ECON 201 Chapter 4 Outline PDF

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Julie Sivilay Econ 201 (Principles Microeconomics) The Micro Economy Today (14th Edition) - Bradley R. Schiller

The Role of Government Chapter 4 Outline Learning Objectives : 1. The nature and causes of market failure. 2. How the public sector has grown. 3. Which taxes finance state, local, and federal governments. 4. The meaning of government failure. I.

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INTRODUCTION A. Markets do work 1. Under what circumstances do markets fail? 2. How can government intervention help? 3. How much government intervention is desirable? MARKET FAILURE ● Optimal mix of output: The most desirable combination of output attainable with existing resources, technology, and social values - the one that maximizes our collective social utility. ● Market mechanism: The use of market prices and sales to signal desired outputs (or resource allocations). ○ If point X is the optimal, or best possible mix, all other output mixes must be suboptimal. ● Changes in market prices direct resources from one industry to another, moving us along the perimeter of the production possibilities curve. ● Market failure: situations where the market generates imperfect (suboptimal) outcomes - an imperfection in the market mechanism that prevents optimal outcomes. ○ If the invisible hand of the marketplace produces a mix of output that’s different from the one society most desires, then it has failed. ○ Market failure implies that the forces of supply and demand haven’t led us to the best point on the production possibilities curve. ○ Market failure establishes a basis for government intervention. 1. Causes of Market Failure a) The four specific sources of market failure are (1) Public goods. (2) Externalities. (3) Market power. (4) Inequity. B. Public Goods ● Private good: A good or service whose consumption by one person excludes consumption by others. 1. No Exclusion a) Public good: consumption of a public good by one person doesn’t preclude consumption of the same good by another person. 2. The Free-Rider Dilemma a) Free rider: An individual who reaps direct benefits from someone else’s purchase (consumption) of a public good.

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Julie Sivilay Econ 201 (Principles Microeconomics) The Micro Economy Today (14th Edition) - Bradley R. Schiller

b) The difference between public goods and private goods rests on technical considerations, not political philosophy. c) Public goods does not have the capability to exclude non payers. d) If public goods were marketed like private goods, everyone would wait for someone else to pay. e) In the PPC, demand of public goods will be hidden because nearly everyone will withhold demand, waiting for a free ride to Point A (optimal mix). 3. Underproduction of Public Goods a) In economics, the meaning of public goods refers only to those non excludable goods and services that must be consumed jointly, both by those who pay for them and those who don’t. b) Public goods (along with private goods) can be produced by either the government or the private sector. c) Problem: The market tends to underproduce public goods and overproduce private goods. C. Externalities ● Externalities: All costs or benefits of a market activity borne by a third party that is, by someone other than the immediate producer or consumer. ● Whenever externalities are present, market prices aren’t a valid measure of a good’s value to society. (So, the market will fail to produce the right mix of output.) ● The market will underproduce goods that yield external benefits and overproduce those that generate external costs. 1. External Costs a) External costs create a gap between market demand and social demand. Social demand = Market demand + or - Externalities 2. External Benefits a) If a product yields external benefits, the social demand is greater than the market demand. b) The market fails by (1) Overproducing goods that have external costs. (2) Underproducing goods that have external benefits. D. Market Power 1. Restricted Supply a) Monopoly: The only producer in a particular industry. b) Monopoly is the most severe form of market power. c) Market power: The ability to alter the market price of a good or service. d) Antitrust: Government intervention to alter market structure or prevent abuse of market power. e) Natural monopoly: Where a single firm can achieve economies of scale over the entire range of market output. E. Inequity 1. Taxes and Transfers

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Julie Sivilay Econ 201 (Principles Microeconomics) The Micro Economy Today (14th Edition) - Bradley R. Schiller

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a) The tax-and-transfer system is the principal mechanism for redistributing incomes. b) Transfer payments: Payments to individuals for which no current goods or services are exchanged, like Social Security, welfare, and unemployment benefits. 2. Merit goods a) Merit goods: A good or service society deems everyone is entitled to some minimal quantity of. (1) In-kind transfers: (e.g., food stamps, housing vouchers, Medicaid) (2) Cash transfers: (e.g., welfare checks, Social Security benefits). F. Macro Instability 1. The micro failures of the marketplace imply that we’re at the wrong point on the production possibilities curve or inequitably distributing the output produced. 2. Unemployment: The ability of labor force participants to find jobs. 3. Inflation: An increase in the average level of prices of goods and services. 4. The goal of macro intervention is to foster economic growth - to get us on the production possibilities curve (full employment), maintain a stable price level (price stability), and increase our capacity to produce (growth). GROWTH OF GOVERNMENT ● The potential micro and macro failures of the marketplace provide specific justifications for government intervention. A. Federal Growth 1. Direct Expenditure 2. Income Transfers a) Direct expenditure on goods and services absorbs real resources, but income transfers don’t. b) Income transfer effects are primarily distributional, not allocative. c) Distributional: The FOR WHOM question d) Allocative: the WHAT question e) Most of the growth in federal spending has come from increased income transfers, not purchases of goods and services. B. State and Local Growth TAXATION A. Federal Taxes 1. Income Taxes 2. Social Security Taxes 3. Corporate Taxes 4. Excise Taxes B. State and Local Revenues 1. Taxes GOVERNMENT FAILURE A. Perceptions of Government Failure B. Opportunity Cost 1. Efficiency: Are we getting as much service as we could from the resources we allocate to

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Julie Sivilay Econ 201 (Principles Microeconomics) The Micro Economy Today (14th Edition) - Bradley R. Schiller

government? 2. Opportunity cost: Are we giving up too any private sector goods in order to get those services? C. Valuation Problems D. Ballot Box Economics E. Public Choice Theory

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