1. Macroeconomics The Government and the Economy
EDBA 2014

2. Solving World Problems!
Governments and the Economy
Circular Flow and National Public Accounting
Money and Price Level
International Trade

3. 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

4. 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
Taxes are used to pay for public goods!
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

5. 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

6. 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
Minimum Wages
Price Floors
Price Ceilings (Rent Control)
Taxes
Subsidies

7. Minimum Wage
This is relatively prevalent in Western Countries

8. 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.

9. Price Ceiling A imposed limit of the price charged for a product
Only if the price ceiling is below the equilibrium price will it be effective.
Consequences of Price Ceilings
Black Markets
Reduction in Quality
Discrimination

10. Taxes
You can tax the firm or the consumer.
Taxes change behaviour.

11. 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

12. 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.

13. 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
Misunderstanding the true costs or benefits of a product
Uncertainty about costs and benefits
Complexity of information
Inaccurate or misleading information
Addiction.

15. Fiscal Policy and its Instruments
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

16. Taxation in Sri-Lanka According to the Inland Revenue Income Tax
VAT – introduced in 2002 to replace GST
Standard Rate 12%
Luxury 20%
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
Stamp Duty
Social Responsibility Levy
Turnover Tax

17. 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.

18. 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
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

19. 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
The principal is that we are “investing”
We borrow  We invest  We reap higher tax revenue later
It eventually has to be paid back.

20. Multiplier Effect
When the government spends 1 billion rupees worth of construction from a local company there are consequences.
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.

21. 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.
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.

22. Privatization
Privatization is the process of transferring owner of a business, enterprise, agency or public service from the public sector to the private sector
Pros
Performance
Increased Efficiency
Specialization
Less Political interference
Less corruption
Accountability
Profit motivation
Cons
Profit may not be the motive
Capital
Strategic and sensitive areas (defense)
Essential services
Job loss