Chapter 3 The Role of Government in a Market Economy

1. Chapter 3The Role of Government in a Market Economy

2. Chapter Objectives • Appreciate the advantage and shortcomings of the free-market system. 2. Describe in your own words the concept behind Adam Smith’s “invisible hand”. 3. Understand the rationale behind government intervention in the free-market system. 4. Graph the impact of price ceilings, price floors, and excise taxes on various markets.

3. Government and the Free Market Why do governments become involved in the operation of the market. The Writings of Adam Smith He believed that the free-market system would channel selfish, egoistic motives toward the betterment of society. The term “invisible hand” was introduced to describe the effect that a free-market economic system has on directing the self-interests of individuals toward a common goal. (Cont.)

4. The Writings of Adam Smith (Continued) And how the free-market will tend to allocate resources to their most efficient use. For example, if you start a business and you are not successful than that means that not enough consumers want your product. If enough people buy your product you will earn a living, your welfare increases and so does that of your customers.

5. The Writings of Adam Smith (Continued) If you are successful at your business this will attract competition. In order to continue to sell your product or service it will be necessary that you make your good or service more attractive. This can be done by lowering prices or improving the quality of the product or service.

6. Possible Shortcomings of the Free-Market System Deficiencies that lead to government intervention. Market Imperfections • Consumers and suppliers may not have satisfactory information with which to make decisions. Advertising often helps to fill this gap although more often than less it is meant to persuade rather than inform. (Cont.)

7. Market Imperfections (Continued) Health standards, government building codes and Human Resource Centres of Canada are designed to fill these gaps. 2. The marketplace does not always create sufficient competition. If new firms are prevented from entering the industry then there would be higher prices and lower quantity of product.

8. Market Imperfections (Continued) Under the Competition Act it is illegal for firms to get together and fix prices, or sell a product at a loss to eliminate competitors, or for manufacturers to refuse to sell to retailers who do not charge a set price for the product. In situations where natural monopolies arise it is inefficient to have more than one firm supply a product or service. The government either provides the service or regulates the company that provides the service.

9. Third-Party Effects A market transactions may affect someone other than the buyer and seller, this third-party may be affected in a positive or negative manner. Government action, either in the form of a tax or the requirement to install new equipment, may be implemented when there is a negative third-party effect, such as polluting a river during production of paper. Such action would decrease the supply of paper and increase the overall price. The higher price would correctly reflect the total cost of providing this product. (Cont.)

10. Third-Party Effects (Continued) Government that takes action with a negative third-party effect.

11. Third-Party Effects (Continued) A product with a positive third-party effect is either subsidized by the government thus increasing supply or paid for on behalf of consumers thus increasing demand.

12. Unmet Public Goods The market may not be able to provide a number of goods and services that are important to society – such as national defense, policy protection or water supply. The benefits from these services are spread over such a large segment of the population that it is difficult to charge a fee for their use based on the benefits received. These unmet public goods are provided by the government or contracted out to private companies.

13. Distribution of Income In the pursuit of earning an income, individuals compete with each other for jobs. If a person is unable to compete in a free-market system, he or she will not be able to earn an income. The government has intervened in the free market in order to achieve a more equitable distribution of income. Social welfare programs, such as assistance to the elderly and disabled, and employment insurance, are financed with a progressive income tax. (Cont.)

14. Distribution of Income (Continued) Income differentials in Canada would not be a serious problem if every Canadian earned enough money to meet his or her basic needs. Poverty is defined in terms of a minimum income necessary for an individual or family. Stats Canada prepares the lowest-income cut-off (LICO) which is set at an income level where the family spends 64% of its income on food, shelter and clothing.

15. Distribution of Income (Continued) The market basket measure introduced by HRDC sets an income level that is too low to purchase a basket of goods by a family of four with a 13-year old boy and a 9-year old girl. The presence of regional income differences has prompted the federal government to transfer tax dollars in the form of equalization payments to the lower-income provinces and to undertake economic development projects. In Canada social-welfare spending accounts for the largest portion of all federal government spending and approximately one-fifth of all provincial and local government spending.

16. Economic Stabilization Classical economists believed that fluctuations in economic growth, employment, and prices were temporary and the free-market system would make adjustments to return to a period of more stable economic activity. The Great Depression in the 30’s shifted the focus to John Maynard Keynes. (Cont.)

17. Economic Stabilization (Continued) Keynes argued that in order to ensure stability in the economy, governments had to intervene. The adjustments of government spending and tax policy to economic conditions is know as fiscal policy.

18. Impact of Government Intervention Price Ceilings A price ceiling is a government imposed maximum price. It is used when the government believes that the equilibrium price established in the market is too high and many people feel that they cannot afford to buy the product. (Cont.)

19. Price Ceilings (Continued) It is illegal to set a price above a price ceiling, as a result a shortage occurs. A subsidy may be offered to the seller or the product must be rationed to eliminate the shortage.

20. Price Floors A price floor is a government imposed minimum price. It is illegal to set a price below a price floor, as a result a surplus occurs. A limit on the quantity produce is one method used to eliminate a surplus. Another method is to shift the demand to the right through advertising.

21. Excise Taxes An excise tax is one levied by government on the suppliers of certain products. Excise tax on liquor and tobacco is a source of revenue for the government. Excise tax on air conditioners in automobiles is meant to reduce the sales of air conditioners for environmental reasons. (Cont.)

22. Excise Taxes (Continued) Price elasticity of demand and supply determine the incidence of tax, or who bears the larger burden of the tax. If the demand is more inelastic than supply than the consumer bears the larger burden of the tax, and vice versa. If the government wants to raise tax revenue it will tax a product which has an inelastic demand. If the government wants to reduce consumption than it will tax a product which has an elastic demand.