GOVERNMENT INTERVENTION IN THE ECONOMY Learning Objectives: The role of government in the economy Government provision of goods and services Fiscal policy Monetary policy Supply side policies

WHAT ROLE DOES GOVERNMENT PLAY IN THE ECONOMY?  Brainstorm all the things that you think the government does which affects business

GOVERNMENT ROLES  Creates the legal and regulatory framework which govern the way in which businesses and individuals relate to each other  Provides goods and services which would otherwise be under provided by the market mechanism  Uses taxes and subsidies to influence the way individuals and businesses behave  Uses government spending and taxation to influence demand in the economy

GOVERNMENT PROVISION OF GOODS AND SERVICES  Public goods  Merit goods

PUBLIC GOODS  Possess two characteristics:  Non-rivalry – consumption of the good by one person does not reduce the amount available for consumption by another person (also known as non-diminishability or non-exhaustability )  Non-excludability – once provided, no person can be excluded from benefiting Street lighting Defence Light house

THE FREE RIDER PROBLEM  Public goods are not provided by the free market (there has been market failure)  Once the good has been provided, it is impossible to prevent others from benefitting from it  There is little incentive for people to pay for it  Leads to the free rider problem – free rider: someone who benefits from a good or service without paying for it  Someone who doesn’t pay tax won’t be denied the use of a public road, street lighting etc.

MERIT GOODS  A merit good is one which is underprovided by the market mechanism  This may be because individuals lack perfect information (find it hard to make decisions about costs today, for benefits received in the future)  Or because there are significant positive externalities present

 Suggest reasons why health care might be considered a merit good

DEMERIT GOODS  Goods which are over provided by the market mechanism  Consumption of demerit goods produces large negative externalities  Governments intervene to correct this market failure by banning consumption, taxation or persuading consumers to stop using the product

DEMERIT GOODS  Identify demerit goods which the government has tried to prevent consumption of through:  Banning  Taxation  Advertising  Why does the government want to prevent consumption of these goods?

EQUITY  A free market system would not distribute resources equitably  The government sees it has a duty to reallocate resources  EG over 30% of public spending is devoted to social security payments  Some of these payments come form the National Insurance fund and can be seen as merit goods  Benefits such as family credit are an explicit attempt to redistribute income to those in need  The free provision of healthcare and education also leads to a more equitable distribution of resources

GOVERNMENT INTERVENTION Can occur in three ways:  Direct provision  Subsidised provision  Regulation

DIRECT PROVISION  Governments supply public and merit goods directly to consumers free of charge  The government may produce the good or service itself (eg schools) or buy it from firms in the private sector (eg GPs work for themselves, the government buys their services)

DIRECT PROVISION  Advantage:  The government directly controls the supply of goods and services  Disadvantage:  May lead to inefficiency  Employees of the state have no incentive to cut costs to a minimum  May produce the wrong mix of goods, particularly if goods are free to taxpayers  In a free market, if the wrong mix of goods was produced, they would remain unsold and firms would switch production

SUBSIDISED PROVISION  The government may pay for part of the good or services ( subsidy) but expect the consumer to pay for the rest  EG prescription charges  Subsidies increase consumption of a good, hopefully to a level which maximises economic welfare, and helps those on low incomes  BUT subsidies can become ‘captured’ by producers  EG CAP – instead of ministers deciding on the level of farm subsidy, they bow to the pressure of the farming lobby

REGULATION  The government may leave provision to the private sector, but force consumers to purchase a merit good  EG motorists are forced to buy car insurance by law  The government may force producers to provide a merit good  EG motorway service areas are forced to provide free public toilet facilities to motorists whether they buy anything or not

REGULATION  Requires little or no taxpayers’ money to provide the good  consumers are free to shop around in the free market for best value, ensuring productive and allocative efficiency  BUT regulations can impose heavy costs on the poor in society  Regulations are sometimes ignored, eg many motorists do not buy insurance In all, around one in 20 of all drivers on our roads do not have insurance - adding between £30 and £60 each year to the bills everyone else pays. They are up to nine times more likely to have a crash

PUBLIC, MERIT AND DEMERIT GOODS Explain the difference between public, merit and demerit goods Explain the ‘free rider’ problem Explain three ways in which the government intervenes

FISCAL AND MONETARY POLICY

FISCAL POLICY - DEFINITION  Decisions concerning Government spending, taxation, and borrowing  The manipulation of government spending, taxation and borrowing affects aggregate demand  It can also affect the pattern of economic growth

GOVERNMENT SPENDING AND INCOME The main areas of Govt spending are: – NHS – Defence – Education – Roads – Social Security – National Insurance benefits Over the past 20 years, Govt spending has accounted for between 40%-50% of national expenditure All of this is financed mainly through taxes such as income tax and VAT

EXPANSIONARY FISCAL POLICY  An increase in Govt spending, with the price level constant, will increase aggregate demand  A cut in taxation will increase household’s disposable income and lead to a rise in consumer expenditure, leading to a rise in AD

RESTRICTIVE FISCAL POLICY  An decrease in Govt spending, with the price level constant, will decrease aggregate demand  An increase in taxation will decrease household’s disposable income and lead to a fall in consumer expenditure, leading to a fall in AD

MONETARY POLICY; A DEFINITION  Is the manipulation of the rate of interest and the amount of money circulating in the economy to achieve government objectives

MONEY AND THE RATE OF INTEREST  The rate of interest is the price of money (lenders receive interest as money is supplied for loans to money markets, borrowers pay interest on the loans)  In the past the government has restricted how much money can be borrowed on a mortgage or on hire purchase  Some governments have attempted to directly control the supply of money available for spending and borrowing in the economy  In recent years, the rate of interest set by the Bank of England has been the main instrument of monetary policy in this country

AGGREGATE DEMAND  The rate of interest affects the economy through its influence on AD  The higher the rate of interest, the lower the level of AD  Why would this be?  Interest rates affect AD:  Consumer durables  The housing market  Wealth effects  Saving  Investment  The exchange rate

CONSUMER DURABLES  Many households buy consumer durables on credit  The higher the rate of interest, the greater the monthly repayments will be on any loan  High interest rates lead to lower sales of durable goods and lower AD

SAVINGS  When interest rates rise, savings become more attractive  This reduces consumer spending  If interest rates fall, saving becomes less attractive  Consumers spend now rather than save for the future, increasing AD

INVESTMENT  Investment projects become more attractive when interest rates fall  This increases AD  A rise in consumption will lead to an increase in income for the firm  This will lead to increased investment  Increased investment is needed to increase supply to meet increased demand

INFLATION  If AD increases, it can lead to inflation  If interest rates are increased, it will reduce AD  This leads to a lower equilibrium price level  Inflation lowers  If monetary policy is loosened; ie interest rates are lowered, AD will increase  Looser monetary policy can therefore be inflationary

SUPPLY SIDE POLICIES  Fiscal and monetary policy is used to affect AD  By adjusting Government spending and taxation, government influences the amount of spending in the economy  A long term aim is to increase the productive capacity of the economy  Policies to increase the productive capacity of the economy are known as Supply Side policies  Eg reduce tax to encourage investment  Raise spending on education and training