The Mixed Economy: Private and Public Sectors

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The Mixed EconomyPrivate and Public Sectors

• Chapter 5

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I. Goals of the Chapter

• To describe household and business components of
  the private sector economy.
• To describe the public sector (or government) in
  the U.S. economy.

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II. Households as Income Receivers
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Personal Consumption

• Durable goods Expected to last at least 3
  years.
• Non-durable goods Expected to last less than 3
  years.
• Services Intangibles

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Composition of Consumer Expenditures, 2002
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IV. Businesses

• A. Definitions
• Plant Physical establishment where production
  or distribution takes place.
• Firm Business organization which owns and
  operates the plants.
• Industry A group of related firms producing the
  same or similar products.

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Multi-Plant Firms

• Vertical combination The firm owns plants at
  different stages of production. (Disney)
• Horizontal combination The firm owns plants
  that produce the same or similar products.
  (Banks)
• Conglomerate The firm owns plants in different
  industries. (Phillip Morris)

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B. Legal Forms of Businesses

• Definitions
• Sole Proprietorship A business owned by a single
  individual.
• Partnership Two or more individuals own the
  business in a partnership agreement.
• Corporation A legal entity distinct from its
  individual owners (shareholders). The
  organization acts as a legal person.

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Sole Proprietorship
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Partnership
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Corporations
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Corporations, contd.

• Financing
• Equity financing Stocks represent ownership.
  Earn dividends.
• Common
• Preferred
• Debt financing Bonds represent debt. Earn
  interest.
• Read Last Word, pg. 88

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Corporations, contd

• Hybrid Structures
• Taxed like a partnership
• Limited liability (like a corporation)
• Limited Liability company (LLC)
• S corporation

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Corporations, contd.

• The Principal agent problem
• In sole proprietorship and partnership the
  owner(s) directly control the firms assets.
• In large corporations there is a separation of
  ownership and control.
• A possible conflict of interest occurs when
  managers are hired to run a business on behalf of
  the owners.

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Corporations, contd.

• Small numberlarge impact
• In 1996, 45 U.S corporations had sales over 20
  billion.
• 143 had sales over 10 billion.
• G.M. sales 168 billion.
• Only 22 nations produced more than G.M.
• All U.S. farm production totaled was less than
  the total sales of the 2 largest corporations.

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V. Economic Functions of the Government

• Provide a legal structure
• Maintain competition
• Redistribute income

• Reallocate resources
• Provide public goods and services
• Stabilize the economy

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1. Providing the Legal Structure

• Define ensure property rights
• Enforcement of contracts
• Settle disputes
• Impose penalties for foul play

• Protection of life and property
• System of standard weights and measurements
• Product quality assurance
• Reliable money supply

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2. Maintaining Competition

• A firm or small number of firms with monopoly
  power can restrict output and extract higher
  prices.
• If a natural monopoly exists, government
  regulates price and service.
• Anti-trust laws are designed to regulate business
  behavior and promote competition.

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3. Redistribution of Income

• Transfer payments Welfare, unemployment
  compensation, social security, Medicare
• Market intervention (Price supports) minimum
  wage, farm subsidies, rent controls
• Federal income tax Takes a larger portion of
  larger incomes (progressive tax).

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4. Reallocation of Resources

• In a pure market economy, the most efficient use
  of resources occurs automatically.
• ?The buyer and seller enjoy all the benefits and
  incur all the costs of a transaction.
• And, resources are allocated to the production of
  all economically justified goods and services.
• If not ? market failure

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Market Failure

• Market failure occurs when the competitive market
  system
• produces the wrong amount of certain goods and
  services (spillovers), or
• fails to allocate any resources to the production
  of certain goods and services whose output is
  economically justified (public goods).

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Spillovers

• Spillover costs Production or consumption costs
  inflicted on a third party without compensation.
• i.e. pollution, 2nd hand smoke, noise
• The producer does not bear the cost because it is
  passed on to society.
• Causes over-allocation of resources to the
  production of the good.
• To correct, the government must get the producer
  to internalize these costs.

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Correcting for Spillover Costs

• Legislation to limit or prohibit the cost.
• i.e. catalytic converters, seat belts,
  noise ordinance
• Taxes
• i.e. pollution tax which causes firms to
  cut back on pollution and provides funds
  for cleanup.

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Spillovers, contd.

• Spillover benefits Occur when the production or
  consumption of a product confers spillover
  benefits to a third party without compensating
  payment.
• i.e. immunizations, education
• Individuals who have a demand for the good will
  buy only enough to satisfy their demand.
• Causes under-allocation of resources.

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Correcting for Spillover Benefits

• Government can increase demand by
• Subsidize consumers.
• i.e. food stamps, education grants,
• Subsidize producers.
• i.e. higher education, immunization program
  s,...
• Provide goods via government
• i.e. U.S. Postal Service, public
  schools,...

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5. Public Goods and Services

• Private goods
• Produced through the competitive market system.
• Divisible Produced in units small enough to be
  purchased and used by individuals.
• Subject to exclusion principle Buyers who are
  willing and able to pay the market price of the
  product obtain it. Others are excluded

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Public Goods Services, contd.

• Public goods
• Not produced by the competitive market system.
• Indivisible Cannot ordinarily be sold to
  individuals.
• Exclusion principle does not apply. (The
  free-rider problem)
• Classic example A lighthouse

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Quasi-Public Goods Services

• Subject to the exclusion principle.
• ?they could be produced by private firms.
• They produce large external benefits.
• ?the market system would under-produce.
• Examples education, roads, police/fire
  protection, libraries, museums

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Allocation of Resources to Public and
Quasi-public Goods

• Purchased through government by group, or
  collective, choice.
• i.e. voting for a candidate whose priorities
  for spending most closely match yours.
• Resources are reallocated from private to public
  use by taxing households and businesses.

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Reallocation of Resources Through Taxes

• Government taxes households businesses
• Households businesses have less money to spend
  on G S
• Firms produce less G S
• Lower production reduces use of resources by the
  private sector
• More resources available for public use

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6. Stabilizing the Economy

• Full employment of resources.
• - low unemployment rate
• Stable prices
• - low rate of inflation

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VI. The Circular Flow (again??)

• Review Fig. 2-6, pg. 34
• Compare to Fig. 5-6, pg. 84

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VII. Government Finance

• 1. Government purchases
• Exhaustive products purchased directly absorb
  resources and are part of domestic output. Ex
  police car
• 2. Transfer payments
• Non-exhaustive do not directly absorb resources
  or account for production.
• Ex social security, welfare

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Government Growth

• Fig. 5-7, pg. 85
• 1960 Total government spending ? 26 of domestic
  output (GDP).
• Purchases ? 21, transfers ? 5
• 2002 Total government spending ? 30 of GDP.
• Purchases ? 18, transfers ? 12

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Personal Income Tax

• Levied on taxable income (gross income
  exemptions/deductions).
• Progressive tax
• Marginal tax rate
• Average tax rate total tax paid /total taxable
  income

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Payroll Taxes

• Taxes based on wages and salaries (other than
  income tax).
• Used to finance Social Security Medicare
• Proportional tax
• 2003 employees employers each paid 7.65 of
  the first 87,000, and 1.45 of all additional
  earnings.

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Federal Taxes, contd.

• Corporate income tax Levied on a corporations
  profit (total revenue total costs). Rate 35
  for most corporations.
• Excise tax Levied on specific products
• Gasoline, tobacco, alcoholic beverages

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State Local Finance
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Fiscal Federalism

• The system of intergovernmental transfers
• Grants from the federal to state/local
  governments.
• Grants from state to local governments.
• Represents 15 to 20 percent of all state local
  revenue.

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Lotteries

• Critics
• gambling ? morally wrong
• people become addicted
• regressive
• attract criminal element
• luck and fate rather than education and hard
  work lead to success

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Lotteries, contd.

• Supporters
• Preferable to taxes voluntary
• Painless way to finance government
• Compete with illegal gambling helps fight
  organized crime

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The End