Chapter 5

An Introduction to the Foreign Exchange Market and the Balance of Payments

The Public Sector

The Circular Flow: Households, Firms, Government, and Foreign Countries

Economic efficiency

An efficient use of resources implies a maximum value of output from a resource base (producing on the PPC). This is called technical efficiency. Equivalently, it is when one person cannot be made better off without making someone else worse off. This is called economic efficiency. If the market system doesnt result in economic efficiency, there will be a role for the government to correct it. 3

The Governments Role

There are five reasons why markets may fail, creating a role for government:
1. 2. 3. 4. 5.

Imperfect Information Externalities Public Goods Lack of Competition Business Cycles

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Imperfect Information

False information Asymmetric information Either the buyer or seller has more or better information than others Brand names, franchises, and product warranties are helpful ways of dealing with information problems. When information is not perfect, market imperfections may result, leading to inefficiency. Government may require full and correct disclosure. (Food labels, stock prospectuses, etc.)
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Externalities

Externalities are the costs or benefits of a transaction that are borne by someone not directly involved in the transaction. External benefits and External costs

Someone opens a large shopping mall next to an existing retail business. Pollution by a manufacturer

The government intervene to resolve externality problems.

The E.P.A and the department of education

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Public Goods

Public Goods are goods whose consumption by one person does not diminish the quantity or quality available to other consumers. Specifically, they:

Can be jointly consumed Individuals can simultaneously enjoy consumption of same product or service. Are non-excludable Consumption of the good cannot be restricted to the customers who pay for it.
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Characteristics of a Public Good

It is not possible to offer a public good to some people while simultaneously restricting access to it to others. No one enjoys a private property right to the good. As a result, people have an incentive to try and enjoy the benefit of the good without helping to pay for them. That is, everybody has an incentive to become a free rider: a person who receives the benefits of the good without helping to pay for it. But to the extent that people do become free riders, too little will be produced.
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Lack of Competition

Sellers may gain by restricting output and raising price.

Too few units will be produced. Consumers may not be able to get needed goods. Example: utility companies

Monopoly: a market with only one producer

Oligopoly: a market with only few producers (who may operate jointly as a monopolist through a cartel).

Example: OPEC

Monopsony: a market with only one buyer Role of the Government: ..

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Business Cycles
Fluctuations in the economy between growth and recessions When there is recessions, people are hurt (higher unemployment for example) Government intervene to help people during recessions

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Public Choice Theory

Public Choice is the study of how government actions result from the self-interested behaviors of voters and politicians. Self-interested behavior is present in both the public and private sectors, it only differs in the way it plays out. Public Choice theory suggests that government may be brought in to benefit specific individuals or groups. Such people may seek government intervention because they do not favor the market outcome. This is referred to as rent-seekingthe use of resources to transfer wealth from one individual to another without increasing production or total wealth. Thus government intervention may not seek efficiency gains.
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Public Choice Conclusions

Self-interest directs public sector activity, just as it directs market activity. Government actions (like price ceilings or floors) are often enacted for political gain, not as a remedy for economic inefficiency.

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Microeconomic Policy

Government provides public goods to avoid the free rider problem in the private production of certain goods. Government taxes or subsidizes activities that create externalities.

If you tax something, you get less of it. If you subsidize something, you get more of it.

Government regulates noncompetitive industries in the public interest, and ensures competitive markets where possible.
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Macroeconomic Policy

Monetary Policy

Policies directed toward the control of money and credit (money supply and interest rates). In the U.S., the Federal Reserve Board (the fed) is responsible for this. Policies directed toward government spending and taxation. In the U.S. federal government, it is Congress that enacts these policies, signed into law by the President.
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Fiscal Policy

Federal, State, and Local Government Expenditures for Goods and Services

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Government Spending
Transfer payments: income transferred by the government from a citizen to another citizen. Budget surplus: when government spending is less than revenue. Budget deficit: when government spending is greater than revenue

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U.S. Federal Budget Deficits

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The Economic Systems around the world

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Test question
Does copying from another student a positive externality ? Property rights refer to what? If the government doesnt intervene, goods and services will be underprovided. There is no pure private economy. True or False?

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