Econ 2305 Ch 05 Slides PDF

Macroeconomics Chapter 5 – Public Spending and Public Choice Learning Objectives: 5.1 Explain how market failures such as externalities might justify economic functions of government 5.2 Distinguish between private and...

Macroeconomics Chapter 5 – Public Spending and Public Choice Learning Objectives: 5.1 Explain how market failures such as externalities might justify economic functions of government 5.2 Distinguish between private and public goods and explain the free rider problem 5.3 Describe the political functions of government and its involvement in the economy 5.4 Analyze how public spending programs affect consumption incentives 5.5 Discuss the central elements of the theory of public choice [Let’s review] Characteristics of a price system (market system or free market) from prior chapters: Consumers and producers answer the what, how and for whom questions (not the government or central authority). Price is set by the interaction of supply and demand. Markets automatically move to equilibrium where QD = QS if prices are free to change. Price rations (or allocates) goods and services to those who are willing and able to pay for them. I. Market Failures and Externalities A. Advantages of a Price System Resources move to their most valuable uses resulting in efficiency. Consumers signal their desires based on what they purchase, and producers respond. Competition benefits both buyers and sellers. B. Market Failures and Externalities Market failure – occurs when the market economy leads to too few or too many resources going to a specific economic activity Causes a combination of goods and services that is not optimal or results in an inequitable distribution. Provides justification for government correction or intervention. Four microeconomic sources of market failure are: 1) externalities, 2) market power, 3) public goods, and 4) inequity Externalities – cost or benefit of a market activity that affects or spills over to a third party Third party – those not directly involved in an activity or transaction 1. Negative externality, such as pollution: Creates an external cost; producer does not pay the cost of polluting. The cost is imposed on society or spills over. Too much of the polluting good is produced; too many resources are allocated to it. Government intervention to correct negative externalities: Taxes or fees charged to the producer Regulations to limit or prohibit Intervention shifts the cost to the producer, the supply curve shifts to the left; equilibrium P and Q (Figure 5-1 Panel a) 2. Positive externality, such as inoculations against a communicable disease: Creates an external benefit. The benefits spill over to those who don’t participate. Too little is produced; too few resources are allocated to it.  Government intervention to correct positive externalities: Government financing or production (operate free inoculation centers) Regulation to require an action (inoculations required for school attendance) Subsidies (negative taxes) If government encourages or mandates an activity, the demand curve shifts to the right; equilibrium P and Q (See Figure 5-1 Panel b) II. The Other Economic Functions of Government A. Promoting Competition A competitive economic system contributes to economic efficiency. Monopoly – a firm that can set the market price of the goods they sell A monopoly has market power. Monopolies tend to underproduce goods and services and charge a higher price than a competitive market would. The government intervenes to correct market power through: Antitrust legislation – laws that restrict the formation of monopolies and regulate certain anticompetitive practices; the Federal Trade Commission (FTC) and the Antitrust Division of the Department of Justice enforce antitrust laws  B. Providing Public Goods Private goods – can be consumed by only one person at a time Public goods – can be jointly consumed by multiple people at the same time Free-rider problem – some people can benefit from a public good without paying for it Since nonpayers can’t be excluded, the market has no incentive to provide public goods. The government must provide public goods. BUT, just because the government provides a good, that does not make it a public good. C. Ensuring Economywide Stability Our macroeconomic goals are full employment, price stability, and economic growth. Failure to meet these goals results in macroeconomic failure and provides justification for government programs. III. The Political Functions of Government Inequity – unfair or unjust The government uses some of the money collected through income taxes to make transfer payments. This income redistribution helps to reduce inequities. Transfer payments – monetary payments to individuals for which no goods or services are received in return (Social Security payments and unemployment benefits)  Transfers in kind – payments in the form of actual goods and services for which no goods or services are received in return (school meals and healthcare) IV. Public Spending and Transfer Programs Federal Government Spending For 2023, the federal government spending was ~ $6.4 trillion (preliminary data). Federal spending breakdown based on Figure 5-3: Income transfers (Social Security, Medicare, income security, etc.): ~ 60% State and Local Government Spending For 2023, state and local government spending was ~ $3.8 trillion (preliminary data). State and local spending breakdown based on Figure 5-3: Education: 33% V. Collective Decision Making: The Theory of Public Choice Theory of public choice – the study of collective decision making Examines how decisions are made in the public sector Emphasizes that voters, politicians, political parties, etc. act in their own self-interest