Macroeconomics The Government and the Economy EDBA 2014

Solving World Problems!

• • • • Governments and the Economy Circular Flow and National Public Accounting Money and Price Level International Trade

Market Failure

• • Market Failure – “A condition that arises when unrestrained operations in the markets yield socially undesirable outcomes” What do governments do to prevent market failure?

– Establishing and Enforcing the Rules of the game • Market efficiency depends on people using your resources to maximize your utility.

– Promoting Competition • Preventing firms from colluding. – Regulating Natural Monopolies • Natural monopolies – when one first serves the market at a lower cost than other firms. (and charges a higher price than socially optimal) – Providing Public Goods

What is a Public Good

• A public good is a good that is non-rival and non excludable. – Non-Rival – Means consumption of the good by one person does not reduce the availability of the good for others. – Non Excludable – means that no one can effectively be excluded from using the product – Examples: Air, Mp3 Songs, Youtube

Excludable Non-Excludable

Rivalries Non-Rivalries Private goods – Food, Clothing Cars Common Goods – Fish Stocks, timber Club Goods – Cinema, Private parks, satellite television Public goods – National TV, Defense • Taxes are used to pay for public goods!

Externalities

– Dealing with Externalities • Externality – a cost or benefit that falls on a third party and therefore ignored by the two parties to the market transaction. – Negative externalities - pollution – Positive externalities – beautification of the neighborhood • Market prices do not reflect externalities • Governments use the items below to discourage negative externalities and promote positive positions – Taxes – Subsidies – Regulations

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What do governments do to prevent market failure?

A more equal distribution of wealth – Resource markets does not guarantee a minimum level of income. – TRANSFER PAYMENTS – Reflect societies attempts to provide a basic standard of living. – This is also called welfare economics • • Minimum Wages Price Floors • Price Ceilings (Rent Control) • • Taxes Subsidies

Minimum Wage

• This is relatively prevalent in Western Countries

Price Floors

• • A price floor is a government or group imposed limit on how low a price can be charged for a product Effective Price floors are when the price floor is greater than the equilibrium price.

Price Ceiling

• • A imposed limit of the price charged for a product Only if the price ceiling is below the equilibrium price will it be effective.

• Consequences of Price Ceilings – Black Markets – Reduction in Quality – Discrimination

Taxes

• • You can tax the firm or the consumer. Taxes change behaviour.

Subsidies

• • Is a form of financial assistance paid to a business sector. Subsidies are given to – Prevent the decline of industry – Keep the cost of living down

Most important role of the government

• • • The most important role is to foster a healthy economy.

Full Employment, Price Stability and Economic Growth.

To do this governments use – Fiscal Policy – pursuing a healthy economy by using taxation and spending is known as fiscal policy – Monetary Policy – Regulating the money supply to achieve a healthy economy is called monetary policy.

Imperfect Information

• • • In competitive theory we assume all players enjoy perfect information. Imperfect information can cause the misallocation of resources and possibly market failure. Imperfect information can be caused by – Misunderstanding the true costs or benefits of a product – Uncertainty about costs and benefits – Complexity of information – Inaccurate or misleading information – Addiction.

Fiscal Policy and its Instruments

• Fiscal Policy – The use of government purchase and transfer payments, taxes and borrowing to influence aggregate economic activity such as inflation, employment and economic growth. – The two main instruments of fiscal policy are • Taxes • Government Spending

Taxation in Sri-Lanka

• According to the Inland Revenue – Income Tax – VAT – introduced in 2002 to replace GST • Standard Rate 12% • Luxury 20% – Economic Service Charge (does not exceed 30 million) – Debits tax – 0.1% of all savings and debit accounts – Betting and gambling levy – Nation building tax – 3% if your turnover is over 6500000 – Stamp Duty – Social Responsibility Levy – Turnover Tax

Taxation in Sri-Lanka

• • Currently the tax revenue is 14% of GDP Used to be 19% in 1992 • Taxes – Proportional – a fixed tax rate – Progressive – a tax by which the tax rate increases as the taxable base rate increases – Regressive – a tax where the rate decreases as the amount subject to taxation increases.

Budget Deficits

• • • A deficit is the amount by which a sum of money falls short of the required amount.

When you have a deficit what can you do – – You can borrow You can ask for a raise – – Sell some assets Spend less Governments do the same as shown above except one extra thing – They can print money

Budget Deficits Continued

• • • Gt – Tt (primary deficit) • • • G – Government Spending t – Time Frame T – All forms of taxes. Total Deficit = Spending + Interest Payment on Debt – Tax Revenue Budget Deficit Country Comparison https://www.cia.gov/library/publications/the-world factbook/rankorder/2222rank.html

• • • The principal is that we are “investing” We borrow  We invest  We reap higher tax revenue later It eventually has to be paid back.

Multiplier Effect

• • When the government spends 1 billion rupees worth of construction from a local company there are consequences. – Higher demand from the government – Increasing Employment – Higher wages, higher profits – Increased spending Because each rupee spent by the government raises aggregate demand by more than a rupee, government purchases are said to have a MULTIPLIER EFFECT on aggregate demand.

Crowding Out Effect

• • • There is another effect working in the opposite direction. As income rises, people choose to hold on to their money in liquid form. – There is an increase in demand for money – Government increases interest rates – This reduces investment spending – This puts downward pressure on aggregate demand. The reduction in aggregate demand that results when a fiscal expansion raises the interest rate is called the CROWDING OUT effect.

Privatization

• Privatization is the process of transferring owner of a business, enterprise, agency or public service from the public sector to the private sector • • Pros – Performance – Increased Efficiency – Specialization – Less Political interference – Less corruption – Accountability – Profit motivation Cons – Profit may not be the motive – Capital – Strategic and sensitive areas (defense) – Essential services – Job loss