Market Economics PDF

## Chapter 2 The Modern Mixed Economy ### Taxes - The government must find revenues to pay for public goods and income redistribution programs. - Revenues come from taxes levied on personal and corporate income, wages, sales of goods, and other items. - City, state, and federal governments all col...

## Chapter 2 The Modern Mixed Economy ### Taxes - The government must find revenues to pay for public goods and income redistribution programs. - Revenues come from taxes levied on personal and corporate income, wages, sales of goods, and other items. - City, state, and federal governments all collect taxes to pay for spending. - Taxes are the price we pay for public goods, but they aren't voluntary. - We are all subject to the tax laws. - We, as citizens, choose both public goods and the taxes to pay for them through democratic processes. - The connection between spending and consumption we see for private goods doesn't hold for taxes and public goods. - We pay for a hamburger only if we want it, but we must pay our share of taxes for defense and public schools even if we don't care for them. ### Equity - Our discussion of market failures (like monopoly or externalities) focused on defects in the allocative role of markets. - These defects can be corrected by careful intervention. - Assume the economy functioned with complete efficiency: always on the production possibility frontier and never inside it. - Assume the economy always chooses the right amount of public versus private goods. - Even if the market system worked perfectly, it might still lead to a flawed outcome. - Markets don't necessarily produce a fair distribution of income. - A market economy may produce inequalities in income and consumption that are not acceptable to the electorate. ### Why Might the Market Mechanism Produce an Unacceptable Solution? - Incomes are determined by a wide variety of factors, including effort, education, inheritance, factor prices, and luck. - The resulting income distribution may not correspond to a fair outcome. - Recall that goods follow dollar votes, not the greatest need. - A rich man's cat may drink the milk a poor boy needs to remain healthy. - Is this happening because the market is failing? Not at all. - The market mechanism is doing its job (putting goods in the hands of those who have the dollar votes.) - Even the most efficient market system may generate great inequality. ### Often the Income Distribution in a Market System is the Result of Accidents of Birth - Every year, **_Forbes_** magazine lists the 400 richest Americans. - Many of them either received their wealth by inheritance or used inherited wealth as a springboard to even greater wealth. - Should everyone regard this as necessarily right or ideal? - Should someone be allowed to become a billionaire simply by inheriting 5,000 square miles of rangeland or the family's holding of oil wells? - This is how the cookie crumbles under *laissez-faire* capitalism. ### For Most of American History, Economic Growth was a Rising Tide that Lifted All Boats, Raising the Incomes of the Poor as Well as Those of the Rich - Over the last three decades, changes in family structure and declining wages of the less skilled and less educated have reversed the trend. - With a return to greater emphasis on the market has come greater homelessness, more children living in poverty, and deterioration of many of America's central cities. ### Income Inequalities May Be Politically or Ethically Unacceptable - A nation does not need to accept the outcome of competitive markets as predetermined and immutable. - People may examine the distribution of income and decide it is unfair. - If a democratic society doesn't like the distribution of dollar votes under a *laissez-faire* market system, it can take steps to change the distribution of income. ### Assume Voters Decide to Reduce Income Inequality - What tools could the government use to implement that decision? - First, the government can engage in progressive taxation, taxing large incomes at a higher rate than small incomes. - The government can impose heavy taxes on wealth or on large inheritances to break the chain of privilege. - Federal income and inheritance taxes are examples of such redistributive progressive taxation. ### Second, Because Low Tax Rates Cannot Help Those Who Have No Income at All, Governments Can Make Transfer Payments - Transfer payments are money payments to people. - Today these payments include aid for the elderly, blind, and disabled, as well as for those with dependent children. - Transfer payments also include unemployment insurance for the jobless. - This system of transfer payments provides a “safety net” to protect the unfortunate from privation. ### And Finally, Governments Sometimes Subsidize Consumption of Low-Income Groups by Providing: - Food stamps - Subsidized medical care - Low-cost housing ### In the United States, Such Spending Comprises a Relatively Small Share of Total Spending ### Tax and Transfer Programs Have Always Been Controversial - Few people think about the public goods their tax dollars are buying when they fill out tax returns or look at big deductions in paychecks. - People feel that societies must provide the basic necessities for everyone (for food, schooling, and health care). ### What Can Economics Contribute to Debates About Equality? - Economics as a science cannot answer such normative questions as: - How much of our income should taxed? - How much income should be transferred to poor families? - What is the proper size of the public sector? - These are political questions that are answered at the ballot box in democratic societies. ### Economics Can Analyze the Costs and Benefits of Different Redistributive Systems - Economists have devoted much time to analyzing the impact of different tax systems (such as those based on income or consumption). - Economists have also studied whether giving poor people cash, rather than goods and services, is likely to be a more efficient way of reducing poverty. ### And Economics Can Remind Us that the Market Giveth and the Market Taketh Away - In a world of rapid structural change, we should always remember, “There, but for the grace of supply and demand, go I.” ### Macroeconomic Growth and Stability - Since its origins capitalism has been plagued by periodic bouts of inflation (rising prices) and recession (high unemployment). - For example, since World War II, there have been 10 recessions in the United States, some putting millions of people out of work. - These fluctuations are known as the *business cycle*. - Thanks to the intellectual contributions of **_John Maynard Keynes_** and his followers, we know how to control the worst excesses of the business cycle. - By careful use of fiscal and monetary policies, governments can affect output, employment, and inflation. ### The Fiscal Policies of Government Involve the Power to Tax and the Power to Spend ### Monetary Policy Involves Determining the Supply of Money and Interest Rates - These affect investment in capital goods and other interest-rate-sensitive spending. - Using these two fundamental tools of macroeconomic policy, governments can influence the level of total spending, the rate of growth and level of output, levels of employment and unemployment, and the price level and rate of inflation in an economy. ### Governments in Advanced Industrial Countries Have Successfully Applied the Lessons of the Keynesian Revolution Over the Last Half-Century - Spurred on by active monetary and fiscal policies, the market economies witnessed a period of unprecedented economic growth in the three decades after World War II. ### In the 1980s, Governments Became More Concerned with Designing Macroeconomic Policies to Promote Long-Term Objectives, Such as Economic Growth and Productivity - **Economic growth** denotes the growth in a nation's total output, while **productivity** represents the output per unit input or the efficiency with which resources are used. - For example, tax rates were lowered in most industrial countries in order to improve incentives for saving and production. - Many economists emphasize the importance of public saving through smaller budget deficits as a way to increase national saving and investment. ### Macroeconomic Policies for Stabilization and Economic Growth Include: - Fiscal policies (of taxing and spending) - Monetary policies (which affect interest rates and credit conditions) ### Since the Development of Macroeconomics in the 1930s, Governments Have Succeeded in Curbing the Worst Excesses of Inflation and Unemployment **Table 2-1: Government Can Remedy the Shortcomings of the Market** | Failure of Market Economy | Government Intervention | Current Examples of Government Policy | | :-: | :-: | :-: | | Inefficiency: Monopoly, Externalities, Public Goods | Encourage Competition, Intervene in Markets, Encourage Beneficial Activities | Antitrust Laws, Deregulation, Antipollution Laws, Antismoking Ordinances, Provide Public Education, Build Roads | | Inequality: Unacceptable Inequalities of Income and Wealth | Redistribute Income | Progressive Taxation of Income and Wealth, Income-Support or Transfer Programs (e.g., Subsidize Health Care) | | Macroeconomic Problems: Business Cycles (High Inflation and Unemployment), Slow Economic Growth | Stabilize Through Macroeconomic Policies, Stimulate Growth | Monetary Policies (e.g. Changes in Money Supply and Interest Rates), Fiscal Policies (e.g., Taxes and Spending Programs), Improve Efficiency of Tax System, Raise National Savings Rate by Reducing Budget Deficit or Increasing Budget Surplus | ### The Rise of the Welfare State - Our textbook focuses on the mixed market economy of modern industrialized nations. - It's useful to trace its history briefly. - Before the rise of the market economy, going back to medieval times, aristocracies and town guilds directed much of the economic activity in Europe and Asia. - However, about two centuries ago, governments began to exercise less and less power over prices and production methods. - **Feudalism** gradually gave way to **markets**, or what we call the "market mechanism." ### In Most of Europe and North America, the Nineteenth Century Became the Age of Laissez-Faire - **Laissez-faire** translates as “leave us alone.” - This doctrine holds that government should interfere as little as possible in economic affairs and leave economic decisions to the private decision making of buyers and sellers. - Many governments adopted this economic philosophy starting in the middle of the nineteenth century. ### Nevertheless, a Century Ago the Many Excesses of Capitalism (Including Monopolies and Trusts, Corruption, Dangerous Products, and Poverty) Led Most Industrialized Countries to Retreat From Unbridled Laissez-Faire - The government’s role expanded steadily as it regulated businesses, levied income taxes, and provided a **social safety net** for the elderly, unemployed, and impoverished. ### This New System, Called the Welfare State, is One in Which Markets Direct the Detailed Activities of Day-to-Day Economic Life While Government Regulates Social Conditions and Provides Pensions, Health Care, and Other Necessities for Poor Families. ### Conservative Backlash - Many critics of the welfare state worried that government interventions were tilting the scales in favor of **socialism**, in which the state owns, operates, and regulates much of the economy. - In 1942, the great Harvard economist **_Joseph Schumpeter_** argued that the United States was “capitalism living in an oxygen tent” on its march to socialism. - Capitalism’s success would breed alienation and self-doubt, sapping its efficiency and innovation. ### Libertarian Critics Like **_Friedrich Hayek_** and **_Milton Friedman_** Argued for a Return to Free Markets and Minimal Government - This group argued that the state is overly intrusive, governments create monopoly, government failures are just as pervasive as market failures, high taxes distort the allocation of resources, **social security** threatens to drain the public purse, and environmental regulations dull the spirit of enterprise. ### The Mixed Economy Today - In weighing the relative merits of state and market, public debate often oversimplifies the complex choices that societies face. - Markets have worked miracles in some countries. - But markets need well-crafted legal and political structures, along with the social overhead capital that promotes trade and ensures a stable financial system. - Without this, markets often produce corrupt capitalism, great inequality, pervasive poverty, and declining living standards. ### In Economic Affairs, Success Has Many Parents, While Failure Is an Orphan - The success of market economies may lead people to overlook the important contribution of collective actions. - Government programs have helped reduce poverty and malnutrition and reduced the scourge of terrible diseases like tuberculosis and polio. - Even as the world’s largest economies head into a deep recession, macroeconomic policies help to stem financial-market panics and reduce the length and severity of business cycles. - State-supported science has split the atom, discovered the DNA molecule, and explored space. ### The Debate About Government's Successes and Failures Demonstrates That Drawing the Boundary Between Market and Government Is an Enduring Problem - The tools of economics are indispensable to help societies find the golden mean between an efficient market mechanism and publicly decided regulation and redistribution. - The good mixed economy is, perforce, the limited mixed economy. - But those who would reduce government to the constable plus a few lighthouses are living in a dream world. - An efficient and humane society requires both halves of the mixed system-market and government. - Operating a modern economy without both is like trying to clap with one hand. ### Summary **A The Market Mechanism** 1. In an economy like the United States, most economic decisions are made in **markets**, which are mechanisms through which buyers and sellers meet to trade and to determine prices and quantities for goods and services. - **Adam Smith** proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. - While markets are far from perfect, they have proved remarkably effective at solving the problems of *how*, *what*, and *for whom.* 2. The market mechanism works as follows to determine *what* and *how*: - The dollar votes of people affect prices of goods; these prices serve as guides for the amounts of the different goods to be produced. - When people Demand more of a good, its price will increase and businesses can profit by expanding production of that good. - Under **perfect competition**, a business must find the cheapest method of production, efficiently using labor, land, and other factors, otherwise, it will incur losses and be eliminated from the market. 3. At the same time that the *what* and *how* problems are being resolved by prices, so is the problem of *for whom*. - The distribution of income is determined by the ownership of factors of production (land, labor, and capital) and by factor prices. - People possessing fertile land or the ability to hit home runs will earn many dollar votes to buy consumer goods. - Those without property or with skills, color, or sex that the market undervalues will receive low incomes. **B Trade, Money, and Capital** 4. As economies develop, they become more specialized. - Division of labor allows a task to be broken into a number of smaller chores that can each be mastered and performed more quickly by a single worker. - **Specialization** arises from the increasing tendency to use roundabout methods of production that require many specialized skills. - As individuals and countries become increasingly specialized, they tend to concentrate on particular commodities and trade their surplus output for goods produced by others. - Voluntary trade, based on specialization, benefits all. 5. Trade in specialized goods and services today relies on **money** to lubricate its wheels. - Money is the universally acceptable medium of exchange-including primarily currency and checking deposits. - It is used to pay for everything from apple tarts to zebra skins. - By accepting money, people and nations can specialize in producing a few goods and can then trade them for others; without money, we would waste much time negotiating and bartering. 6. **Capital goods** —produced inputs such as machinery, structures, and inventories of goods in process—permit roundabout methods of production that add much to a nation's output. - These roundabout methods take time and resources to get started and therefore require a temporary sacrifice of present consumption in order to increase future consumption. - The rules that define how capital and other assets can be bought, sold, and used are the **system of property rights.** - In no economic system are private-property rights unlimited. **C The Visible Hand of Government** 7. Although the market mechanism is an admirable way of producing and allocating goods, sometimes market failures lead to deficiencies in the economic outcomes. - The government may step in to correct these failures. - Its role in a modern economy is to ensure efficiency, to correct an unfair distribution of income, and to promote economic growth and stability. 8. Markets fail to provide an efficient allocation of resources in the presence of **imperfect competition** or **externalities**. - **Imperfect competition** , such as monopoly, produces high prices and low levels of output. - To combat these conditions, governments regulate businesses or put legal **antitrust** constraints on business behavior. - **Externalities** arise when activities impose costs or bestow benefits that are not paid for in the marketplace. - The government may decide to step in and regulate these spillovers (as it does with air pollution) or provide for **public goods** (as in the case of public health). 9. Markets do not necessarily produce a fair distribution of income; they may spin off unacceptably high inequality of income and consumption. - In response, governments can alter the pattern of incomes (the *for whom*) generated by market wages, rents, interest, and dividends. - Modern governments use **taxation** to raise revenues for transfers or income-support programs that place a financial safety net under the needy. 10. Since the development of macroeconomics in the 1930s, the government has undertaken a third role: using fiscal powers (of taxing and spending) and monetary policy (affecting credit and interest rates) to promote long-run economic growth and productivity and to tame the business cycle's excesses of inflation and unemployment. 11. Drawing the right boundary between market and government is an enduring problem for societies. - Economics is indispensable in finding the golden mean between an efficient market and publicly decided regulation and redistribution. - An efficient and humane society requires both halves of the mixed system—market and government. **Concepts for Review** * **The Market Mechanism** * Markets, Market Mechanism, Markets for Goods and for Factors of Production, Prices as Signals, Market Equilibrium, Perfect and Imperfect Competition, Adam Smith’s Invisible-Hand doctrine * **Features of a Modern Economy** * Specialization and Division of Labor, Money, Factors of Production (land, labor, capital), Capital, Private Property, and Property Rights * **Government's Economic Role** * Efficiency, Equity, Stability, Inefficiencies: Monopoly and Externalities, Inequity of Incomes Under Markets, Macroeconomic Policies: Fiscal and Monetary Policies, Stabilization and Growth ### Questions for Discussion 1. What determines the composition of national output? - In some cases, we say that there is “consumer sovereignty,” meaning that consumers decide how to spend their incomes on the basis of their tastes and market prices. - In other cases, decisions are made by political choices of legislatures. - Consider the following examples: transportation, education, police, energy efficiency of appliances, health-care coverage, television advertising. - For each, describe whether the allocation is by consumer sovereignty or by political decision. - Would you change the method of allocation for any of these goods? 2. When a good is limited, some means must be found to ration the scarce commodity. - Some examples of rationing devices are auctions, ration coupons, and first-come, first-served systems. - What are the strengths and weaknesses of each? - Explain carefully in what sense a market mechanism "rations" scarce goods and services. 3. This chapter discusses many "market failures," areas in which the invisible hand guides the economy poorly, and describes the role of government. - Is it possible that there are, as well, "government failures," government attempts to curb market failures that are worse than the original market failures? - Think of some examples of government failures. - Give some examples in which government failures are so bad that it is better to live with the market failures than to try to correct them. 4. Consider the following cases of government intervention: - Regulations to limit air pollution, income support for the poor, and price regulation of a telephone monopoly. - For each case (a) explain the market failure, (b) describe a government intervention to treat the problem, and (c) explain how “government failure” (see the definition in question 3) might arise because of the intervention. 5. The circular flow of goods and inputs illustrated in Figure 2-1 has a corresponding flow of dollar incomes and spending. - Draw a circular-flow diagram for the dollar flows in the economy, and compare it with the circular flow of goods and inputs. - What is the role of money in the dollar circular flow? 6. Consider three periods of American history: - (a) the early 1800s, when Jones lived on an isolated farm cut off from the rest of the world; - (b) the late 1940s, when Smith lived in a country where domestic trade and exchange were extensive but international tradewas cut off because of damage from World War II; and (c) 2009, when Hall lives in a globalized world that promotes trade with all countries. - Suppose you were living in each of these situations. - Describe the opportunities for specialization and division of labor of Jones, Smith, and Hall. - Explain how the globalized world in (c) both allows greater productivity of Hall and allows a much greater variety of consumption goods. - Give specific examples in each case. 7. "Lincoln freed the slaves. With one pen stroke he destroyed much of the capital the South had accumulated over the years." Comment. 8. The table to the right shows some of the major expenditures of the federal government. - Explain how each one relates to the economic role of government. 9. Why does the saying "No taxation without representation" make sense for public goods but not private goods? - Explain the mechanisms by which individuals can “protest" against: - (a) taxes that are thought excessive to pay for defense spending, - (b) tolls that are thought excessive to pay for a bridge, and - (c) prices that are thought excessive for an airline flight from New York to Miami. ### Major Expenditure Categories for Federal Government | Budget Category | Federal Spending, 2009 ($ Billion) | | :-: | :-: | | Health Care | 713 | | National Defense | 675 | | Social Security | 649 | | Income Security | 401 | | Natural Resources and Environment | 36 | | International Affairs | 38 | *Source: Office of Management and Budget, Budget of the United States Government, Fiscal Year 2009.*