Macroeconomics
The Government and the Economy
EDBA 2014
Solving World Problems!
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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
outcomes”
• 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
excludable.
– Non-Rival – Means consumption of the good by one
person does not reduce the availability of the good for
others.
– Non Excludable – means that no one can effectively be
excluded from using the product
– Examples: Air, Mp3 Songs, Youtube
Excludable
Non-Excludable
Rivalries
Private goods – Food, Clothing Cars
Common Goods –
Fish Stocks, timber
Non-Rivalries
Club Goods – Cinema, Private parks,
satellite television
Public goods –
National TV, Defense
• Taxes are used to pay for public goods!
Externalities
– Dealing with Externalities
• Externality – a cost or benefit that falls on a third party
and therefore ignored by the two parties to the market
transaction.
– 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
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Minimum Wages
Price Floors
Price Ceilings (Rent Control)
Taxes
Subsidies
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
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A imposed limit of the price charged for a product
Only if the price ceiling is below the equilibrium price will it be effective.
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Consequences of Price Ceilings
– Black Markets
– Reduction in Quality
– Discrimination
Taxes
• You can tax the firm or the consumer.
• Taxes change behaviour.
Subsidies
• 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
government
• The most important role is to foster a healthy
economy.
• Full Employment, Price Stability and Economic
Growth.
• 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
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Misunderstanding the true costs or benefits of a product
Uncertainty about costs and benefits
Complexity of information
Inaccurate or misleading information
Addiction.
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%
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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
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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
https://www.cia.gov/library/publications/the-worldfactbook/rankorder/2222rank.html
• 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.
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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
direction.
• As income rises, people choose to hold on to
their money in liquid form.
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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
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Privatization is the process of transferring owner of a business, enterprise, agency
or public service from the public sector to the private sector
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Pros
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Performance
Increased Efficiency
Specialization
Less Political interference
Less corruption
Accountability
Profit motivation
Cons
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Profit may not be the motive
Capital
Strategic and sensitive areas (defense)
Essential services
Job loss