.

Social Security Tax


It is a regressive tax system.
As income rises, the tax rate falls.
Compared to those with lower incomes,
those with higher incomes:
Pay more taxes.
But pay a smaller 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.

A related question is: are we giving up


too many private-sector goods in order
to get those public services?
Is the opportunity cost too high?

Valuation of Costs and Benefits


Additional public-sector activity is
desirable only if the benefits from
that activity exceed its opportunity
costs of taxation.
How do we identify the benefits?
How do we enumerate the costs?
Whose values should be used to do this?

Public Choice: Benefit-Cost Analysis


Private-sector

Benefits and costs


usually accrue to the
same person.
Makes it easy to
compare the two and
make a decision.

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.

What Does Society Want Produced?


Can either the market based or the state-run
system, or a combination of the two, produce
the mix of output desired by society in
general?
A pure market system will not produce adequate
quantities of some goods.
A pure government system cannot determine the
mix of output desired by buyers and sellers.
By trial and error, a combination of the two
systems may arrive at the optimal mix of
goods produced.

The Economy Tomorrow


Right-sizing Government.
The optimal mix is X.
G1, G2, G3, and G4
indicate a wrong-sized
government, due to poor
benefit-cost analysis,
politics, and bureaucracy
power grabs.
Improvement is not likely
in the economy tomorrow.