Government Intervention in the economy

Government Intervention in the economy

Spillover Benefits & costs • When 1 person’s consumption of a good provides utility to a 3rd party who has not directly purchased the good, we have spillover benefits • Not reflected in the market price of the good • AKA. Positive externality

Example • A home in a neighborhood spends money to professionally landscape their front yard. As a neighbor rides her bike past the yard, she smells the lovely scent of the roses. Although the neighbor did not spend any money on the roses, she is benefitting.

And, on a graph P S } P market Spillover benefits D social D private Q social Q market Q

So, what does this mean? • The market demand curve for roses captured the private benefits received by consumers of roses, but not the additional benefits received by neighbors of those who consumed roses • The private demand curve, which does not include the spillover benefits, lies below the societal demand curve. • The market produces only Qmarket roses, but the optimal amount is greater at Qsocial • Since the market produces less than the socially optimal amount, there is an underallocation of resources to rose production—society wants more than the market provides • The existence of spillover benefits in a market results in an underallocation of resources in that market= there’s not enough of a good thing

And… • The neighbor provided a public good (community beautification) while the other neighbors were free riders • How could we have contributed to the provision of the public good?

Subsidies for consumers • Market failures on a larger scale, are remedied through subsidies • The goal is to move the EQ from the Qmarket to the Qsocial • In the ex. of roses, the govt could provide a subsidy to gardeners, equal to the amount of the spillover benefit • By sending a check to the home who had the yard landscaped, the demand for roses would have increased, & shifted the Dprivate to the Dsocial

Subsidy for consumers P S Pfirm } Pmarket D social Subsidy Pcons D private Qsocial Qmarket Q

Subsidies for producers • What happens to the supply curve with a subsidy? • Let’s look at the next graph to see…

Subsidy for Producers P S S1 Pfirm } Pmarket D social Subsidy Pcons D private Qsocial Qmarket Q

Pollution & spillover costs • When a person’s consumption of a good imposes a negative utility on a 3rd party who did not purchase the good, we have spillover costs/negative externalities

Ex. Cigarette smoke • The thought is to move the spillover costs from those who do not smoke, and onto the producers (hence the cigarette tax)

On a graph… P Ssocial Sprivate } spillover cost Pmarket D Qmarket Qsocial Q

Coase Theorem • Ronald Coase is a Nobel Laureate in Economics • His theory states that resources can be allocated efficiently if private ownership rights are assigned and when there are no transaction costs. • no matter who receives the legal rights to ownership, the assignment will have no effect on the way economic resources are used.

Continued…. • The Coase Theorem changes the way people look at economic problems. • There is less need for govt intervention • In any economic transaction, solutions that can benefit most parties can be achieved by negotiations. • Ex. Environmental problems can be resolved if property rights are assigned rather than relying on government command & control. • Sounds like the free market to me!

Public Choice

Is it rational for government leadersto favor special interests over the general public interest? • The idea is that special interests have a big stake in govt, or a big interest in govt. • When special interests give politicians contributions & support, each member of the public may lose just a little when a special interest gets its way, so the public doesn’t pay attention. • The public is ignorant. Therefore, the politician goes with the special interest. • The more concentrated the benefit for the special interest and the more diffused the cost to the public, the more likely the special interest will get its way.

Why are politicians mainly in themiddle of the road? • The median-voter hypothesis predicts that politicians, regardless of party, will appeal to the median voter in the constituency they represent. • It also predicts that politicians will take a more extreme position in the party primary election (when they are appealing to the median voter in the party) than in the general election.

Are people rational or irrationalwhen they spend little time evaluatingcandidates before they vote and when they don’t vote? • This is known as rational ignorance! Why be informed about the candidates when your vote counts so little? Why even vote? • If this is true, why do so many people vote? The public-choice answer is that voting is a consumption activity. • Voting gives people a feeling that they did their civic duty. By voting, they can complain without guilt when they don’t like a government policy.

What is the effect of bureaucraticentrepreneurs on government? • A business is successful if it can maximize profits. • A bureaucrat is successful if he or she can maximize power. • Bureaucrats are rewarded when they expand the duties & clientele of their departments. • A bureaucrat will have a smaller department if it becomes more efficient. • Bureaucrats have an incentive to expand their departments, not to reduce them. With larger departments come more power, a bigger office, a higher salary etc.

Efficiency, equity & tax structure

Income distribution & tax structure • The govt is also called to action to remedy issues of equity or fairness • Markets do not provide equity or fairness • Ex. Some consumers can afford a new Mercedes, come cannot • Ex. Some parents can not afford pediatric care for their children

Equity as a goal • Some purpose that economics resources should be equally divided amongst all members of society • Egalitarianism:belief in the equality of all people, especially in political, social, or economic life. • Incentive to work hard, take risk or seek a competitive advantage are gone

Ex. • Everyone in class is guaranteed to be compensated with a “B” regardless of your effort. • What does this mean? • “C” level students won’t work hard because their grade will increase anyways • “A” students lack motivation to do well because they are compensated below their quality of work • Everyone works less

How do we measure income Distribution? • Let’s see what ReffEnomics has to say! • http://www.reffonomics.com/TRB/chapter19/LorenzCurveLesson5.swf

tax structures • Tax: is a mandatory payment to local, state, or nat’l govt • Revenue: is govt income from taxes & other nontax sources. • Revenues raised from taxes fund programs & govt services such as highways, police, education, & parks. • Other forms of revenues include lotteries & fees

Tax structures • Equity—tax applied uniformly; people in same situations pay the same • Simplicity—should be easy for taxpayers to understand & govt to collect • Efficiency—how well tax raises revenue with least administrative cost & how small the effort & expense are required to pay the tax • Criteria sometimes conflict; a given tax may not meet all

Tax structures • All taxes fall under the classification of 1 of these: • Proportional tax—flat tax—all taxpayers pay same %age of income Ex. Corporate income tax (35%) • Progressive tax—higher income earners pay higher %age of income Ex. Federal Income Tax • Regressive tax—lower income earners pay higher percentage of income, Ex. sales tax

And that… ladies & gentlemen is the end of Microeconomics!

Government Intervention in the economy