This section describes in detail, the role of the government in the economy. It is one of the more
controversial topics in Economics. Should government be more or less involved in the economy?
In other words how large should government be? With the introduction of the Government sector,
our discussion moves from a private economy (Household + Business sectors) to a “mixed
economy”. As noted previously, the Government sector consists of federal, state and local
Economic Purposes or Functions of Government
The “economic basis” why government intervenes in markets follows.
1). Provide a Legal Structure
- the establishment and enforcement of laws that allow markets to operate in an
organized and fair fashion is a fundamental reason for government involvement in
markets. This involves necessary contract laws, securities laws, safety laws, fair
labor laws, environmental laws and etc.
2). Maintain Competition
- To protect consumers by encouraging competition and preventing single firms
(monopolies) from restricting output and charging high prices. One of the market
failures in a market system is that left along, larger companies will acquire or drive
out smaller companies. Government plays a role in preventing this from happening.
- Anti-trust laws are used to punish and prevent monopoly firms.
- Government regulation is also used to control the output and prices of what are
called “natural monopolies.
3). Redistribute Income
- the pure market system will lead to an inequitable distribution of income. This is one
of the market failures or flaws in the market system. Those who have special skills
are able to earn more than those who don’t; sickness, health, age and handicaps
prevent some from working; and individuals from wealthy families can inherit assets.
- tools government can use to redistribute income more equitably or fairly.
a). price ceiling/floors that benefit low income groups, i.e. minimum wage laws,
crop price supports, rent controls.
b). transfer payments – gifts of money or products to low income groups that require
nothing in return, i.e. welfare payments, food stamps. Transfer payments are a
component of total government expenditures. The other component is
government expenditures that involve “purchases” of products. This distinction is
c). taxation – tax higher incomes at a higher % than lower incomes to reduce
difference between high and low income workers.
- benefits vs. cost of government redistribution of income
Costs: reduced incentives for work and investment hence lower output/income.
4). Promote Economic Stability and Economic Growth
Take appropriate steps to correct for:
- Insufficient economic growth
5). Reallocate Resources Due to Markets Failure to “Properly” Allocate Resources
(means too much or too little of a product is produced and resources need to be
transferred from one industry to another)
- Case of Public Goods and Quasi-Public Goods
a). a public good is a product that must be “jointly consumed” and possesses “non-
rivalry” and non-excludability. A public good is a special type of good in
contrast to a private good. An example of a public good is a lighthouse on the
coast of Maine or national defense. If a lighthouse is built, all ships at sea
would benefit and if national defense is provided for one citizen all citizens
would benefit. With a private good, the satisfaction accrues only to the one that
owns the good, unless they want to share it! Other examples are national
defense and police protection.
b). a private good is a product that people can be “excluded from consuming”.
A private good possesses rivalry. Examples are a car, sweater, apple.
c). the “free rider problem” applies to a public good. Citizens will wait until a public
good is produced so they will not have to pay for it.
d). because of the nature of a public good, the private market won’t produce them.
Since many public goods are of benefit to society, the government intervenes
and produces them.
e). Quasi-Public Goods or Merit Goods
1). these are goods that people can be excluded from and that would be
underproduced in a market, but the government produces and provides free
to all because of their special merit or value to society.
2). examples are libraries, roads, museums, police, fire protection, etc.
- Case of Spillovers or Externalities
a). situation where the market does not account for a cost or benefit associated
with the market.
b). spillover cost/benefits occur when the production or consumption of a
product causes harm or benefit to a 3rd party (not a buyer or seller of a
An example of a spillover cost would be the pollution of a stream by an oil
refinery. The government's role is then to correct the spillover cost by forcing
the refinery to take steps to clean up and prevent the pollution.
c). another way to look at spillover costs/benefits: Private costs/benefits are those
affecting only buyer and seller in a market transaction. Social costs/benefits are
those affecting society as a whole (including buyer and seller). Private
costs/benefits + spillovers = social costs/benefits. If there are no spillovers then
the private costs/benefits = the social benefits which is the way the market
outcome should be.
d). markets left alone will overproduce products that generate external costs.
e). tools government can use to correct spillover costs.
- legislation/regulation to penalize/reduce spillover costs: clean air water acts,
- specific taxes equal to spillover costs.
- these tools attempt to correct spillover costs and overproduction by
increasing price and reducing output.
f). markets left alone will underproduce products that generate external benefits.
g). tools government can use to correct external benefits.
- subsidies to consumers.
- subsidies to producers.
- government production of products that have spillovers benefits.
- these tools attempt to correct spillover benefits and underproduction by
reducing price and increasing output.
There are two important classes of government expenditures. They are
1). government purchases.
2). government transfer payments.
Public Sector Finance
This section describes where the public sector spends its money and where the money to
finance the spending comes from.
- Major Federal Government Expenditures
a). public goods and services and quasi-public goods/services.
b). welfare payments
c). social security payments
d). transfer payments to state/local government
e). interest on debt
The last four listed expenditures are transfer payments and account for over 50% of all government expenditures.
- Major Sources of Funds for Federal Government
a). personal income taxes
b). corporate income taxes
c). payroll taxes, i.e. social security and medicare taxes
d). excise taxes.
- Major State/Local Government Expenditures
a). local public goods and services
b). welfare benefits
Note: state/local government have no interest payments
- Major Sources of Funds for State/Local Governments
a). sales taxes
b). property taxes
c). income taxes (not Texas)
d). federal aid
e). user fees (fees paid to use public or quasi-public goods
- Growth of Government
a). absolute size of public sector in terms of $ spent has increased tremendously
during last 100 years.
b). relative size of government spending for goods and services as a % of GDP
has remained stable between 20-25% since 1960.
a). purpose of taxes are twofold: 1). raise revenue and 2). discourage production
or consumption of products.
b). the effect of taxes is to transfer resources from the private sector to the public
sector. Taxes involve an opportunity cost, i.e. that which the private sector
has to give up.
- Tax Rates
a). average tax rate = total tax divided by total income
example: $2,000 in taxes divided by $20,000 income = 10% average tax rate
b). marginal tax rate = “change” in tax divided by “change” in income
example: taxes go from $1,450 to $2,000, while income goes from $15,000 to
$20,000. Therefore, marginal tax rate = $550 increase in taxes divided by
$5,000 increase in income = 11% marginal tax rate.
- Tax Rate Structures
a). Proportional – average tax rate is constant as income increases.
b). Progressive – average tax rate increases as income increases.
c). Regressive – average tax rate declines as income increases.
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