1. McConnell and Brue Chapters 4, 28, 29, and 32

2. What role does government play in a market economy? What are some responsibilities/functions of federal government? State government? Local government?

3. 1. Enforce laws and contracts. 2. Maintain competition. 3. Redistribute income. Provide an economic safety net.

4. 4. Provide public goods: Nonexclusion: individuals cannot be excluded from the benefits of a good or service, regardless of whether or not they have paid for it. Shared consumption: when one person’s use or consumption of a good or service does not reduce its usefulness to others.

5. 5. Correct market failures: Provide market information. Correct negative externalities. Subsidize goods with positive externalities. Externality: the uncompensated impact of one person’s actions on the well-being of a bystander

6. Free goods provide a special challenge for economic analysis. Most goods in our economy are allocated in markets…

7. When goods are available free of charge, the market forces that normally allocate resources in our economy are absent.

8. When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts.

9. In such cases, government policy can potentially remedy the market failure that results, and raise economic well-being.

10. When thinking about the various goods in the economy, it is useful to group them according to two characteristics: Is the good excludable? Is the good rival?

11. Excludability – Excludability refers to the property of a good whereby a person can be prevented from using it. The seller controls who can receive benefits from the product. Rivalry – Rivalry refers to the property of a good whereby one person’s use diminishes other people’s use. When one buys or consumes the product, it is not available for someone else.

12. Four Types of Goods Private Goods Public Goods Common Resources Natural Monopolies

13. Private Goods Private Goods – Are both excludable and rival. Public Goods Public Goods – Are neither excludable nor rival. Common Resources Common Resources – Are rival but not excludable. Natural Monopolies Natural Monopolies – Are excludable but not rival.

14. Copyright © 2004 South-Western Rival? Yes Ice-cream cones Clothing Congested toll roads Fire protection Cable TV Uncongested toll roads No Private GoodsNatural Monopolies No Excludable? Fish in the ocean The environment Congested nontoll roads Tornado siren National defense Uncongested nontoll roads Common ResourcesPublic Goods

15. A free-rider is a person who receives the benefit of a good but avoids paying for it.

16. Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. The free-rider problem prevents private markets from supplying public goods.

17. Solving the Free-Rider Problem The government can decide to provide the public good if the total benefits exceed the costs. The government can make everyone better off by providing the public good and paying for it with tax revenue.

18. National Defense Basic Research Fighting Poverty

20. Cost-benefit analysis refers to a study that compares the costs and benefits to society of providing a public good. In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good.

21. A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. The value of life, the consumer’s time, and aesthetics are difficult to assess.

22. Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Common resources are rival goods because one person’s use of the common resource reduces other people’s use.

23. The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole. Common resources tend to be used excessively when individuals are not charged for their usage. This is similar to a negative externality.

24. Clean air and water Congested roads Fish, whales, and other wildlife

25. Will the market protect me? Private Ownership and the Profit Motive!

26. Recall: Adam Smith’s “invisible hand” of the marketplace leads self- interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen.

27. An externality refers to the uncompensated impact of one person’s actions on the well-being of a bystander. Externalities cause markets to be inefficient, and thus fail to maximize total surplus. An externality arises...... when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for that effect.

28. When the impact on the bystander is adverse, the externality is called a negative externality. Negative externalities lead markets to produce a larger quantity than is socially desirable. When the impact on the bystander is beneficial, the externality is called a positive externality. Positive externalities lead markets to produce a smaller quantity than is socially desirable.

29. Negative Externalities Automobile exhaust Cigarette smoking Barking dogs (loud pets) Loud stereos in an apartment building

30. Positive Externalities Immunizations Restored historic buildings Research into new technologies

31. Copyright © 2004 South-Western Quantity of Aluminum 0 Price of Aluminum Equilibrium Demand (private value) Supply (private cost) Q MARKET

32. The Market for Aluminum The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers.

33. The Market for Aluminum For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution.

34. Copyright © 2004 South-Western Equilibrium Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q OPTIMUM Optimum Cost of pollution Q MARKET

35. The intersection of the demand curve and the social-cost curve determines the optimal output level. The socially optimal output level is less than the market equilibrium quantity.

36. Internalizing an externality involves altering incentives so that people take account of the external effects of their actions.

37. Achieving the Socially Optimal Output The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity.

38. When an externality benefits the bystanders, a positive externality exists. The social value of the good exceeds the private value.

39. A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole.

40. Copyright © 2004 South-Western Quantity of Education 0 Price of Education Demand (private value) Social value Supply (private cost) Q MARKET Q OPTIMUM

41. The intersection of the supply curve and the social-value curve determines the optimal output level. The optimal output level is more than the equilibrium quantity. The market produces a smaller quantity than is socially desirable. The social value of the good exceeds the private value of the good.

42. Internalizing Externalities: Subsidies – Used as the primary method for attempting to internalize positive externalities. Industrial Policy – Government intervention in the economy that aims to promote technology- enhancing industries Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. The patent is then said to internalize the externality.

43. Government action is not always needed to solve the problem of externalities.

44. Moral codes and social sanctions Charitable organizations Integrating different types of businesses Contracting between parties

45. The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. – 3 Conditions Property ownership is clearly defined The number of people involved is small Bargaining costs (transaction costs) are negligible Transactions Costs – Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain.

46. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

47. When externalities are significant and private solutions are not found, government may attempt to solve the problem through... command-and-control policies. market-based policies.

48. Command-and-Control Policies Usually take the form of regulations: Forbid certain behaviors. Require certain behaviors. Examples: Requirements that all students be immunized. Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA).

49. Market-Based Policies Government uses taxes and subsidies to align private incentives with social efficiency. Pigovian taxes are taxes enacted to correct the effects of a negative externality.

50. Examples of Regulation versus Pigovian Tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could… tell the firm to reduce its pollution by a specific amount (i.e. regulation). levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).

51. Market-Based Policies Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. A market for these permits will eventually develop. A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

52. Governments levy taxes to raise revenue for public projects.

53. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden.

54. Tax incidence is the manner in which the burden of a tax is shared among participants in a market. The economic burden of a tax is independent of the legal burden.

55. Copyright©2003 Southwestern/Thomson Learning Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium without tax Tax ($0.50) Price buyers pay D1D1 D2D2 Supply,S1S1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). $3.30 90 Equilibrium with tax 2.80 3.00 100

56. Copyright©2003 Southwestern/Thomson Learning 2.80 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Price without tax Price sellers receive Equilibrium with tax Equilibrium without tax Tax ($0.50) Price buyers pay S1S1 S2S2 Demand,D1D1 A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). 3.00 100 $3.30 90

57. So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic.

58. How do taxes affect the economic well-being of market participants?

59. It does not matter whether a tax on a good is levied on buyers or sellers of the good... the price paid by buyers rises, and the price received by sellers falls.

60. Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

61. A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks.

62. Tax Revenue – T = the size of the tax – Q = the quantity of the good sold T  Q = the government’s tax revenue

63. Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

64. Copyright © 2004 South-Western A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

65. Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

66. The change in total welfare includes: The change in consumer surplus, The change in producer surplus, and The change in tax revenue. The losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss.

67. What determines whether the deadweight loss from a tax is large or small? – The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. price elasticities – That, in turn, depends on the price elasticities of supply and demand.

68. Copyright © 2004 South-Western (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

69. Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

70. Copyright © 2004 South-Western Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

71. Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

72. The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and, the greater the deadweight loss of a tax.

73. The Deadweight Loss Debate – Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. – Some examples of workers who may respond more to incentives: Workers who can adjust the number of hours they work Families with second earners Elderly who can choose when to retire Workers in the underground economy (i.e., those engaging in illegal activity)

74. Copyright©2003 Southwestern/Thomson Learning Quantity of Labor 0 Wage Labor demand Labor supply Tax wedge Wage workers receive Wage firms pay Wage without tax

75. With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

76. Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

77. Copyright © 2004 South-Western Tax revenue Quantity 0 Price (b) Medium Tax PBPB Q2Q2 PSPS Supply Demand Q1Q1 Deadweight loss

78. Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

79. As the size of a tax increases, its deadweight loss quickly gets larger. By contrast, tax revenue first rises with the size of a tax, but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall.

80. Copyright © 2004 South-Western (a) Deadweight Loss Deadweight Loss 0 Tax Size

81. Copyright © 2004 South-Western (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size

82. The Laffer curve depicts the relationship between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

83. 0 20 40 60 80 100 Taxes paid in Ben Franklin’s time accounted for 5 percent of the average American’s income. 1789

84. 0 20 40 60 80 100 1789 Today Today, taxes account for up to a third of the average American’s income.

85. Copyright © 2004 South-Western State and local Federal 0 5 10 15 20 25 30 35 Revenue as Percent of GDP Total government 190219221927191319401932197019801990200019501960

86. The U.S. federal government collects about two-thirds of the taxes in our economy. – The largest source of revenue for the federal government is the individual income tax. The marginal tax rate is the tax rate applied to each additional dollar of income. Higher-income families pay a larger percentage of their income in taxes.

87. Other taxes Payroll Taxes: tax on the wages that a firm pays its workers. Social Insurance Taxes: taxes on wages that is earmarked to pay for Social Security and Medicare. Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.

88. Federal Government Spending Government spending includes transfer payments and the purchase of public goods and services. Transfer payments are government payments not made in exchange for a good or a service. Transfer payments are the largest of the government’s expenditures.

89. Federal Government Spending Expense Category: Social Security National Defense Income Security Net Interest Medicare Health Other

90. State and local governments collect about 40 percent of taxes paid.

91. Receipts Sales Taxes Property Taxes Individual Income Taxes Corporate Income Taxes Federal government Other Taxes $

92. Spending Education Public Welfare Highways Other

93. Policymakers have two objectives in designing a tax system... Efficiency Equity

94. One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

95. The Cost of Taxes to Taxpayers The tax payment itself Deadweight losses Administrative burdens

96. Complying with tax laws creates additional deadweight losses. Taxpayers lose additional time and money documenting, computing, and avoiding taxes over and above the actual taxes they pay. The administrative burden of any tax system is part of the inefficiency it creates.

97. The average tax rate is total taxes paid divided by total income. The marginal tax rate is the extra taxes paid on an additional dollar of income.

98. A lump-sum tax is a tax that is the same amount for every person, regardless of earnings or any actions that the person might take.

99. How should the burden of taxes be divided among the population? How do we evaluate whether a tax system is fair?

100. The benefits principle is the idea that people should pay taxes based on the benefits they receive from government services. An example is a gasoline tax: Tax revenues from a gasoline tax are used to finance our highway system. People who drive the most also pay the most toward maintaining roads.

101. The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden. The ability-to-pay principle leads to two corollary notions of equity. Vertical equity Horizontal equity

102. Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. For example, people with higher incomes should pay more than people with lower incomes.

103. Vertical Equity and Alternative Tax Systems – A proportional tax is one for which high-income and low-income taxpayers pay the same fraction of income. – A regressive tax is one for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers. – A progressive tax is one for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.

104. Horizontal Equity Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amounts. For example, two families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.

105. Copyright©2004 South-Western

106. The difficulty in formulating tax policy is balancing the often conflicting goals of efficiency and equity. The study of who bears the burden of taxes is central to evaluating tax equity. This study is called tax incidence.

107. If the goal is equality, we must be able to measure income inequality Two tools Lorenz Curve Gini Coefficient

108. Lorenz Curve shows the degree of inequality that exists in the distributions of two variables, and is often used to illustrate the extent that income or wealth are distributed unequally in a particular society.

109. Gini Coefficient = area between Lorenz curve and diagonal___ total area below the diagonal = A / A+B

110. Gini Coefficient – Closer to zero means less inequality – Closer to one means more inequality How do we get closer to zero? – More progressive tax system? Estate and gift taxes Graduated income tax – More redistribution of income? Social programs Medicare and Medicaid Welfare and unemployment assistance

111. Asymmetric Information – Unequal Knowledge Adverse Selection – When info known by the first party to a contract or agreement is not known by the second party, causing the second party to incur major losses Moral Hazard – Tendency for one party in a contract or agreement to alter behavior in ways that could be costly to the other party Principal-Agent Problem – Interests of the principal does not align with interests of the agent