11/21/21, 5:06 PM The Economic Functions of Government

Chapter 5 - The Public Sector: The Role of Government

and
Government Finance
 Assignments

Chapter
5 - The Public Sector (Government): Role and Finance
(includes parts of chapters 5, 22W, 3,
and micro
Ch.16)

Reading Assignments:
Chapter 3: Application: Government-Set Prices pp.
61-64
Chapter 5: Public Goods; Externalities;
Government's Role in the Economy pp. 99-110
 The Role of Government found in Web Chapter
22W, pp. 12 -13 at: http://highered.mcgraw-
hill.com/sites/dl/free/0077337727/883829/mcc37727_ch22W_001_020.pdf
Microeconomics Chapter 16, pp 238-246 (Government
Finance; Federal Finance; State and Local
Finance;
Local, State, and Federal Employment; Apportioning the
Tax Burden; The VAT). Found
on our Blackboard
site.
Study Guide
Chapter 3
Multiple Choice: # 29, 30
Problems # 1, 7
Chapter 3 Appendix
Multiple Choice: # 9
Chapter 5
Multiple Choice: # 7, 8, 17-22
Problems # 6
Worked Problems: 16.1 at http://highered.mcgraw-
hill.com/sites/0077337735/student_view0/chapter16/worked_problems.html
Web Quizzes:
Chapter 3: #5-6 at http://highered.mcgraw-
hill.com/sites/0077337727/student_view0/chapter3/quiz.html
Chapter 5: #4-6, 9 at http://highered.mcgraw-
hill.com/sites/0077337727/student_view0/chapter5/quiz.html
Chapter Micro 16: #1, 2, 3, 5, 7, 9 at http://highered.mcgraw-
hill.com/sites/0077337735/student_view0/chapter16/quiz.html
End-of-Chapter Questions and Problems:

[The answers to the End-of-Chapter Questions and

Problems are on our class Blackboard site - see:
"TEXTBOOK SOLUTIONS".]
Chapter 3: Questions 11, 12; Problem 7
Chapter 5: Questions 1, 4, 5, 7, 8, 10

Outline
Introduction
Review : Supply, Demand, and Economic Efficiency
The Role of Government in a Market Economy
Review how market economies achieve allocative
efficiency [from the chapter 3 online lecture
(supply and
demand)]
Government Set Prices:
Sometimes governments
interfere and CAUSE allocative
INefficiency (from the end of chapter
3)
price ceilings
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price floors
Achieving the 5Es: Economic Functions of Government in a
Market (Capitalist) Economy
Providing the legal structure
Maintaining competition
Redistributing income
Reallocating resources
negative externalities
positive externalities
public goods and services
Promoting stability
Government's Role: A Qualification
Government Finance
Federal Expenditures and Tax Revenues
State and Local Expenditures and Tax Revenue
Income Taxes
The Growth of Government

Introduction

In this first unit we are learning fundamental economic principles

in the context of globalization and structural
adjustment. We have
learned that structural adjustment policies include:

Structural Adjustment Policies:

1. Privatization
2. Promotion of
Competition

3. Limited and Reoriented

Role for Government
4. Price Reform: Removing
Controls

5. Joining the World Economy (free

trade)
6. Macroeconomic Stability

In this chapter we will look in greater depth at two of these

policies

3. Limited and Reoriented Role

for Government
4. Price Reform: Removing
Controls

We have defined Structural Adjustment as a series of economic

policies designed to lessen the role of
government in an economy
moving it closer to a market economy. The goal of Structural
Adjustment Programs
(SAPs) is to reduce scarcity and increase
society's satisfaction, i.e. to satisfy more of their unlimited wants
and
achieve the 5Es.

In chapter 2 we discussed the characteristics of market economies

or capitalism:

Privatization
Promotion of Competition
Reduced Role of Government
Removing Price Controls
Freer Trade
Foreign Investment

Here we will concentrate on the Reduced Role

of Government characteristic. As countries move toward
capitalism they reduce the role that their governments play in their
economies.

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But just WHAT IS THE ECONOMIC ROLE OF GOVERNMENT IN A MARKET

ECONOMY?

As we address this issue in this chapter we will examine:

How governments sometimes interfere and CAUSE allocative

INefficiency (from the end of chapter 3)
What are the economic functions of government in a market
(capitalist) economy or what can
governments do to help the market
achieve the 5Es?
Government Finance (government spending and taxes)

REVIEW - Supply, Demand, and Economic Efficiency

In chapter 3 (demand and supply) we explained how market economies

achieve allocative efficiency. It would be
useful for you to review
that section near the end of that online lecture. (See:
http://www.harpercollege.edu/mhealy/eco212i/lectures/ch3-17.htm#efficiency.)

WHY ARE MARKETS EFFICIENT?

Businesses will produce the profit maximizing quantity. This is

the equilibrium quantity where Qd=Qs (see
graph below on the right).
This is WHAT WE GET.

Society wants the allocatively efficient quantity. This is the

quantity where MSB=MSC (see graph above on the
left). This is WHAT WE
WANT.

If there are no negative externalities (spillover or external

costs) the S = MSC, and if there are no positive
externalities
(spillover or external benefits) the D = MSB, Therefore: WHAT WE GET
= WHAT WE WANT
and self-interested, profit maximizing, businesses
will end up doing what is best for society - achieving
allocative
efficiency - as if there is some "invisible hand " guiding their
decisions.

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SUMMARY:

Businesses will produce the profit maximizing or market

equilibrium quantity - the quantity where
Qd=Qs; (this is
WHAT WE GET)

Society wants the allocatively efficient quantity - the

quantity where MSB=MSC ; (this is
WHAT WE WANT)

WHAT WE GET = WHAT WE WANT if:

Market Demand = Marginal Social Benefits (D=MSB)
(and this is true if there are no positive externalities
(spillover or external benefits))
Market Supply = Marginal Social Costs (S=MSC)
(and this is true if there are no negative externalities
(spillover or external costs))

THEREFORE if there are no negative externalities (spillover or

external costs) and no positive externalities
(spillover or external
benefits) competitive markets (capitalism) achieves allocative
efficiency.

WHAT WE GET = WHAT WE WANT

and profit maximizing businesses in market economies will produce

the allocatively efficient quantity.

This is the "invisible hand" of capitalism.

So, pure market economies usually achieve allocative efficiency

and therefore there is only a limited role for
government - why do we
need the government if the market is already maximizing our
satisfaction? If you think
about it, in the United States the
government does not do very much. The government does not produce our
food. It does not build our homes. It does not provide us with
electricity, nor heat, nor clothes, nor most of the

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important things
in our lives. But the government DOES provide public education,
public parks, public libraries,
military/defense, streets and
highways, US mail, etc.

WHY?

That is the goal of this chapter.

The Role of Government in a Market Economy

Before we look at how the economic functions of government help

society achieve the 5Es, we will first look at
some examples of
governments CAUSING INEFFICIENCY.

We noted above, and in chapter three, that usually the working of

demand and supply in market economies
produce an equilibrium price
that achieves allocative efficiency. This is one of the reasons why
countries around
the world are undertaking structural adjustment,
moving their economies toward capitalism by removing price
controls.
Here we will look at the negative effects of governments
controlling prices in market economies.

When governments set prices, it prevent the market from reaching

the equilibrium, and the allocatively efficient,
price and
quantity.

Price Ceilings

A price ceiling is the maximum legal (government

set) price that a seller may charge. The GOAL
of a price ceiling
is to LOWER the price. (The price cannot go through the ceiling.)
Therefore, an
effective price ceiling is set below the equilibrium
(and efficient) price. We will see below that if a
price ceiling
is set above the equilibrium price, it will have no effect.

What is the effect of a price ceiling? Look at the graph below.

Without the government this market
would result in an equilibrium
price of P1 and an equilibrium quantity of Q1. If there are no
externalities (we will discuss these soon) then P1 is the
allocatively efficient price (what we get =
what we want). If the
government decides that P1 is too high they may set a price
ceiling at Pc. This
means the at the highest legal price is Pc.
What will happen? At Pc the quantity demanded will be
Q2 and the
quantity supplied will be Qo. Therefore at the price of Pc there
will be a shortage of Q2-
Qo. Effective price ceilings cause
shortages. This is allocatively inefficient!

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Look at the graph below. The efficient quantity is Q1, this is

where MSB=MSC, the is
WHAT WE WANT but the quantity that
we get with the price ceiling is Qo since this will be the
quantity supplied by businesses at the price Pc. This is
WHAT WE GET. We get less than the
efficient quantity so
there is an UNDERALLOCATION of resources because at a price of Pc
the
MSB > MSC. An underallocation of resources means that
society is using too few resources on this
product or that society
would be happier if they produced more of this product an less of
something
else. Remember from chapter 1 that whenever MB>MC,
TOO LITTLE is being done.

If we look at a graph with numbers (see graph below) we see

that the equilibrium (and efficient)
price and quantity are $9 and
3000 pizzas. If a price ceiling of $6 is put on pizzas then the
quantity
that will be produce is 2000 since this is the quantity
supplied at $6. But at $6 the quantity
demanded is 5000, so there
will be a shortage of 3000 pizzas. Effective government price
ceilings
cause shortages and allocative inefficiency. 

The principle effect of an effective price ceiling is a

shortage and allocative inefficiency. A function
of prices is to
ration goods and services. Price ceilings counteract this function
so alternative
methods of rationing must be found to take the
places of the price mechanism. These may be formal
(rationing
coupons) or informal (lines at the pump) or black (illegal)
markets may emerge to satisfy
the unmet consumer demand.

What would happen if the price ceiling is put ABOVE the

equilibrium price? Assume that a price
ceiling of $12 is set on
pizzas. How many pizzas would be produced?

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3000 !
Why? Because if the legal MAXIMUM price is $12 it still allows
business to charge less. We
discussed in chapter 3 that business
want to maximize their profits so, if they can, they will charge
the equilibrium price and produce the equilibrium quantity ($9 and
3000). If there is a price ceiling
set at $12, business can still
charge less and since they want to maximize their profits, they
will. The
$12 price ceiling, set above the equilibrium price, has
no effect.

Examples of price ceilings

Even though price ceilings cause shortages (allocative

inefficiency) they do exist.
Government leaders either don't
understand the important role of free markets or their
constituents don't. Examples of price ceilings include:

Rent controls in large cities - intended to keep housing

affordable but resulting in
housing shortages.
Price controls during World War II like the one on
gasoline which prompted the
government to issue rationing
coupons.
Gasoline price controls in the 1970s which resulted in
"out of gasoline" signs at
gas stations or "5 gallon
limits".
Anti -price gouging laws after natural disasters like
the plywood in Florida
example that we have discussed
several times.
Many less developed countries would have price controls
on food. the idea was
to make food affordable to the poor,
but the result was - - a shortage of food.
What do we call a
shortage of food? FAMINE! Think about it. Millions of
people, mostly children, have died, slow painful deaths,
because government
leaders did not understand that price
ceilings create shortages.

Price Floors

A price floor is the minimum legal (government

set) price that a seller may charge. The GOAL of a
price floor is
to RAISE the price. (The price cannot go any lower or it cannot go
through the floor.)
Therefore, an effective price floor is set
above the equilibrium (and efficient) price. We will see
below
that if a price floor is set below the equilibrium price, it will
have no effect.

What is the effect of a price floor? Look at the graph below.

Without the government this market
would result in an equilibrium
price of P1 and an equilibrium quantity of Q1. If there are no
externalities (we will discuss these soon) then P1 is the
allocatively efficient price (what we get =
what we want). If the
government decides that P1 is too low they may set a price floor
at Pf. This
means the at the lowest legal price is Pf. What will
happen? At Pf the quantity demanded will be Qo
and the quantity
supplied will be Q2. Therefore at the price of Pf there will be a
surplus of Q2-Qo.
Effective price floors cause surpluses. This is
allocatively inefficient!

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Look at the graph below. The efficient quantity, where MSB=MSC,

is Q1 and the quantity that we
get with the price floor is Q2
since this will be the quantity supplied by businesses at the
price Pf.
We get more than the efficient quantity so there is an
OVERALLOCATION of resources. too much
is being produced because at
a price of Pf the MSB < MSC. Remember from chapter 1 that
whenever MB<MC, TOO MUCH is being done.

If we look at a graph with numbers (see graph below) we see

that the equilibrium (and efficient)
price an quantity are $9 and
3000 pizzas. If a price floor of $12 is put on pizzas then the
quantity
that will be produce is 4000 since this is the quantity
supplied at $12. But at $12 the quantity
demanded is 2000, so
there will be a surplus of 2000 pizzas Effective government price
floors cause
surpluses.

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What would happen if the price floor is put BELOW the

equilibrium price? Assume that a price
floor of $6 is set on
pizzas. How many pizzas would be produced?

3000 !
Why? Because if the legal MINIMUM price is $6 it still allows
business to charge more. We
discussed in chapter 3 that business
want to maximize their profits so, if they can, they will charge
the equilibrium price and produce the equilibrium quantity ($9 and
3000). If there is a price floor set
at $6, businesses can still
charge more and since they want to maximize their profits, they
will. The
$6 price ceiling, set below the equilibrium price, has
no effect.

Examples of price floors

Even though price floors cause surpluses (allocative

inefficiency) and waste our
resources, they do exist.
Government leaders either don't understand the important role
of free markets or their constituents don't. Examples of price
floors include:

Farm Price Supports are price floors on farm products

that are designed to raise
the price of farm products to
help poor, small, farmers. Of course, like all price
floors
the result is a surplus - i.e. if the price is higher,
farmers will grow more.
the way the price supports help
farmers is that they sell what they can at the high
price
and then sell the rest to the government. So, using the
graph below, if the
price floor is set at $12, farmers would
grow a quantity of 4 and consumers
would buy a quantity of 2
for $12 (2x12 = 24). The government then would buy
the
surplus 2 (2x 12 = 24). So farmers make $48 with the price
support. without
the price support their revenue would only
be $27 ($9 x3=$27).

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Unfortunately, one of the effects of farm price supports

is that most of the money
goes to the larger, richer, farms
who can grow the largest surplus. and , although
the small,
"family farmers" do receive larger incomes, it is a very
costly way to
help poor farmers. Currently (February 2007)
there are discussions in congress to
reduce the amount of
price support money that goes to larger, richer,
farms.

The minimum wage is also a price floor. According to the

law you cannot pay
your workers any less than the legal
minimum wage. One result of the minimum
wage is that the
number of people employed (quantity demanded) decreases and
the number of people looking for work (the quantity
supplied) increases, and the
result is a surplus of workers.
A "surplus" of workers is called "unemployment".
Note that
in the federal minimum wage is below equilibrium in some
labor
markets (large cities). In that case the price floor
has no effect. Also, in
microeconomics we study HOW MUCH
unemployment is caused by the
minimum wage and HOW MUCH more
poor families make. If only a few people
lose their jobs due
to the minimum wage and if many receive higher incomes
then
maybe the benefits are greater than the costs.

So government price ceilings and price floors can cause allocative

inefficiency. This then is NOT a suggested
role of government in a
market economy. Just what ARE the economic functions of
government?

ACHIEVING THE 5Es: ECONOMIC FUNCTIONS OF THE GOVERNMENT IN A

MARKET
(Capitalist) ECONOMY

There are five economic functions of government:

Providing the legal structure

Maintaining competition
Redistributing of income
Reallocating of resources
negative externalities
positive externalities
public goods
Promoting stability

The first two (providing the legal structure and maintaining

competition) HELP the market achieve the 5 Es. The
remaining three
(redistributing of income, reallocating of resources, and promoting
stability) CORRECT the
market when it FAILS to achieve the 5 Es.

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Providing the legal structure

Certain conditions must exist in order for the invisible hand of

capitalism to work. That is to say, certain
conditions must exist in
order for the decisions of profit maximizing businesses to achieve
the 5 Es for society.
They include things like:

Government must provide the proper environment in which

business can go about their work
Government must ensure property rights, provide enforcement of
contracts, act as a referee and impose
penalties for foul
play.
Government intervention also improves the allocation of
resources by supplying a medium of exchange
(money), ensuring
product quality, defining ownership rights, and enforcing
contracts.

For example, businesses in a country at war, or where laws against

stealing and arson are not enforced, will not
achieve allocative
efficiency or economic growth. The government is needed to provide
the proper environment.

Maintain competition

When we said at the end of chapter 3 that when businesses produce

the profit maximizing quantity (where
Qd=Qs) they will also be
producing the allocatively efficient quantity (where MSB=MSC assuming
no
externalities) we should have stressed that this is true ONLY IF
THERE IS COMPETITION. In chapter 2 we
learned that the definition of
competition in economics is slightly different than what most
students are used to.
Competition exists where there are very many
buyers and sellers. If there are not many sellers then profit
maximizing businesses WILL NOT be allocatively efficient.

For example, we have said that after a hurricane hits the coast of
Florida it may be GOOD for the people of
Florida if the price of
plywood increases, because higher prices will help prevent shortages.
But this is only true
if there is competition. If there is only ONE
seller (a monopoly) of plywood in Florida then they may take
advantage of the situation and raise prices greatly resulting in
extreme profits and allocative inefficiency. If there
are many
sellers of plywood in Florida, they will compete for your business
and the price will not go as high. We
get efficiency in capitalist
economies only if we truly have capitalism. One of the
characteristics of capitalism is
COMPETITION.

Therefore, one of the roles of the government in a capitalist

economy to to assure that there is competition.

In microeconomics we study an exception to this rule. If a

"natural monopoly" exists, the government allows it
to continue and
regulates price and service. This is why the government allows there
to be only one electric
company and then regulates electricity rates.
Commonwealth Edison is a natural monopoly and therefore has the
only
license in northern Illinois to distribute electricity. This is more
efficient than if we had many electric
companies, all running wires
to every house.

Where competitive markets are more efficient, the government uses

anti-monopoly laws called "anti-trust" laws
which promote
competition. with these laws the government can "break up" an
monopoly into several smaller,
competing, companies.

The above roles of government HELP capitalism achieve the 5 Es.

Sometimes, even with competition, a
capitalist economy will not
achieve the 5 Es. Therefore society is not reducing scarcity as much
as possible and
not maximizing its satisfaction. In these cases where
the market FAILS to achieve the 5 Es the role of
government is to
INTERVENE to CORRECT the market failure.

Redistributing of income

There is nothing built into capitalism that assures a fair

distribution of income (equity). In fact, in many
command economies
the distribution of income is more equal (fair??) than in capitalist
economies. In the first
chapter we discussed the actual distribution
of income in the US and in the world. to review see the links
below:

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US
World

If the government determines that the distribution of income is

not "fair", what can be done? There are three
commonly used policies
to achieve equity.

transfer payments
progressive income taxes
market intervention (price supports and price ceilings)

Transfer Payments are often used. Transfer payments are payments

for which nothing is expected in return.
Transfer payments (welfare)
provide relief to the poor, dependent, handicapped, and unemployment
compensation to those unemployed who qualify for benefits. Social
Security and Medicare programs support the
sick and aged. All of
these redistributes income among groups in society.

In the US the progressive personal income tax takes a larger

proportion of incomes of the rich than the poor. We
will discuss this
in greater detail later in this online lecture.

Sometime, in order to achieve equity, the government intervenes in

markets by modifying prices, i.e. they enact
price ceilings and price
supports. Price support programs for farmers and minimum wage laws
are examples. We
have said above that price supports and price
ceiling may CAUSE INEFFICIENCY, but they may also help
society
achieve EQUITY. Sometimes there is a tradeoff between equity and
efficiency. Most economists would
advise that the government be
careful if using price supports or price ceilings to achieve equity.
Often, the
increase in allocative inefficiency outweighs the benefits
of more equity ESPECIALLY if there are other options
available, like
transfer payments and progressive income taxes, to achieve
equity.

Reallocation of resources:

Market failure occurs when the competitive market system produces

the "wrong" amounts of certain goods or
services or fails to provide
any at all. In such cases the government may intervene to improve the
allocation of
resources and achieve allocative efficiency. There are
three examples of market failures that result in allocative
inefficiency WITHOUT government intervention:

negative externalities (spillover or external costs)

positive externalities (spillover or external benefits)
public goods

Negative Externalities (spillover or external costs)

Externalities occur when some of the benefits or costs of

production are not fully reflected in market
demand or supply
schedules. Some of the benefits or costs of a good may "spill
over" onto third
parties.

A negative externality occurs when some of the costs of

producing or consuming a product are not
paid by the producer or
consumer by rather "spillover" onto a third party who otherwise
would not
be involved in the market transaction. If negative
externalities exist the producer AVOIDS some of
the costs of
production so their costs are lower. With lower costs, more - too
much - will be
produced.

Graphically when negative externalities exist the supply curve

does not equal the MSC curve. Since
the firm AVOIDS some costs,
the costs to the firm are lower than the costs to society and the
supply
curve is further to the right (supply increases when costs
decrease). So the profit maximizing
quantity occurs where Qs=Qd or
at quantity 2 on the graph below. This is the quantity that will
be
produced. This is WHAT WE GET when negative externalities
exist. But the allocatively efficient
quantity is 1, where
MSB=MSC. This is the quantity that maximizes society's
satisfaction. This is

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WHAT WE WANT. So when negative externalities

exist TOO MUCH will be produced and there is
an overallocation of
resources. At quantity 2 the MSB<MSC. We said in chapter 1 that
when
MB<MC too much is being done.

An example of a negative externality (or spillover or external

cost) is any product that creates
polution when produced or
consumed. pollution. Assume that a paper manufacturer dumps toxic
chemicals into a river killing the fish sport fishers seek. The
buyer in this market is the purchaser of
paper. The seller is the
paper manufacturer. If the firm is allowed to pollute the river a
third party,
i.e. people who fish, or live, downstream, suffer
from this pollution. They pay the cost. A negative
externality
allows polluters to enjoy lower production costs because the firm
is passing along the
cost of pollution damage or cleanup to
society. Because the firm does not bear the entire cost, it will
overallocate resources to the production of goods. TOO MUCH will
be produced. Other products
that have negative externalities (or
spillover or external costs) include:

cigarettes
alcohol
gasoline

So what is the role of government when negative externalities

exist? Well, the GOAL is to reduce
the amount that is produced.
Using the graph above the goal would be to reduce the quantity
from 2
to 1.

To correct for negative externalities requires that government

get producers to internalize these
costs. There are two ways that
the government can do this:

1. Legislation can limit or prohibit pollution,

smoking, drinking, etc. Such legislation
causes the firm's
costs to increase and the firm's supply curve to shift to the
left
resulting in a higher price and a smaller quantity
demanded. (See graph below.)

2. Specific taxes on the amounts of pollution, smoking,

alcohal, etc. can be assessed,
which causes the firm's supply
curve to shift to the left resulting in a higher price and a
smaller quantity demanded. (See graph below.)

Think about the products that the government does tax: alcohol,
cigarettes, gasoline. Now we know
why. Because without the tax the
produce avoids some costs and passes them onto society as a
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whole.
therefore without the tax the price would be lower and more would
be consumed. TOO
MUCH would be consumed - more than the quantity
that is optimum for society or the allocatively
efficient
quantity.

Have you ever wondered why bar owners live above their bars? It
may be so that they can avoid the
problems of drunk drivers
leaving their bars. This way they feel safer and can sell more
alcohol and
make more money. What would happen to the amount of
alcohol sold if there was a law that said all
bar owners or
bartenders must stand in the middle of the street outside their
bar when their
customers leave? Would they sell the same amount to
their customers? I believe that in this case
THEY would have to
PAY (possibly with their lives) if they sell the profit maximizing
quantity of
alcohol to their customers, so they would sell less
which would be better for society.

Another example of spillover or external costs, or negative

externalities is gasoline. Even with the
national average gasoline
tax of $0.44 per gallon we might ask if the price of gasoline is
still TOO
LOW? The following question is on our class Discussion
Board. Read the instructions below, listen
to the five minute news
article, then post your comments on our class Dissuasion
Board.

DISCUSSION BOARD DISCUSSION

QUESTION

APPLICATION: SHOULD GAS PRICES BE

HIGHER?

Listen to the news article below.

As you listen try to explain the following:

Why does James Surowiecki believe the current

price of gasoline is too low and
results in
inefficiency?
which kind of inefficiency?
does he believe that there are spillover or
external costs or spillover or
external benefits
and what are they?
how would you show the inefficient quantity
on a graph
What are the effects of the higher tax that
James Surowiecki is proposing?
what effect does it have on efficiency?
how would you show the effect of the higher
tax on a graph
how would you use a graph to discuss how the
tax makes the market for
gasoline more
efficient

Arguing the Upside of High Gas Prices

Morning Edition, September 22, 2005, National

Public Radio

One writer believes gas prices actually should be

high. Steve Inskeep talks with James
Surowiecki, a
financial columnist for The New Yorker who says a
50-cent gas tax
would make drivers pay for the real
cost of cars on the road and make business cater
to
the fuel-conscious.

Click here to listen:

http://www.npr.org/templates/story/story.php?storyId=4858826

After listening to the news article and after

studying chapter 4, do you support higher
gasoline
taxes? Discuss this issue on the class Discussion
Board.

Positive Externalities (spillover or external benefits)

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A positive externality ( or spillover or external

benefit) occurs if some of the benefits of producing
or consuming
a product "spillover" onto a third party who does not have to pay.
Not just the buyer
or the seller benefit but someone else also
benefits Public health vaccinations and education are two
examples. Other examples of products with positive externalities
are public parks and public
libraries. Because some of the
benefits of these services go to others, not just the person being
vaccinated or the student being educated, but others also benefit.
Even if you do not get vaccinated
you will benefit if everyone
else does. It is not just the student (or the school and teachers)
who
benefit from your education but also future employers and
society as a whole benefit. When positive
externalities exist
individuals will demand too little for themselves and resources
will be
underallocated by the market. Therefore positive
externalities are bad for society.

Since some people benefit from positive externalities who do

not demand, or pay for, the product,
the demand curve does not
include all of the benefits that society gets from the product.
The
demand curve only measures the benefits that go to those who
demand, and pay for, the product.
Therefore the demand curve does
not equal the MSB (marginal Social Benefits) that all of society
receives from the product. The demand will be less than the MSB
and on the graph the demand
curve will be further to the left. See
graph below.

Profit maximizing business will produce the equilibrium

quantity where QS = Qd, or quantity 1 on
the graph below. But the
allocatively efficient quantity is where MSB=MSC or quantity 2 on
the
graph below. When positive externalities exist TOO LITTLE will
be produced, there will be an
UNDERallocation of resources to the
production of these products, and society will suffer from
allocative inefficiency.

Correcting for positive externalities requires that the

government somehow increase the quantity to
the allocatively
efficient amount. The goal of government is to have more produced
- more than
what would be produced if there were no government
involvement. The government has three tools
to achieve this:

1. Government can increase demand by providing

subsidies to consumers like food
stamps and education
grants to subsidize consumers. On the graph this would increase
demand because it is like giving consumers additional income to
buy the product. See
Graph.

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2. Government can finance production of good or

service itself such as public
education or public health. This
would increase supply just like having more producers.
(See
graph below.)

3. Government can increase supply by subsidizing

production, such as higher
education, immunization
programs, or public hospitals. This would also increase
supply.
(See graph below.)

Note that government finance and subsidizing producers

does not increase
demand, but it does increase the quantity
for 1 to 2 which is just what
society wants.

 REVIEW

NEGATIVE EXTERNALITIES (spillover

or external costs)

Define Negative Externalities (Spillover

Costs)
Examples of spillover or external
costs:
Use the graph below to answer the questions
that follow.

What is the allocatively efficient

quantity?
What is the profit maximizing
quantity?
Which quantity will be produced without
government involvement?
Is there an OVER allocation or an
UNDERallocation of resources?
What is the goal of government
involvement?
What are the possible government policies to
achieve this goal?

POSITIVE EXTERNALITIES (spillover

or external benefits)

Define Positive Externalities (spillover or

external benefits)
Examples of Positive Externalities (spillover
or external benefits)
Use the graph below to answer the questions
that follow.

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What is the allocatively efficient

quantity?
What is the profit maximizing
quantity?
Which quantity will be produced without
government involvement?
Is there an OVER allocation or an
UNDERallocation of resources?
What is the goal of government
involvement?
What are the possible government policies to
achieve this goal?

Public Goods

A third example of a market failure (when the competitive market

system produces the "wrong" amounts of
certain goods or services or
fails to provide any at all) is public goods. The term "public good"
has a different
definition in economics than that which we are use
to. A public good has the characteristics of being
NONRIVAL and NOT
BEING SUBJECT TO THE EXCLUSION PRINCIPLE. Because of these
characteristics
public, or social, goods would not be produced
through the market. Therefore if these are products that society
wants then the government must provide public goods (and quasi-public
goods) and services. Otherwise NONE
would be produced and there would
be a severe UNDERallocation of resources. NOTE that the term "public
good" does NOT MEAN that it is produced by the government. The
government produces many "private
goods". Private goods are different
than public goods are usually produced through the market because
they are
rival (one's use of a good makes it unavailable for others)
and come in units small enough to be afforded by
individual buyers.
Private goods are subject to excludability, the idea that those
unable and unwilling to pay do
not have access to the benefits of the
product.

Public goods than are nonrival, meaning one person can use the
good and there is just as much left for others to
use, and public
goods are NOT subject to excludability, meaning that there is no way
to economically exclude
those who are unable or unwilling to pay.
Even those who do not pay can get the good and there is nothing that
can be done to stop them. The efforts to reduce terrorism and
national defense in general are good examples of
public goods.
Increased national security is there for all to enjoy whether or not
they paid for it. Those who
receive benefits without paying are part
of the so called free rider problem. Other examples include flood
control, lighthouses, street lights, insect control.

Why would private businesses not produce such goods? Producers

would not be able to find enough paying
buyers for "public goods"
because of the free rider problem mentioned above. Therefore, "public
goods" are not
produced voluntarily through the market but must be
provided by the public sector and financed by compulsory
taxes.

Are the following public goods? If not why does the government
provide them?

1) public education
2) public parks
3) public libraries

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No, these are not public good because it is economically possible

to exclude nonpayers if we wanted to. We
could charge people to use
public parks, public libraries, public education so they are subject
to the exclusion
principle. Furthermore they are rival goods. If I
check out a book form the library, use a table at a public park, or
register for a spot in this economics class, are there just as many
left over for others? No. So - if public goods
have to be produced by
the government and if these goods are not public goods, why are they
produced by the
government too?

The answer is above - - - these goods have positive externalities.

Sometimes such goods are called quasi-pubic
goods.

Promoting stability:

An economy's level of output is dependent on its level of total

spending relative to its productive capacity.

2. The government may promote macroeconomic stability through

changes in government spending and
taxation.

a. When total spending is too low, the government may

increase its spending and/or lower taxes to
reduce unemployment;
the central bank may lower interest rates.

b When total spending is excessive, the government may cut its

spending and/or raise taxes to foster
price stability; the central
bank may raise interest rates.

Government's Role: A Qualification

1. Government carries out its economic functions within a

political context (and the constraints on
activity that come with
that).

2. In attempting to balance and satisfy both political and

economic objectives, government may end
up over- or
under-regulation, or over- or under-providing public goods.

GOVERNMENT FINANCE.

Before we discuss the economic functions of the government in a

market economy we will first look at
government finance - or
government spending and taxes.

We have defined economics as the study of how we

choose to use limited resources to obtain the
maximum
satisfaction of unlimited human wants.

We have used our 5Es model to better understand what this

definition implies. There are five ways for a society
to reduce the
effects of scarcity. (Actually there are six if we include "reducing
wants".) The study of
macroeconomics focuses on two of these:
Economic Growth and Full Employment.

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To these issues we will add price stability (low inflation). So

the issues discussed in MACROeconomics are:

1. full employment,
2. price stability, and
3. economic growth

Governments in market economies often employ policies to help the

economy achieve these goals. Some of
these policies involve
government spending and taxation. People often complain about
government spending
and taxes, but it is surprising how little they
actually know about them.

You do not have to memorize all the data that follows, but you do
need to know the simple structure: what are
the main sources of
government revenues and and what are the main government expenditures
categories? We'll
analyze government finance by looking at each level
of government in the United States:

the federal government (Washington DC),

state government, and
local governments.

Government Finance

Government expenditures on goods and services and transfer

payments.
Government purchases directly use or employ resources to
produce goods or services measured in
domestic output.
Government transfer payments are not directly part of
domestic output, but include payments like
social security,
unemployment compensation, welfare payments, and subsidies to
corporations.
Government purchases of goods and services, expenditures on
transfer payments, and total spending as
percentages of U.S.
output, 1960 and 2005 (Figure 4.7).
Major growth in government spending since the 1960s has been
in transfer payment area.

Federal Finance (see Figure 4.8)

Expenditures emphasize four important areas.

Income security (pensions and disability payments),
National defense,
Health, and
Interest on the public (national) debt.
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Receipts come from several sources.

Personal income tax is a major source.
The Federal personal income tax is progressive. People
with higher incomes pay a higher
percentage of that income
as tax than do people with lower incomes.
A marginal tax rate is the rate at which the tax is paid
on each additional unit of taxable
income (Table 4.1).
The average tax rate is the total tax paid divided by
total taxable income.
A tax whose average tax rises as income increases is
progressive.
Payroll taxes, such as social security contributions, are a
close second as source of revenue.
Corporate income taxes on corporation profits are the third
largest source of revenue.
Excise taxes are similar to sales taxes on specific
commodities, like alcoholic beverages, tobacco,
and gasoline.
They are levied at the wholesale level, so are hidden from the
consumer.
Global Perspective 4.2 shows that Australia, the United
States, South Korea, and Japan enjoy relatively
low tax burdens.
European nations (particularly Scandinavian countries) have
relatively high burdens.

State and Local Finance

State expenditures and receipts differ in composition from the

Federal government.
State revenues primarily come from sales and excise taxes
(about 48 percent) and secondly from
personal income taxes
(about 34 percent).
States vary widely in terms of revenue sources, with seven
having no personal income tax, and two
having no general sales
tax.
State spending goes primarily for public welfare,
education, highways, and health care.
Local revenues and spending differ from the state and federal
levels.
Local revenue is derived primarily from property
taxes.
Local spending is primarily on education.
Gap between local tax revenues and spending is largely
filled by grants from state and Federal
government (referred to
as "intergovernmental grants").

LAST WORD: The Long-Run Fiscal Imbalance: Social Security

There is an impending long-run shortfall in Social Security

funding.
It is "pay-as-you-go" system, meaning that current revenues
are used to pay current retirees (instead
of paying from funds
accumulated over time).
Despite efforts to build a trust fund, in 2017 Social
Security revenues will fall below payouts to
retirees.
In 2040 the trust fund will be exhausted and benefits will
exceed revenues by an estimated 37
percent, with that figure
rising to 56 percent annually in 2075.
Demographic changes are creating the problem.
Baby boomers are entering retirement age and living longer,
meaning that there will be more
recipients receiving payouts
for longer periods of time.
The ratio of the number of workers contributing to the
system for each recipient has declined from
5:1 in 1960 to 3:1
today. By 2040 the ratio will be only 2:1.
Numerous solutions have been suggested.
Reduce benefits by reducing direct payments, taxing
benefits, and/or increasing the age at which
workers are
eligible to receive benefits (already part of the system)
Increase revenues by raising payroll taxes.
Increase the trust fund by setting aside more of current
system revenues, or by investing trust fund
monies in corporate
stocks and bonds.
Allow workers to invest half of their payroll taxes in
approved stock and bond funds - sometimes
referred to as
"privatizing" Social Security.
There are many possible solutions, and the political
process may well result in a combination of the
many policies
proposed

 
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Government Finance

OUTLINE -- CHAPTER 5
Government Finance

I. Federal Finance

A. Federal Expenditures

1. pensions and income security

2. national defense

3. health

4. interest on the public debt

5. other

B. Federal Tax Revenues

1. personal income tax

2. payroll taxes

3. corporate income tax

4. excise taxes

C. State and Local Finance

1. state expenditures and receipts

2. local expenditures an receipts

D. Personal Income Tax

1. taxable income
2. progressive tax

a. marginal tax rates

b. average tax rates

3. 1999 Fed. Income Tax Rates

http://www.irs.gov/prod/ind_info/tax_tables/tax_sched.html

TAX TABLE: http://www.irs.gov/prod/forms_pubs/graphics/10311g75.gif

TAX SCHEDULE: http://www.irs.gov/prod/forms_pubs/graphics/10311g87.gif

E. Government Growth

1. ways to measure government size

2. purchases vs. transfer payments

(exhaustive and nonexhaustive expenditures)

3. growth of government expenditures

a. correcting for inflation

b. compared to other sectors

c. growth of transfer payments

Federal Government Finance

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Study the following figures to learn the primary sources of

federal government revenues and where the money is
spent.

 Federal Tax Revenue Sources:

1. personal income tax

2. social security taxes
3. corporate income tax
4. excise taxes

Federal Government Expenditures:

1. pensions and income security (includes welfare and

social security)
2. national defense
3. health
4. interest on the public debt
5. other

Comments:

Which of the taxes you pay go to Washington? - NOT sales taxes,

NOT property taxes.

On what does the federal government spent money? - Not

education. Actually, after Social Security,
welfare, defense,
health care, and interest on the debt, only nine percent (9%) is
left for the issues
that many people are talking about (education,
the environment, energy, etc.).

State Government Finance

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Study the following figures to learn the primary sources of state

government revenues and where the money is
spent.

 State Tax Revenues Sources:

1. Sales taxes
2. Excise taxes
3. Income taxes
4. Business taxes

State Government Expenditures:

1. Education
2. Welfare
3. Health
4. Transportation

Comments:

Note that property taxes are NOT state taxes for

almost all states.

Local Government Finance

Local governments include counties, cities, townships, school

districts, park districts, library districts, etc.
Illinois has a
large number of these local government bodies that have the authority
to collect taxes. Study the
following figures to learn the primary
sources of state government revenues and where the money is
spent.

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Local Tax Revenues Sources

1. Property taxes
2. Sales and Excise taxes

Local Government Expenditures

1. Education
2. Health and Welfare

Comments:

Note that local governments rely mostly on property

taxes to fund their programs. Most
local governments ARE school
districts, so it shouldn't surprise us that education is the
largest expenditure category.

Personal Income Tax

Since the main source of federal government revenues is the

personal income tax, and since many people
misunderstand the federal
income tax rates, and since these are sometimes used as part of a
macroeconomic
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policy to lower unemployment (UE) or to lower inflation

(IN), I think we should spend a little time studying
them.

Tax Rates

In 2000 the federal income tax rates were:

15%
28%
31%
36%
39.6%

BUT, whenever you see "%", you must ask "percent of what?"

First, it is percent of "taxable income" Taxable income is your

income MINUS deductions. In the discussion that
follows, the word
"income" will mean "taxable income", but keep in mind that your
taxable income can be quite
a bit less than your total income.

These tax rates are "marginal tax rates", NOT "average tax rates"
Most students, and many politicians often
confuse the two.

An average tax rate is the percent of your income that

you pay in taxes. To calculate the average tax rate you
divide
the amount you pay in taxes by your income;

taxes paid
 
average tax rate = x 100

total income

The marginal tax rate, which is what is used on our income

taxes, is the percent of ADDITIONAL income that
you pay in
taxes ("marginal" means "additional" or "extra").

additional taxes paid

 
marginal tax rate = x 100

additional income

This is important. Look at the 2000 Federal Income Tax schedule

for a single person.

Schedule X -- Use if your filing status is

Single

  If the amount on
     of the
  Form 1040,     Enter on
     amount
  line 39, is:      But not     Form 1040,
     over ---
  Over ---      over ---     line 40
 

$0     $26,250     .........        15% $0    

26,250     63,550     $3,937.50 +   28% 26,250    
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63,550     132,600     14,381.50 +   31% 63,550    

132,600     288,350     35,787.00 +   36% 132,600    
288,350     .......        91,857.00 +   39.6% 288,350    

So, if your (taxable) income is $26,250 you pay 15% in taxes or

$3,937.50 (.15 x $26,250 = $3,937.50) or you
are paying 15% of your
income (taxable income) in taxes. BUT, if you receive a $1000 dollar
raise, your income
is now $27,250 and you are in the 28% tax bracket.
If this 28% was an average tax rate, then you would have to
pay .28 x
$27,250 = $7630. You received a $100) raise, but your taxes would go
up $3692.5 ($7630 -
$3,937.50). You would beg your boss NOT to give
you a raise because you end up with less take-home pay than
before.

BUT IT DOESN'T WORK THAT WAY, because the tax rates are MARGINAL
tax rates and they only apply to
ADDITIONAL income. So you pay 15 %
of the first $26,250 (= $3,937.50) and 28% of the additional $1000 (=
$280). So if your income is $27,250, you will pay $4142.50 in taxes
($3,862.50 + $280 = $4217.50).

So, if your income is $27,250, you are in the 28% tax bracket, but
what is your average tax rate? What percent
of your total income are
you paying in taxes? See the formula above: Average tax rate = taxes
paid divided by
total income. so if your income is $27,250 your
average tax rate is $4142.50 / $27,250 = 15.2 %. You are in the
28%
tax bracket, but you are paying 15.2% of your income in taxes.
Actually, you are paying a lot less than
15.2% of your total income
in taxes since the tax rates apply only to your taxable income.

PROBLEM: Use the table above to calculate the taxes

that you would have to pay if your taxable income was
$73,550 Also,
calculate the marginal tax rate and the average tax rate (answers).

Government Growth

What has happened to the SIZE of government? Many people argue

that the government is getting bigger. How
would we know? How would
we measure the size of government?

One way would be to compare how many laws and regulations that the
government makes in a year. I think that
if we used that as the
measure the government is probably getting bigger.

Another measure could be the number of governmental employees

compared to nongovernmental employees.
"The ratio of civilian
governmental employees per 1000 population has actually dropped from
a peak of
16.5/1000 in 1952 to 11/1000 in 1995." (http://www.harding.edu/USER/lklein/WWW/KWTEST3CPA.HTM)

A popular measure of the size of government is the amount that

they spend. See the graph below:

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But most of the increase in government expenditures occurred in

Social Security, Medicare, and other medical
care.

Expenditures such as these are called "transfer payments" because

the government is NOT BUYING
ANYTHING, but simply transferring money
from the taxpayers to certain groups of recipients. If we want to see
how the size of government affects SCARCITY we should exclude such
transfer payments because the
government is not using up any
resources. See table below.

From: http://www.rand.org/publications/RB/RB2500/rb2500.html

If we remove transfer payments and only look at government PURCHASES

we see the the effect of government
on scarcity has stayed about the
same between 1952 and 1993. (But, the government's role in
redistributing
income has increased.)

The government purchases about 20% of what is produced in the

country and this has stayed about the same
since World War II.

Is the government getting bigger? -- NOT as a user of our limited

resources.

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ANSWER

Your calculations: $17,481.50

IRS table: $ 17,489 ( See: 10311g83.gif)
Marginal tax rate: 31%
Average tax rate = $17,489 / $73,550 = 23.8%

HOW TO GET THE ANSWER:

PROBLEM: Use the table above to calculate the taxes that you would
have to pay if your taxable income was
$72,450. Also, calculate the
marginal tax rate and the average tax rate (answers).

How to calculate:

Your income is $73,550

You pay 15% of the first $26,250 or .15 x $26,250 =

$3937.50
You pay 28 % on income between $26,250 and $63,550 or .28 x
$37,300 = $10,444.00
You pay 31% on income over $63,550 or .31 x $10,000 =
$3100.00

Now add:

$3,937.50
$10,444.00
$3,100.00
____________
You Pay this amount in taxes: $17,481.50

OR according to the tax schedule "If the amount on Form 1040, line
39, is: Over $63550, but not over $132,600
Enter on Form 140 Line 40
$14,381.50 + 31% of the amount over $63,550", so you add 14,381 +
3100 to get
$17,481

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Since your income is $73,550, it is more than $63,550, but not

over $132,600.
Therefore, you can see from the tax schedule below you are in the 31%
tax bracket. This is your marginal tax
rate.

Tax Schedule:

Schedule X -- Use if your filing status is

Single

  If the amount on
     of the
  Form 1040,     Enter on
     amount
  line 39, is:      But not     Form 1040,
     over ---
  Over ---      over ---     line 40
 

$0     $26,250     .........        15% $0    

26,250     63,550     $3,937.50 +   28% 26,250    
63,550     132,600     14,381.50 +   31% 63,550    
132,600     288,350     35,787.00 +   36% 132,600    
288,350     .......        91,857.00 +   39.6% 288,350    

An average tax rate is the percent of your income that you

pay in taxes To calculate the average tax rate you
divide the amount
you pay in taxes by your income;

taxes paid
 
average tax rate = x 100

total income

Therefore,
$17,481.50
 
average tax rate = x 100

$73,550

average tax rate = 23.8%

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