Macroeconomics

Unit 4 The Public Sector The Top Five Concepts

©2007, 2005 by E.H. McKay III Some images ©2004, 2003 www.clipart.com

Concept 1: Optimal Mix of Output

An overall goal of our society is to obtain the optimal mix of output that best satisfies society’s needs. The

optimal mix of output

is the most desirable combination of output attainable with existing resources, technology, and social values.

Looking specifically at the production possibilities curve, the optimal mix of output is the location where the best combination of all goods and services occurs.

We often fail to achieve an optimal mix of output because of market failure. Often the government is asked to improve the mix of output when market failure occurs.

Production Possibilities Curve and the Mix of Output

A (

Optimal mix)

B

(Market mix) All Other Goods and Services (units per time period )

Production Possibilities and Optimal Output

At point A on the preceding graph, the correct combination of goods and services are produced, including the optimal number of CDs compared with all other goods and services. All resources used to produce goods and services are fully utilized.

At point B the market is producing too many other goods and services and an insufficient amount of CDs. Market failure has occurred even though all resources are full utilized.

Production Possibilities and Optimal Output

To expand our economic potential for growth, the production possibilities curve needs to shift outward. This can be accomplished by the use of better technology by business and the improved productivity of labor and capital.

As the production possibilities curve shifts outward, more resources are available for the production of goods and services and our economy expands.

Concept 2: Causes of Market Failure

There are four sources of market failure: • Public Goods • Externalities • Market Power • Equity

Public Goods

Public goods

are a good or service whose consumption by ones person does not exclude consumption by another. For example roads, national defense, and the courts are examples of public goods.

Market failure from public goods arises from the concept of free riders.

Free riders

are individuals who reap direct benefits from someone else’s purchase (consumption) of a public good.

Public goods are paid primarily through taxation – otherwise very few people would want to pay for public goods. Everyone would like to be a free rider.

Public Goods

Examples: A group of homeowners establish a sewer system around a lake. Everyone who owns property pays. The lake water becomes clear and the fish thrive. Other people use the public access to the lake and go fishing. They are free-riders.

Building a dam to protect a valley from flooding. Some people may want it, some don’t. Usually no one wants to pay for it. It may get financed through tax dollars or a bond.

Public Goods

We also have goods.

private goods

. A private good is a good or service whose consumption by one person excludes consumption by others. The pop you drank this morning or the mint or gum you have in your mouth are examples of private The problem is that the market tends to overproduce private goods and underproduce public goods.

The solution is to have government intervention to force people to pay for flood control, sewers, etc. Increasing public good expenditures causes a reduction in private good spending.

Externalities

Externalities

are costs (or benefits) of a market activity borne by a third party; the difference between the social and private costs (benefits) of a market activity.

Examples include smoking and secondhand smoke; paper production and water pollution; sharing your knowledge of economics with a friend.

The market tends to overproduce items that have external costs while under producing items that have external benefits.

Externalities

External costs

are costs not being accounted for by a business. For example, if a paper company produces paper products but does not have to pay for the water it pollutes when it dumps its wastes into the local river, this is an external cost.

External costs need to be captured and accounted for by the business producing the product. If the same business installs equipment that cleans the water before it is discharged into the river, then the external cost has been captured.

In this situation, the price of paper products will rise to reflect the cost of compliance – the external cost has been eliminated.

Externalities

Market failure can occur when externalities are present and the costs (or benefits) of those activities are not reflected in the market. For example, if a company pollutes a river during the process of manufacturing a product and the costs associated with the river damage are not recognized.

Government intervention is needed to ensure the external costs are reflected in the price (anti-pollution equipment or clean-up costs, for example) and external benefits are recognized.

Market Power

Market power

is the ability to alter the market price of a good or service at any time. Market power provides a business with the ability to initiate significant price changes, not incremental changes.

Companies with the most market power are called monopolies.

Monopolies

are firms that produce the entire market supply of a particular good or service.

Market Power

Most of the monopolies in existence are called

natural monopolies

. Because of economies of scale, some markets are better served by one provider.

Examples of natural monopolies include your local telephone company, cable company, and many utility companies.

Market Power

Excessive market power may lead businesses to charge excessive prices for their products or services. The optimal mix of output under this condition would not be attained. Market failure then occurs.

If market power is abused, antitrust regulations can be used to curtail it. The focus of abuse of market power.

antitrust regulation

is to prevent the Government regulation can also be focused on the behavior of the monopoly. Service and quality issues are common complaints with regulated natural monopolies.

Equity

Equity issues

are concerned with for whom the goods and services are produced. If a significant population is not receiving goods or services, then market failure occurs.

Taxes are used by the government as a method to redistribute income from wealthy individuals to needy individuals.

Transfer payments

, which are payments to individuals for which no current goods or services are exchanged, are used (Social Security, welfare, unemployment, subsidized student loans) to redistribute income.

Concept 3: Taxation

The U.S. Federal Income tax on individuals is called a progressive tax. A

progressive tax

is a tax system in which tax rates (percentages) rise as incomes rise.

Current federal rates vary from 10% on incomes over $15,000, to 35% on incomes over $300,000. The progressive nature of the federal income tax indicates that as incomes rise, the

amount

of tax paid and the

percentage

both increase.

Taxation

The State of Michigan and many other states and cities have a tax on income which is the same percentage, regardless of income.

A tax that charges the same percentage or rate on every dollar of income is called a

proportional tax

, or a flat tax. Even though the rate (percentage) is constant, the dollar amount of taxes you pay increases as your income increases.

The sales tax and the social security tax are considered regressive taxes. A

regressive tax

is a tax system in which tax rates fall as income rises.

Taxation

The federal government obtains about 45% of its tax revenue through the individual income tax. About 40% of the revenue is derived from the social security tax, 7% from corporate income taxes, and 8% from other taxes.

Since the social security tax is not applied to all income (over around $90,000/year is exempt), the tax is considered a regressive tax.

A

regressive tax

is a tax in which the actual rate paid falls as income rises.

Taxation

Regressive taxes like the sales tax tend to affect lower and middle income people more.

These income levels tend to spend a greater portion or percent of their income on consumption subject to the sales tax. As a result the total percentage of income spent on the tax is higher for lower income groups than upper income groups.

Corporations also pay a federal income tax rate of up to 38%.

State and Local Taxes

State governments obtain most of their revenue from income and sales taxes. Revenues are primarily spent on welfare and education.

Local governments obtain most of their revenue from property taxes, sales taxes, and income taxes. Revenues are primarily spent on education and public safety.

Taxation Other Revenue Sources

Categorical grants

are federal grants to state and local governments for specific expenditure purposes. Examples include sewer projects, crime prevention, economic development, etc.

User Charges

are a fee paid for the use of a public sector good or service. Examples include state park passes, tuition, parking meters, etc.

Concept 4: Government Failure

Government failure

public.

occurs when government intervention fails to improve market outcomes. Common sources of government failure include waste, outdated regulations, and a concern that the priorities of government may not match those of the general Government intervention examples include regulations for product safety, content, labeling, and use. Other examples include worker safety regulations and environmental emissions.

Government intervention is frequently analyzed on the basis of a cost-benefit analysis. Do the benefits of government intervention exceed the costs including the opportunity costs?

Concept 5: Public-Choice Theory

Public-Choice theory

is a theory that explains public sector behavior by emphasizing rational self-interest of decision makers and voters.

At the core of the theory is the concept that bureaucrats and elected officials are just as selfish as everyone else. Consequently they will support legislation and projects that help them achieve their personal goals (including re-election).

Concept 5: Public-Choice Theory

Public-Choice theory does not explain some popular public policy decisions like the War on Poverty during the Johnson administration, the rise of environmentalism, or the deregulation movement.

Obviously then individuals have some goals that arise out of the needs of society rather than personal needs.

Summary

Major concepts from this unit are: • Optimal Mix of Output • Market failure • Government Failure • Taxation • Public-Choice Theory