Business In Brief Economics

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Business In BriefEconomics

• Jim Knudsen

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Economic Overview

• Microeconomics
• Macroeconomics
• Government Budget and Taxation Issues

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Microeconomics

• Microeconomics deals with the decisions made by
  individuals and firms
• Microeconomics deals with markets for individual
  goods and services
• The US has a market based economy
• The allocation of resources is determined by
  interactions in the market place

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Market Economy

• Most economists agree that markets are a good way
  to organize economic activity
• Competitive markets yield economic efficiency
• Profit motives mean that goods are produced at
  their lowest cost
• Markets and prices allocate resources to their
  most productive use

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Efficiency and Market Structure

• The assumption of efficiency depends on
  competitive markets and the invisible hand
• Competitive markets are not the only types we
  observe
• Competition can be described along a spectrum
  from perfect competition to monopoly
• The competitiveness is what economists call
  market structure

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Market Structure

• Perfect Competition many firms, homogeneous
  product, low barriers to entry
• Monopolistic Competition many firms,
  differentiated products, low barriers to entry
• Oligopoly few firms, barriers to entry
• Monopoly one firm, barriers to entry

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Market Structure

• The more competitive the market, the greater the
  efficiency (from societies view point)
• The more competitive the market, the lower the
  profits
• Generally, firms within an industry will try to
  move away from perfect competition if it is
  possible

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Government Policy and Market Structure

• Since perfect competition is the most efficient,
  it is in societys best interest to enforce
  competition
• This enforcement is antitrust policy
• Antitrust policy may lead to break up of monopoly
  or monopoly prevention
• Monopolistic competition is not seen as an
  antitrust problem

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Market Failure

• There are other times that markets fail to result
  in efficiency
• Public Goods
• Externalities

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Public Goods

• Public goods are goods that are nonrival in
  consumption and nonexcludable
• Examples National Defense, Broadcast TV
• The market generally fails to provide the
  efficient quantity
• Government may step in and provide these types of
  goods
• Most people wont be happy with the provision

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Externalities

• Externalities are costs or benefits that accrue
  to others not party to the market transactions
• An example of a good with a benefit is education
• When individuals get an education society
  benefits
• These types of goods may be subsidized

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Negative Externalities

• Goods with negative externalities are goods that
  impose costs on others not involved in the
  transaction
• The most common type of negative externality is
  some type of pollution
• The pollution is a harm to those who breathe the
  smoke, drink or swim in polluted water, etc.

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Government Policy

• When externalities exist there is the opportunity
  for the government to improve efficiency with
  well designed policy
• With negative externalities the goal is to reduce
  (but not to eliminate) the externalities
• Typical policies include taxes, regulation,
  tradable permits

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Lessons of Microeconomics

• Competitive markets allocate resources
  efficiently
• Government has a role when markets arent
  competitive or there is market failure

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Efficiency?

• Minimum wage
• Price of a beef
• Price of Windows XP
• Steel tariffs
• Cigarette, gas taxes

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Why some policies?

• If policies are obviously inefficient, why do we
  have them?
• Equity trade off
• Political process

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Macroeconomics
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Macroeconomics

• Macroeconomics deals with the economy as a whole
• We look at the health of the economy
• We consider ways that the economy may be improved

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Macroeconomic Health

• Common measures of economic health
• Gross Domestic Product
• Unemployment Rate
• Consumer Price Index
• Productivity

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Gross Domestic Product
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Unemployment Rate
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Consumer Price Index (Inflation)
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Labor Productivity
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Macroeconomic Policy

• There are two goals with which macroeconomic
  policy may be concerned
• One is long term growth
• The other is stabilization of the business cycle

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Long Run Growth

• Sources of growth are
• Investment
• Human Capital
• Technological Innovation
• Discovery

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Policies for Growth

• Supply Side School
• Incentives for saving, investment and work lower
  taxes
• Stable monetary policy
• Little worry for short run fluctuations
  (nonactivists)

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Short Run Fluctuations

• The short run fluctuations are usually called the
  business cycle
• The economy tends to go through boom and bust
  cycles
• The question is whether the government should try
  to smooth out the cycle
• Activists are those who believe that
  discretionary monetary and fiscal policy should
  be used.

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Monetary Policy

• Monetary Policy is administered by the Federal
  Reserve
• The Fed can use open market operations and
  discount rate changes to stimulate or slow the
  economy
• The Fed has primary interest in price stability

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Fiscal Policy

• Fiscal Policy is the use of the governments
  spending and taxation policies to stimulate or
  slow the economy
• In bad economic times the government would tend
  to spend more (deficit spending) and/or tax less
• In good times the government would constrain
  spending and raise taxes

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Long Run vs. Short Run

• There may be a conflict between the policies that
  are best for the economy in the short run and the
  long run
• For instance, when in a recession, the government
  would typically try to inspire consumption rather
  than saving
• In addition, budget deficits may be bad for
  interest rates in the long term
• In good times the Fed may increase interest rates
  and the government may increase tax rates

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Federal Budget

• Recently the reversion to deficit spending by the
  federal government has been in the news
• Table S-2 from the Presidents FY 2004 Budget
  (January 2003) provides an overview of the
  federal budget
• Notice that Social Security surpluses hide the
  true size of the operating budget

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Social Security Trust Fund

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Taxation

• The government provides many services--Defense,
  Roads, Education, Welfare, etc.
• These must be paid for with tax dollars
• How the taxes are raised is a subject of debate
• As usual, there is a tradeoff between efficiency
  and equity

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Efficiency

• The most efficient taxes are taxes that do not
  distort decisions
• The most efficient tax is a lump sum or head
  tax
• Lump sum taxes are extremely unpopular
• The next most efficient tax would be taxes on
  goods with inelastic demand/supply

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Equity vs. Efficiency

• The taxes that are most efficient tend to be
  perceived to be unfair
• How can a tax system be designed to be fair?
• It depends on the definition of fair
• People often disagree about this concept

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Benefits Principle

• One concept of fair is called the benefits
  principle
• The benefits principle states that the
  individuals who receive the benefits from the
  government program should pay for the program
• This principle applies to some programs--roads
  are financed by gas taxes

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Benefits Principle

• Obviously, not all programs can be financed this
  way
• You could not finance unemployment benefits with
  a tax on the unemployed
• An alternative way to judge fairness is based on
  ability to pay

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Ability to Pay Principle

• The ability to pay principle implies that people
  with a higher ability to pay should pay more than
  people with a low ability to pay
• One difficulty is defining ability to pay
• The most common measure is income but wealth is
  another alternative

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Ability to Pay

• Under the ability to pay principle people who
  have higher incomes should pay more in taxes
• The burden of the tax is generally defined in
  terms of the average percentage of income paid in
  taxes
• Under this concept, taxes may be regressive,
  proportional, or progressive

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Regressive Taxes

• Regressive taxes are taxes that take a higher
  proportion of income for low income individuals
  than for high income individuals
• Most excise taxes are regressive (cigarettes,
  gasoline, alcohol)
• The social security payroll tax is another
  example

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Proportional Taxes

• Proportional taxes take the same percentage of
  income regardless of income level
• Most taxes are not proportional
• An example would be the medicare payroll tax on
  earned income

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Progressive Taxes

• Progressive taxes take a higher percentage of
  income as income rises
• The income tax is an example of a progressive tax
• People with higher incomes pay a higher
  proportion in taxes

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The Income Tax

• The income tax in the U.S. is a progressive tax
• It has a progressive rate structure
• This means that marginal tax rates increase as
  income increases
• This results in an increase in average tax rate
  as income increases

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Flat Tax

• One proposal to change the income tax is to have
  a flat tax--one tax rate
• The proposals are for a rate of 15-20
• They are accompanied by an elimination of many
  deductions
• Usually, there is a large zero bracket
• Is this progressive?

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Vertical Equity

• When looking at a taxs progressivity we are
  considering the concept of vertical equity
• A tax is said to be vertically equitable if
  people who are in differing circumstances (higher
  vs. lower income) are treated fairly
• Fairly, is defined as people with higher ability
  to pay paying more

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Horizontal Equity

• Horizontal equity is another goal of the tax
  system
• Horizontal equity is when people in like
  circumstances pay the same amount of taxes
• In the news lately has been the marriage penalty