Handout 1 - CA Sri Lanka

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
• 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
– Non-Rival – Means consumption of the good by one
person does not reduce the availability of the good for
– Non Excludable – means that no one can effectively be
excluded from using the product
– Examples: Air, Mp3 Songs, Youtube
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!
– Dealing with Externalities
• Externality – a cost or benefit that falls on a third party
and therefore ignored by the two parties to the market
– 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
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)
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
• You can tax the firm or the consumer.
• Taxes change behaviour.
• 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
• The most important role is to foster a healthy
• Full Employment, Price Stability and Economic
• 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
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
• 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
• 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 is the process of transferring owner of a business, enterprise, agency
or public service from the public sector to the private sector
Increased Efficiency
Less Political interference
Less corruption
Profit motivation
Profit may not be the motive
Strategic and sensitive areas (defense)
Essential services
Job loss