Chapter 6Chapter 6Chapter 6Chapter 6

Government and the Economy

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

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Chapter ObjectivesChapter ObjectivesChapter ObjectivesChapter Objectives

• Public vs. private sector

• History of government intervention

• The Great Depression and the New Deal

• Era of government growth

• Deregulation

• The pluses and minuses of Government Action

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Private versus Public SectorsPrivate versus Public SectorsPrivate versus Public SectorsPrivate versus Public Sectors

• Economists generally believe that providing goods and services through the private sector is preferable to having it supplied by government. – Private sector includes privately owned

businesses and shareholder-owned corporations.

– Public sector includes the federal, state and local government.

• The public sector provides goods and services, collects taxes, and regulates industry.

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Private versus Public SectorsPrivate versus Public SectorsPrivate versus Public SectorsPrivate versus Public Sectors

• How large the public sector should be and what goods and services it should provide are the subject of heated debate among economists.

• Controversial questions include:– Should the government or the private sector

be the main provider of health care?– Should the government regulate the gas

mileage of automobiles?– Should passenger trains be funded and

operated by the government?

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The Changing Role of The Changing Role of GovernmentGovernment

The Changing Role of The Changing Role of GovernmentGovernment

• Today, the government plays a large role in the economy.

• But 80 years ago, the role of the government was much smaller.

• The change in the government’s role occurred during the Great Depression, beginning in 1929.

• Economic conditions were so bad that people began to look to the government for help.

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The Great Depression and the The Great Depression and the New DealNew Deal

The Great Depression and the The Great Depression and the New DealNew Deal

• Because of the Great Depression, businesses and voters demanded that the federal government do something to stimulate the economy.

• The Roosevelt Administration proposed a series of programs called the New Deal.

• Many of the New Deal programs are still with us today.

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Programs Created During the Programs Created During the New DealNew Deal

Programs Created During the Programs Created During the New DealNew Deal

Program What it does today

Social Security Financial support for elderly

Unemployment insurance Financial support for unemployed

Securities and Exchange Commission

Protection for stock investors

Federal Deposit Insurance Protection for bank deposits

Federal minimum wage Minimum wage for workers

Ban on Child Labor Restrictions on child labor

Welfare for dependent mothers and children

Financial support for poor families

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Era of Government GrowthEra of Government GrowthEra of Government GrowthEra of Government Growth

• After World War II and during the decades of the 1950s, 1960s, and 1970s the role of government gradually expanded.

• This occurred during both Democratic and Republican administrations.– The Interstate highway program was started

during the term of President Eisenhower.– The space program was started during the

term of President Kennedy.

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Era of DeregulationEra of DeregulationEra of DeregulationEra of Deregulation

• Beginning in the mid-1970s, the public began to feel the role played by government in the economy had grown too far.

• The mid-1970s was the start of the era of deregulation, when the role of government in the economy was reduced.

• Deregulation is defined as reduction of government control over particular industries.

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Era of DeregulationEra of DeregulationEra of DeregulationEra of Deregulation

• President Carter began the move toward deregulation when he rolled back government oversight of the airline and trucking industries.

• The deregulation movement got into full swing during the term of President Reagan.

• The goal of the deregulation movement was to restrict the role of the government in the economy and reduce government spending and employment.

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Era of DeregulationEra of DeregulationEra of DeregulationEra of Deregulation

• The philosophy under the Reagan Administration shifted to the less government, the better.

• Despite the anti-government movement, the role of the public sector in today’s economy remains very significant, and much higher than the pre-Depression level.

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Comparing Government Spending in Comparing Government Spending in Different CountriesDifferent Countries

Comparing Government Spending in Comparing Government Spending in Different CountriesDifferent Countries

In comparison to other countries, role of the public sector in the US economy is relatively small.

0

10

20

30

40

50

60

Korea

Japa

n

United

Sta

tes

Canad

a

Spain

Germ

any

United

King

dom

Franc

e

Sweden

Government outlays as percent of GDP

Per

cent

of G

DP

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The Pluses of Government ActionThe Pluses of Government ActionThe Pluses of Government ActionThe Pluses of Government Action

• Need role for government to protect against external threats.

• Goal of giving everyone at least a high school education (through public schools) achieved by government action.

• Government plays key role in encouraging technological change by funding basic research.

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The Pluses of Government ActionThe Pluses of Government ActionThe Pluses of Government ActionThe Pluses of Government Action

• Government plays a key role in managing global trade by establishing trade agreements.

• Government plays a key role in supervising and regulating the financial markets.

• Government action is required when there are deficiencies in private markets (market failure).– An example of a market failure is pollution.

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Downsides of Government ActionDownsides of Government ActionDownsides of Government ActionDownsides of Government Action

• There are several problems with government intervention in the economy.– First, public sector managers face an

incentive problem, since there isn’t a need to make a profit.

– Second, government often suffers from a lack of flexibility and innovation.

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Downsides of Government ActionDownsides of Government ActionDownsides of Government ActionDownsides of Government Action

– Third, the bigger the role that the government plays in the economy, the more it pays for businesses and individuals to lobby public officials.

• Lobbying is what economists call rent-seeking behavior.

• Rent-seeking behavior means that companies spend money trying to influence the government, rather than cutting costs or improving products.

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Downsides of Government ActionDownsides of Government ActionDownsides of Government ActionDownsides of Government Action

– Finally, the main argument against government intervention has to do with the inefficiency of taxation.

• The imposition of a tax means the seller receives less than the buyer pays.

• Since sellers receive less than in a competitive market, they reduce their quantity supplied.

• Buyers also reduce their quantity demanded, since they pay more.

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Inefficiency of TaxesInefficiency of TaxesInefficiency of TaxesInefficiency of Taxes

Market demand curve

Pre-tax quantity

Pre-tax price paid by buyers and received by sellers

Price of chairs

After-tax quantity

Quantity of chairs

Market supply curve

After-tax price paid by buyers

After-tax price received by sellers

Tax of $20 per chair

A

B

C

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Role for Government Economic Role for Government Economic PolicyPolicy

Role for Government Economic Role for Government Economic PolicyPolicy

• In cases of market failures and where the pluses of government actions are greater than the minuses, there is a role for government intervention.

• One can justify government intervention in the following:– Public good provision, market regulation,

externalities, and income redistribution.

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Public Goods ProvisionPublic Goods ProvisionPublic Goods ProvisionPublic Goods Provision

• Public goods benefit many people in a city, region, or country to some degree.

• In contrast, private goods only benefit the buyer and his or her family.

• Public goods include national defense, police and fire protection, the road system, primary and secondary education, and public health efforts such as clean water.

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Public Goods ProvisionPublic Goods ProvisionPublic Goods ProvisionPublic Goods Provision

• Public goods face the free rider problem.

• People benefit from public goods even if they don’t pay for them. Thus, they get a free ride from everyone else’s contribution.

• Government can solve the free rider problem by forcing everyone to pay through taxes.

• One of the most important public goods provided by government is basic research.

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Market RegulationMarket RegulationMarket RegulationMarket Regulation

• Government sets the rules for market competition.

• While markets in theory could set their own rules, it is easier and more workable for the government to set them.

• Government regulators monitor the safety of products from autos to drugs, protect consumers against defective products, watch the financial system, etc.

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Example of Government AgenciesExample of Government AgenciesExample of Government AgenciesExample of Government Agencies

• Federal Trade Commission (FTC) and Department of Justice (DOJ) are responsible for enforcing antitrust laws.

• Antitrust laws make sure companies don’t unfairly try to get market power or reduce the amount of competition in a market or industry.

• They must approve mergers and acquisitions that companies make, and watch for signs of price-fixing.

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ExternalitiesExternalitiesExternalitiesExternalities

• An externality is the secondary impact that market transactions can have on others.

• With externalities, the benefit achieved from a market economy may break down (market failure).

• Externalities can be either positive or negative.

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ExternalitiesExternalitiesExternalitiesExternalities

• An example of a negative externality is pollution.– A factory that emits dangerous fumes is

imposing a negative externality on the nearby community.

• Positive externalities come about when your actions benefit other people.

• A network externality means that your decision to use a network affects the value of that network to other people.

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Income RedistributionIncome RedistributionIncome RedistributionIncome Redistribution

• An important economic function of government is income redistribution - the shifting of money from rich to poor in order to narrow big income differences. – This is accomplished through the tax system and

through government programs such as Medicare.

• The role that government should play in helping the poor is a controversial economic policy issue.