Module 1: Fundamental Economic Concepts PDF

COBECON (BASIC MICROECONOMICS) MODULE 1: FUNDAMENTAL ECONOMIC CONCEPTS: AN OVERVIEW This introductory module will allow you to understand the very basic foundation of why we have th...

COBECON (BASIC MICROECONOMICS) MODULE 1: FUNDAMENTAL ECONOMIC CONCEPTS: AN OVERVIEW This introductory module will allow you to understand the very basic foundation of why we have the discipline of economics. The nature and scope of economics will be discussed in this module so that you will understand: (1) how economists contribute in the body of knowledge in economics, and (2) what are expected to be studied in the two branches of economics, namely microeconomics and macroeconomics. At the end of this module, you should have achieved the following topic or unit learning outcomes. UNIT LEARNING OUTCOMES Describe the nature of economics. Discuss the scientific method as applied in economics Distinguish between microeconomics & macroeconomics, and positive economics and normative economics. State the basic problem of an economy and how society addresses this problem. There are three topics to be tackled in this module. These are: 1. The Foundation of Economics 2. The Nature and Scope of Economics 2.1 Definition of Economics 2.2 Methodology of Economics 2.3 Branches of Economics 2.4 Approaches to Economics 3. The Economizing Problem 3.1 Resources and Factor Payments 1  3.2 Economic Efficiency 3.3 The Production Possibilities 3.4 Economic Growth 3.5 Basic Economic Questions 3.6 Economic Systems 3.7 Role of Government TOPIC 1: THE FOUNDATION OF ECONOMICS Two basic facts of life exist in the society: we live in a world of scarcity and human wants and needs are unlimited. The word scarce is closely associated with the word limited or economic. Therefore, scarcity means there is a (perpetual) state of insufficiency of resources. The society has limited resources and therefore cannot produce all the goods and services people wish to have. On one hand, there is no end to people’s wants. Man is said to be insatiable – never fully satisfied. When one or two wants is satisfied, more new wants are felt successively. But the means or resources are limited. People do not get sufficient resources which are needed to satisfy the unlimited wants. So, the resources are always scarce in relation to the wants of the individuals, state or the government. Under this situation we have to choose the more urgent wants. The question is: How do we reconcile these two basic facts of life? People are confronted with innumerable wants from the cradle to the grave. If one want is satisfied, other wants emerge in succession. To satisfy these wants people are engaged in different activities in the society. But the means are limited in relation to unlimited wants. So, people are constantly striving to satisfy unlimited wants with limited means. The most basic response people do in dealing with scarcity is to make choices. Scarcity of resources will force individuals to make their choices. The choices individual make are on the other hand influence by three factors: (1) rewards or the benefits that individuals receive or expect to received when choices are made; and (2) costs or opportunity costs which are the values foregone by a resource owner in making a choice (or the next best alternative use of the same resource that is given up by the resource owner); and (3) value judgement which is placing a relative importance to a choice. 2  Commented [SH1]: Because of scarcity, we are imposed to Wants > Resources make choices SCARCITY Opportunity Benefits CHOICE Cost Value Judgment Figure 1.1: Scarcity and Factors Influencing Individuals to Make Choices One of the most important concept that economics will teach you is the concept of opportunity cost, which has a wide range of application when dealing with scarcity problem. And whether the decision is simple or complex, opportunity cost is always involved. Indeed, the cost of something is what you give up to go get it. Making decisions requires comparing the costs and benefits of alternative courses of action because people face trade-offs. In many cases, however, the cost of an action is obvious as it might first appear. When making any decision, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit of a college education is not worth the cost. Consider this example of opportunity cost: Expressed in terms of time, consider a commuter who chooses to drive to work, rather than using public transportation. Because of heavy traffic and a lack of parking, it takes the commuter 90 minutes to get to work. If the same commute on public transportation would have taken only 40 minutes, the opportunity cost of driving would be 50 minutes. The commuter might naturally have chosen driving over public transportation because he could not have anticipated traffic delays in driving. Once the choice has been made to drive, it is not possible to change one's mind, thus the choice itself becomes irrelevant. Experience can create a basis for future decisions, however: the commuter may be less inclined to drive next time, knowing the consequences of traffic congestion. 3 TOPIC 2: THE NATURE AND SCOPE OF ECONOMICS The science of Economics has emerged as a discipline to discuss how people are engaged in different activities to earn money and how do they endeavor to satisfy unlimited wants with limited means. The knowledge of economics is indispensable to know about how best to solve the manifold economic problems by the proper utilization of resources in the society. DEFINITION OF ECONOMICS The English term “Economics” is derived from the Greek word “Oikonomia”. Its meaning is “household management”. Economics was first read in ancient Greece. Aristotle, the Greek Philosopher termed Economics as a science of ‘household management’. But with the change of time and progress of civilization, the economic condition of man changes. As a result, an evolutionary change in the definition of Economics is noticed. Towards the end of the 18th century Adam Smith, the celebrated English Economist and the father of Economics, termed Economics as the ‘Science of Wealth’. According to him, “Economics is a science that enquires into the nature and causes of the wealth of nations.” In other words, how wealth is produced and how it is used, are the subject-matter of economics. In the subsequent period Alfred Marshall defined Economics by saying, ‘Economics is a study mankind in the ordinary business of life’. In other words, Economics studies not only the wealth but also the activities centering the wealth. In modern times, more realistic definitions have been given to economics. Economics studies how to use the limited resources to satisfy the unlimited wants of men. So, Economics as a social science studies how people perform economic activities and how they try to satisfy unlimited wants by the proper use of limited resources. Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. SCOPE OF ECONOMICS The term economics merits considerable attention. First, Economics is a social science. Social science deals with study of man’s behavior. Thus, the subject matter of economics deals with the analysis of economic problems of people in the society and the satisfaction of their wants. Second, Economics is a science discipline. Science is defined as a systematized body of knowledge based from facts. Economists try to address their subject with a scientist’s objectivity. They approach the study of the economy in much the same way as any scientist. Economists provide bodies of knowledge using the scientific method – the development and testing of theories about how the world works. Just like a scientist, an economists follow four scientific steps: 1. Observation and description of a phenomenon or group of phenomena; 2. Formulation of hypothesis to explain the phenomena; 4  3. Use of the hypothesis to predict the existence of other phenomena, or to predict quantitatively the results of new observations; 4. Performance of (experimental) tests of the predictions of several independent experimenters and properly performed experiments. If the hypothesis is supported by experiments, it may come to be regarded as a theory or law of nature. Policy Policy Economics Theoretical Theory Economics Descriptive Facts Economics Figure 1.2: The Methodology of Economics The economic method in providing bodies of knowledge is summarized by the figure above. In Descriptive Economics, economists observe real-world behavior and outcomes then formulate possible explanation of cause and effect (hypothesis). Collection of data follows next and then analyze those data by testing the explanation of cause and effect by comparing the outcomes of specific events to the outcome predicted by the hypothesis. Accepting, rejecting, and modifying the hypothesis tested based on the comparisons. Economists continue to test the hypothesis against the facts. As favorable results accumulate, the hypothesis evolves into a theory. Theoretical Economics is concerned with the formulation of economic theories. A very well-tested and widely accepted theory is referred to as an economic law or an economic principle – a statement about economic behavior or the economy that enables prediction of the probable effects of certain actions. Combinations of such laws or principles are incorporated into models, which are simplified representations of how something works, such as a market or segment of the economy. Economists develop theories of the behavior of individuals (consumers, workers) and institutions (businesses, governments) engaged in the production, exchange, and consumption of goods and services. Theories, principles, and models are “purposeful simplifications.” This means that they are based on simplifying assumptions because full scope of economic reality itself is too complex economists try to simplify the complexity 5 of a reality by using assumptions – these are conditions held to be true. Therefore, there are some other things you should know about economic principles (or theories or laws or models). 1. Generalizations. Economic principles are generalizations relating to economic behavior or to the economy itself. Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms. For example, economists say that consumers buy more of a particular product when its price falls. This “price-quantity” principle, however, holds for the typical consumer and for consumers as a group. 2. Other-Things-Equal Assumption. In constructing their theories, economists use the ceteris paribus or other-things-equal assumption – the assumption that factors other than those being considered do not change. They assume that all variables except those under immediate consideration are held constant for a particular analysis. 3. Graphical Expression. Many economic models are expressed graphically. Be sure to read the special appendix at the end of this chapter as a review of graphs. How useful are theories? Economic theories are highly useful in analyzing economic behavior and understanding how the economy operates. They are the tools for ascertaining cause and effect within the economic system. God theories do a good job of explaining and predicting. Also, they are useful for policy making. Policy economics is concerned with application of policy to resolve (or minimize the impact of) an economic problem. With an understanding of an economic behavior, correct policies are made and implemented. BRANCHES OF ECONOMICS Economic analysis is divided into two main branches: microeconomics and macroeconomics. These two branches are important for scarcity problem. Microeconomics is the part of economics concerned with individual units such as a person, a household, a firm, or an industry. At this level of analysis, the economist observes the details of an economic unit, or very small segment of the economy. In microeconomics we look at decision making by individual customers, workers, households, and business firms. We measure the price of a specific product, the number of workers employed by a single firm, the revenue or income of a particular firm or household, or the expenditures of a specific firm, government entity, or family. Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as the government, household, and business sectors. An aggregate is a collection of specific economic units 6  treated as if they were one unit. In using aggregates, macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy and the relationships of its major aggregates. Macroeconomics speaks of such economic measures as total output, total employment, total income, aggregate expenditures, and the general level of prices in analyzing various economic problems. No or very little attention is given to specific units making up the various aggregates. APPROACHES TO THE STUDY OF ECONOMICS Both microeconomics and macroeconomics contain elements of positive economics and normative economics. Positive Economics focuses on facts and cause-and-effect relationships. It includes description, theory development, and theory testing (theoretical economics). Positive economics avoids value judgments, tries to establish scientific statements about economic behavior, and deals with what the economy is actually like. Such scientific-based analysis is critical to good policy analysis. Positive Economics concerns what is, thus it is a “what is” analysis. Normative Economics, incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal (policy economics). Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for particular economic policies. Normative economics embodies subjective feelings about what ought to be, making it a “what ought to be” analysis. Example: Positive and Normative Statements Positive statement: “The unemployment rate in the Philippines is higher than its neighboring ASEAN countries.” Normative statement: Philippines ought to undertake policies to make its labor market more flexible to reduce unemployment rates. Note: Whenever words such as “ought or “should” appear in a sentence, you are very likely encountering a normative statement. TOPIC 3: THE ECONOMIZING PROBLEM Society must also make choices under conditions of scarcity. It, too, faces an economizing problem. The economizing problem involves the allocation of resources among competing wants. There is an economizing problem because there are: unlimited wants and limited resources. 7 RESOURCES AND FACTOR PAYMENTS Economic Resources 1. Land – includes all natural resources (“gifts of nature”) used in the production process (e.g., arable land, forests, mineral and oil deposits, and water resources), as well as space (i.e., location). “Rent” is the payment for the use of land (the idea that most natural resources are not/cannot be privately-owned, land requires rental payment for its use, the rental payment may come in for example, in the form of taxes). 2. Capital – (or capital goods) includes all manufactured (man-made) aids used in producing consumer goods and services. Included are all factory, storage, transportation, and distribution facilities, as well as tools and machinery. Economists refer to the purchase of capital goods as investment. Note that the term “capital” as used in economics, refers not to money but to tools, machinery, and other productive equipment. Because money produces nothing, it is not considered as an economic resource. Money (or money capital or financial capital) is simply a means for purchasing capital goods. *financial and physical/real *consumer goods = products or services that satisfy needs *capital goods = do not directly satisfy consumer needs but help produce consumer goods more efficiently *(capital) investment = spending or accumulating capital goods Human Resources 3. Labor – consists of the physical and mental talents of individuals used in producing goods and services. It refers to skills, abilities, knowledge (called human capital) and the effort exerted by people in production. “Wages” is the payment for the use of labor, it is a monetary compensation paid by an employer to an employee in exchange for work done. 4. Entrepreneurial ability – a special human resource, distinct from labor, which refers to the talents or abilities of economic agent who creates an enterprise (initiates in combining the resources to create an enterprise; makes strategic business decisions; an innovator; a risk bearer). The entrepreneurial talent is paid “profits”, the amount remaining after subtracting from the revenues (or sales) of a firm the total monetary costs of all business activities, as well as the opportunity costs of all resources used in the current business activity. ECONOMICS AND EFFICIENCY Scarce resources are ideally best allocated if societies used them efficiently. Economic efficiency means that the societies are able to produce 8 the maximum output given limited inputs. Economic efficiency consists of the following components (or the requirements to become efficient): 1. Full employment – the economy is employing all its available resources (implies quantity of resources) 2. Full production – employed resources must contributed to their greatest to total output (implies quality of resources) There are two concepts of economic efficiency: 1. Allocative efficiency – is attained when the goods and services produced are the ones most valued or most demanded by society. This means that goods and services are produced because consumers are willing to pay for them and that meets satisfaction. 2. Productive efficiency – is attained when the economy produces at the least cost possible way. PRODUCTION POSSIBILITIES MODEL Society uses its scarce resource to produce goods and services. How does a society decide how scarce resources are used? The alternatives and choices a society faces can best be understood through a macroeconomic model of production possibilities. To keeps things simple, we initially assume that the economy: Is at its full employment condition; Is using resources at that given time period, thus assumed fixed resources supply; Is using whatever technology (the methods used to produce output) present at that time period (fixed technology); and Is producing only two goods. 1. Production Possibilities Table (Schedule) – lists the different combination of two products that can be produced with a specific set of resources Example: The economy decides to produce only two goods: rice symbolizes consumer goods (goods that satisfy wants directly) and industrial robots symbolize capital goods (products that satisfy wants indirectly by making possible more efficient production of consumer goods) Table 1.1: Production Possibilities of Rice and Industrial Robots Production Alternatives Type of Product A B C D E Rice (in hundred thousands of sacks) 0 1 2 3 4 Industrial Robots (in thousands) 10 9 7 4 0 9  2. Production Possibilities Curve (PPC) – a curve which shows the various combinations of two goods that a society in a fully employed economy, assuming a fixed availability of supplies of resources and constant technology. Characteristics of PPC: Downward sloping If the society wants to move from one point to another point, it requires that one good has to be given up or sacrificed (increase X, decrease Y). The rationale for this is that there is opportunity cost involved in deciding to increase one production at the expense of the other good. Because resources are fixed at a given production time period, an increase in one production requires that the society needs to reduce the inputs used in the other production to increase the inputs used to produce more of the other good. Concave Concavity (bowed out from the point of origin) means that as X increases, Y decreases at an increasing rate. This means that as more and more of pizza is produced, more and more of industrial robots must be given up. This is called the law of increasing opportunity cost. The economic rationale for the law of increasing opportunity costs is that economic resources are not completely adaptable to alternative uses. Many resources are better at producing one type of good than at producing others. This means that as resources are pulled away from one good, the resources will not readily adapt to their next use. This therefore will become costlier for the society to produce one good at the expense of the other good. Analysis of the PPC: All combinations on the curve are maximum output of the two products; the limit of attainable output. Points on the curve are attainable as Industrial robots (thousands) long as all available resources are used. Point A means that all resources are devoted in the production of robots. Point E means that all resources are devoted in the production of rice. Points lying inside the curve are also attainable, but they reflect less total output and therefore are less desirable as points on the curve. Points beyond the production possibilities curve, like W, would represent a greater output than the output at any point on the curve. Such points, however, are unattainable with the current availability of resources and technology. 10  Rice (hundred thousand sacks) Figure 1.3: The Production Possibilities Curve Calculation of Opportunity Cost: Product A B C D E Rice (‘000,000 sacks) 0 1 2 3 4 Robots (‘000 units) 10 9 7 4 0 A to B Opportunity cost of 1st sack (add’l 100,000) of rice = 1 (1000) Robot B to C Opportunity cost of 2nd sack (add’l 100,000) of rice = 2 (2000) Robots C to D Opportunity cost of 3rd sack (add’l 100,000) of rice = 3 (3000) Robots D to E Opportunity cost of 4th sack (add’l 100,000) of rice = 4 (1000) Robots Increasing values of robots UNEMPLOYMENT AND ECONOMIC GROWTH sacrificed for additional unit produced of rice UNEMPLOYMENT AND ECONOMIC GROWTH Any point inside the production possibilities curve, such as U, represents unemployment or a Industrial robots (thousands) failure to achieve full employment. The arrows indicate that by realizing full employment, the economy could operate on the curve. This means it could produce more of one or both products than it is producing at point U. Rice (hundred thousand sacks) Figure 1.4: PPC and Unemployment A society can still attain a combination of goods and services beyond its PPC. And when this happens, the society experiences what is called economic growth, which means that more goods and services are produced than the previous time period. 11  Economic growth is depicted by a shift to the right of the PPC and it requires the following: 1. Increase in the supply of resources (e.g., population growth increases the supplies of Industrial robots (thousands) labor and entrepreneurs; labor quality improves overtime via more education and training; increased investment in capital goods) 2. Advances in technology – brings both new and better goods and improved ways of MODULE 2: THE MARKET MECHANISM producing them. 3. Use of better inputs to production (e.g., better grain of seedling) 4. International trade –it is usually better for a country to specialize on the cheaper product to produce, and use this to trade with another country for more expensive Rice (hundred thousand sacks) product Figure 1.5: PPC and Economic Growth Product A’ B’ C’ D’ E’ Rice (‘000,000 sacks) 0 2 4 6 8 Robots (‘000 units) 14 12 9 5 0 BASIC ECONOMIC QUESTIONS Scarcity imposes every society to make choices. In allocating scarce resources, these choices of societies revolve around three basic economic problems: 1. What to produce? –This question allows decision SCARCITY makers to determine what their scarce resources will be best used for. Goods and services are produced to meet people’s wants and needs or Imposes to satisfy the demands of the society, that is based on many factors. 2. How to produce? – This question allows the CHOICE economy to determine what combination of inputs will be used to produce goods and services. Ideally, the best combination of inputs is that which produces at the least-cost possible way. 1. What to produce? 3. For whom to produce? – This question allows 2. How to produce? societies to decide who gets the produced 12 output (e.g., willingness to pay, centralized 3. For whom to produce distribution such as the case of communism) Figure 1.6: Basic Economic Questions BASIC ECONOMIC SYSTEMS Every society needs to develop an economic system – a particular set of institutional arrangements and a coordinating mechanism – to respond to the economizing problem. The economic system has to determine what goods are produced, how they are produced, who gets them, how to accommodate change, and how to promote technological progress. Economic systems differ as to (1) who owns the factors of production and (2) the method used to motivate, coordinate, and direct economic activity. Economic systems have two polar extremes: the command system and the market system. 1. Traditional System A traditional economic system is one in which people’s economic roles are the same as those of their parents or grandparents. Tradition decides what the people do for a living and how their work is performed. Whatever is done in the past is still carried on at present. Societies in this system are still self-sufficient and needs very little interaction from highly populated and urbanized societies. 2. Command System This system is also known as communism, where the government owns most property resources (public ownernship) and economic decision making occurs through a central economic plan. A central planning board appointed by the government makes nearly all the major decisions concerning the use of resources, the composition and distribution of output, and the organization of production. The government owns most of the business firms, which produce according to government directives. The central planning board determines production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals. The division of output between capital and consumer goods is centrally decided, and capital goods are allocated among industries on the basis of the central planning board’s long-term priorities. 3. Market System Market system or capitalism is the polar alternative to the command system. This system is one in which a nation’s economic decisions are the result of individual decisions by buyers and sellers in the market. A market is 13 a mechanism which brings together buyers and sellers. This system is the widely adapted economic system of most countries in the world. The following are important characteristics of a market system: a. Private Ownership of Property Resources Private individuals and firms, not the government, own most of the property resources (land and capital). It is for this reason that the market system is called capitalism. This right of private property, coupled with freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, use, and dispose of property resources as they see fit. What property rights can do are the following: 1. encourage investment, innovation, exchange, maintenance of property and economic growth; 2. also extend to intellectual property through patents, copyrights, and trademarks; 3. facilitate exchange; 4. encourage owners to maintain or improve their property so as to preserve or increase its value; and 5. enable people to use their time and resources to produce more goods and services, rather than using them to protect and retain the property they have already produced or acquired b. Freedom of Enterprise and Choice Freedom of enterprise ensures that entrepreneurs and private businesses are free to obtain and use economic resources to produce their choice of goods and services and to sell them in their chosen markets. Freedom of choice enables owners to employ or dispose of their property and money as they see fit. It also allows workers to try to enter any line of work for which they are qualified. Finally, it ensures that consumers are free to buy the goods and services that best satisfy their wants and that their budgets allow. c. Self-Interest In the market system, self-interest is the motivating force of the various economic units as they express their free choices. Self-interest simply means that each economic unit tries to achieve its own particular goal, which usually requires delivering something of value to others. d. Competition Market system allows competition or economic rivalry based on the freedom of choice exercised in the pursuit of monetary return. Competition requires: Many buyers and many sellers acting independently in a particular product or resource market. Freedom of sellers and buyers to enter or leave markets, on the basis of their economic self-interest. 14  What competition can do: diffuses economic power – no single buyer or seller can dictate the price of the product or resource because others can undercut that price; limits the potential abuse of power no insurmountable barriers prevent an industry’s expanding or contracting and provides the economy with the flexibility needed to remain efficient over time and enables the economy to adjust to changes in consumer tastes, technology, and resource availability. e. Markets and Prices Millions of decisions made by households and businesses are highly coordinated with one another by markets and prices, which are key components of the market system. They give the system its ability to coordinate millions of daily economic decisions. A market system conveys the decisions made by buyers and sellers of products and resources. The decisions made on each side of the market determine a set of product and resource prices that guide resource owners, entrepreneurs, and consumers as they make and revise their choices and pursue their self-interest. f. Technology and Capital Goods The market system therefore encourages extensive use and rapid development of complex capital goods: tools, machinery, large-scale factories, and facilities for storage, communication, transportation, and marketing. Advanced technology and capital goods are important because the most direct methods of production are often the least efficient. The only way to avoid that inefficiency is to rely on capital goods. g. Specialization Specialization is the use of resources of an individual, firm, region, or nation to produce one or a few goods or services rather than the entire range of goods and services. Those goods and services are then exchanged for a full range of desired products. h. Use of Money A rather obvious characteristic of any economic system is the extensive use of money. Money performs several functions, but first and foremost it is a medium of exchange. It makes trade easier. i. Active, but Limited Government: “Laissez Faire” (Leave it Alone) Ideology Market system relies on the idea that it can be “left alone” without too much government intervention. Market system is characterized as self- adjusting, self-regulating system. The government’s role is limited to provision of legal framework. However limited, the role of government 15  is active and important because market system has inherent shortcomings. 4. Mixed System Today, modern economies have evolved to encompass several characteristics of several economic systems. Market economies, although giving their constituents a very wide range of economic choices and freedom, still enjoy reasonable government intervention, especially in basic goods and services. Most real-world economies today are considered mixed, many are heavily reliant on market system (free enterprise economy) with government intervention (command system). ROLE OF GOVERNMENT The economic activities of the public sector – national, state, and local government – are extensive. The economic functions of the government are: 1. Providing the Legal Structure Government provides the legal framework and the services needed for a market economy to operate effectively. The legal framework sets the legal status of business enterprises, ensures the rights of private ownership, and allows the making and enforcement of contracts. Government also establishes the legal “rules of the game” that control relationships among businesses, resource suppliers, and consumers. Discrete units of government referee economic relationships, seek out foul play, and impose penalties. Government intervention is presumed to improve the allocation of resources. 2. Maintaining Competition When monopoly exists, an industry is controlled by controlling supply and charging higher price, this is the essence of monopoly power. Governments can correct this situation by controlling monopoly through regulation and through antitrust. For example, telecommunications industry in the Philippines used to be a monopoly. But since the government deregulated the industry, competition was brought back with more suppliers now than it used to. 3. Redistributing Income The market system is impersonal and may distribute income more inequitably than society desires. The system has created statuses and income levels, making a gap between the rich and the poor. The poor have less access to some goods and services. Thus, society chooses to redistribute a part of total income through a variety of government policies and programs. They are: Transfer payments – Government payments can come in the form of welfare checks and food stamps, provide relief to the destitute, the dependent, the disabled, and older citizens. 16  Market intervention – Government also alters the distribution of income through market intervention, that is, by acting to modify the prices that are or would be established by market forces. Providing farmers with above-market prices for their output and requiring that firms pay minimum wages are illustrations of government interventions designed to raise the income of specific groups. Taxation – The government uses the personal income tax to take a larger proportion of the income of the rich than of the poor, thus narrowing the after-tax income difference between high-income and low- income earners. 4. Reallocating Resources Market failure occurs when the competitive market system (1) produces the “wrong” amounts of certain goods and services or (2) fails to allocate any resources whatsoever to the production of certain goods and services whose output is economically justified. Market failures are in the form of: a. Externalities An externality occurs when some of the costs or the benefits of a good are passed on to or “spill over to” someone other than the immediate buyer or seller. Such spillovers are called externalities because they are benefits or costs that accrue to some third party that is external to the market transaction. Externalities can be negative or positive. When production or consumption costs inflicted on a third party without compensation, the costs are called negative externalities. Environmental pollution is an example. Some externalities get resolved via private negotiations between those creating the externalities and those affected by them. But when the externalities are widespread and negotiation between parties is unrealistic, government can play an important role. For example, legislation prohibiting or limiting a negative externality can be applied especially in the case of pollution. Another is an imposition of specific taxes, a less direct action imposed on a polluting firm that adds to cost of production. Sometimes externalities appear as benefits to other producers or consumers. These un-compensated spillovers accruing to third parties or the community at large are called positive externalities. Immunization against measles and polio results in direct benefits to the immediate consumer of those vaccines. But it also results in widespread substantial external benefits to the entire community. Education is another example of positive externalities. Education benefits individual consumers: Better-educated people generally achieve higher incomes than less-well- educated people. But education also provides benefits to society, in the form of a more versatile and more productive labor force, on the one hand, and smaller outlays for crime prevention, law enforcement, and welfare programs, on the other. Government can further enhance positive externality especially when the benefit is 17  under-allocated through subsidies (for consumers and producers). Government may finance or, in the extreme, own and operate the industry that is involved. b. Public Goods and Services Everyone can simultaneously obtain the benefit from a public good (eg., national defense, street lighting, and environmental protection). One person’s benefit does not reduce the benefit available to others. More important, there is no effective way of excluding individuals from the benefit of the good once it comes into existence. The inability to exclude creates a free-rider problem, in which people can receive benefits from a public good without having to pay for it. With taxation, government then spends the tax proceeds to provide public goods and services. Taxation releases resources from the production of private consumer goods (food, clothing, television sets) and private investment goods (printing presses, boxcars, warehouses). Government shifts those resources to the production of public and quasi-public goods (post offices, submarines, parks), changing the composition of the economy’s total output. 5. Promoting Stability Unemployment. When private sector spending is too low, resulting in unemployment, government may try to increase total spending (private + public) by raising its own spending or by lowering tax rates to encourage greater private spending. Also, the nation’s central bank may take monetary actions to lower interest rates, thereby encouraging more private borrowing and spending. Inflation. Inflation is a general increase in the level of prices. Prices of goods and services rise when the amount of spending in the economy expands more rapidly than the supply of goods and services. This can happen when the nation’s central bank allows interest rates to remain too low for the economic circumstances. In such situations, the central bank can act to lower inflation by increasing the interest rate so as to dampen private borrowing and spending. The government may also try to reduce total spending by cutting its own expenditures or boosting tax rates to reduce private spending. 18