The Role of GovernmentChapter 4

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

4-2

Government’s Role

• When markets fail government intervention may be needed– Under what circumstances do markets fail?– How can government intervention help?– How much government intervention is desirable?

4-3

Market Failure

• Ideally, the market mechanism leads to an optimal mix of output

• Optimal mix of output: The most desirable combination of output attainable with existing resources, technology and social values

4-4

Market Failure

• The market mechanism uses market prices and sales to signal desired outputs (or resource allocations)

• Market failure: An imperfection in the market mechanism that prevents optimal outcomes

4-5

Market Failure

• When there is market failure the forces of supply and demand don’t lead to the optimal point on the production possibilities curve

• There is a basis for government intervention to push market outcomes closer to the ideal

4-6

Market Failure

All Other Goods (units per time period)

Co

mp

ute

rs (

un

its

per

tim

e p

erio

d)

Production possibilities

M (Market mix)

X (Optimal mix)

4-7

Causes of Market Failure

• The four specific sources of market failure are:– Public goods– Externalities– Market power– Equity

4-8

Public Goods

• Private good: A good or service whose consumption by one person excludes consumption by others

• Public good: A good or service whose consumption by one person does not exclude consumption by others

4-9

The Free-Rider Dilemma

• The communal nature of public goods may cause some consumers to try for a free ride

• Free rider: An individual who reaps direct benefits from someone else’s purchase (consumption) of a public good

4-10

Underproduction of Public Goods

• If public goods were marketed like private goods, everyone would wait for someone else to pay

• Consequently, the market under-produces public goods and over-produces private goods

• Need government intervention to remedy

4-11

Externalities

• Externalities: Costs (or benefits) of a market activity borne by a third party; 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 good’s value to society

4-12

External Costs and Benefits

– Subtract external costs, a negative impact– Add external benefits, a positive impact

• The optimal production mix is where the social demand curve intersects the supply curve

Social Demand Market Demand Externalities

4-13

Externalities

Quantity of Cigarettes (packs per year)

Pri

ce (p

er p

ack)

Market supply

Market demand

Social demand

EM

qM

EO

qO

External cost per pack

Market output

Optimal output

4-14

External Costs and Benefits

• The market fails by:– Over-producing goods that have external costs– Under-producing goods that have external benefits

• To move toward the optimal mix, we need government intervention

4-15

Market Power

• The market may fail when the response to price signals is flawed, rather than the signals themselves

• Market power: The ability to alter the market price of a good or service

4-16

Restricted Supply

• Market power gives a producer the ability to maximize profits rather than produce the optimal mix of output

• Monopoly: A firm that produces the entire market supply of a particular good or service

4-17

Antitrust Policy

• Government intervention is necessary to prevent or dismantle concentrations of market power

• Antitrust: Government intervention to alter market structure or prevent abuse of market power

4-18

Natural Monopoly

• A monopoly structure may be desirable

• Natural monopoly: An industry in which one firm can achieve economies of scale over the entire range of market supply

• Government may need to regulate the behavior of a natural monopoly

4-19

Inequity

• The marketplace distribution of goods and services is not necessarily “fair”

• Taxes and transfers are the principal tools for redistributing income

• Transfer Payments: Payments to individuals for which no current goods or services are exchanged

4-20

Merit Goods

• Merit good: A good or service society deems everyone is entitled to some minimal quantity of

• Government steps in to provide merit goods when market outcomes are inadequate

4-21

Macro Instability

• Micro market failures imply we are at the wrong point on the production-possibilities curve or inequitably distributing output

• The marketplace also experiences bouts of unemployment and inflation, which require government intervention at the macro level

4-22

Macro Instability

• Unemployment: The inability of labor-force participants to find jobs

• Inflation: An increase in the average level of prices of goods and services

4-23

Macro Instability

• The goal of macro intervention is to foster economic growth– Achieve full employment– Maintain stable prices– Increase production capacity

4-24

Growth of Government

• Potential micro and macro market failures justify government intervention

• The public sector has increased dramatically– In 1902 the U.S. government employed fewer than

350,000 people and spent only $650 million– Today the federal government employs nearly 4

million people and spends about $4 trillion a year

4-25

Federal Growth

• Although the absolute size of government has grown, the relative size of government – direct expenditures on government purchases as a share of total output – has declined

• Virtually all recent growth in overall federal expenditures has come from increased income transfers, not purchases of goods and services

4-26

Government Growth

During World War II the public sector purchased nearly half of total U.S. output. Since the early 1950s the public-sector share of total output has been closer to 20 percent.

Source: U.S. Bureau of Economic Analysis

4-27

State and Local Growth

• The share of public-sector spending attributed to different levels of government has changed– State and local spending dominated until World

War II, when the federal share overtook it– In the 1960s state and local spending caught up– Today state and local governments buy much more

output and employ many more people

4-28

Taxation

• The opportunity cost of government spending is the private-sector output sacrificed

• The primary function of taxes is to transfer command over resources (purchasing power) from the private sector to the public sector

4-29

Federal Taxes

• Federal government revenue sources include– Income taxes– Social security taxes– Corporate taxes– Excise taxes

4-30

Income Taxes

• Individual income taxes are the largest single source of federal government revenue

• Progressive tax: A tax system in which tax rates rise as incomes rise

• People with high incomes pay more taxes and pay a larger fraction of their income in taxes

4-31

Social Security Taxes

• Current workers transfer a portion of earnings to retirees through mandatory deductions

• The social security tax is proportional up to a certain income ceiling and regressive after that– Proportional tax: A tax that levies the same rate

on every dollar of income– Regressive tax: A tax system in which tax rates

fall as income rises

4-32

Corporate Taxes

• The federal government taxes the profits of corporations as well as consumer incomes

• Corporate taxes are a relatively small source of revenue

4-33

Excise Taxes

• Excise taxes are imposed on certain goods and services, including such things as liquor, gasoline, and cigarettes

• Excise taxes discourage production and consumption of these goods

4-34

Federal Taxes

Source: Office of Management and Budget, FY2010 data

4-35

State and Local Revenues

• In general, cities depend heavily on property taxes and state governments rely heavily on sales taxes

• State and local taxes tend to be regressive

4-36

Government Failure

• The goal of government intervention is to change the mix of output

• Government failure: Government intervention that fails to improve economic outcomes

4-37

Perceptions of Waste

• Government waste is when the public sector isn’t producing as many services as it could with given resources

• Such inefficiency implies production inside the production-possibilities curve

4-38

Opportunity Cost

• The issue of government waste encompasses two distinct questions:– Efficiency: Are we getting as much as we could

from the resources we allocate to government?– Opportunity cost: Are we giving up too many

private-sector goods in order to get those services?

4-39

Cost-Benefit Analysis

• Additional public-sector activity is desirable only if the benefits from that activity exceed the opportunity costs

• The value (benefits) of public services must be estimated because they don’t have (reliable) market prices

4-40

Ballot-Box Economics

• Voting mechanisms substitute for the market mechanism in allocating resources to the public sector and deciding how to use them

• We do not know what the real demand for public goods is, and votes alone do not reflect the intensity of individual demands

4-41

Public Choice Theory

• Public choice: Theory of public-sector behavior emphasizing rational self-interest of decision-makers and voters

• A central tenet of public-choice theory is that bureaucrats are just as selfish (utility maximizing) as everyone else

The Role of GovernmentEnd of Chapter 4

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin