Econ Exam 2

Market failure

occurs when the market economy leads to too few or too many resources going to a specific economic activity

• Causes a combination of goods and services that is not optimal or results in an
inequitable distribution.
• Provides justification for government correction or intervention.

Four microeconomic sources of market failure are

1) externalities, 2) market power,
3) public goods, and 4) inequity

Negative externality, such as pollution

• Creates an external cost; producer does not pay the cost of polluting.
• The cost is imposed on society or spills over.
• Too much of the polluting good is produced; too many resources are allocated to it.
Government intervention to correct negative externalities:
• Taxes or fees charged to the producer
• Regulations to limit or prohibit
• Intervention shifts the cost to the producer, the supply curve shifts to the left;
equilibrium P up and Q down

Positive externality, such as inoculations against a communicable disease:

• Creates an external benefit.
• The benefits spill over to those who don’t participate.
• Too little is produced; too few resources are allocated to it.

Government intervention to correct positive externalities:
• Government financing or production (operate free inoculation centers)
• Regulation to require an action (inoculations required for school attendance)
• Subsidies (negative taxes)
• If government encourages or mandates an activity, the demand curve shifts to the
right; equilibrium P up and Q down

Antitrust legislation

laws that restrict the formation of monopolies and regulate
certain anticompetitive practices; the Federal Trade Commission (FTC) and the
Antitrust Division of the Department of Justice enforce antitrust laws

Private goods

can be consumed by only one person at a time

Public goods

can be jointly consumed by multiple people at the same time

Free-rider problem

some people can benefit from a public good without paying for it

Our macroeconomic goals are

full employment, price stability, and economic growth.
Failure to meet these goals results in macroeconomic failure and provides justification for
government programs

Inequity

unfair or unjust, The government uses some of the money collected through income taxes to make transfer
payments. This income redistribution helps to reduce inequities.

Transfer payments

monetary payments to individuals for which no goods or services are
received in return (Social Security payments and unemployment benefits)

Transfers in kind

payments in the form of actual goods and services for which no goods or services are received in return (school meals and healthcare)

Federal Government Spending

For 2023, the federal government spending was ~ $6.4 trillion (preliminary data). Federal spending breakdown based on Figure 5-3:
• Income transfers (Social Security, Medicare, income security, etc.): ~ 60%

Theory of public choice

the study of collective decision making
• Examines how decisions are made in the public sector
• Emphasizes that voters, politicians, political parties, etc. act in their own self-interest

Sources of funds available to governments:

• Taxes (income, sales, excise, property, payroll, etc.)
• User charges (state and national parks, highway tolls, etc.)
• Borrowing (through the sale of bonds)

Government budget constraint

every dollar the government spends on goods, services,
transfers, or to repay borrowed funds must be funded by user charges and taxes

Tax base

he value of the goods, services, wealth, or income that is being taxed

Tax rate

the proportion of the tax base that is paid as taxes

Proportional taxation

the tax rate is the same regardless of income

Progressive taxation

tax rates rise as income rises

Regressive taxation

tax rates fall as income rises

The Federal Personal Income Tax

Individual (personal) income taxes account for 50% of all federal revenues

The Corporate Income Tax

• Accounts for 7% of all federal revenues.
• Is assessed on a corporation’s profits (equal to revenues minus expenses).
• Is a flat rate of 21% since 2018

Payroll taxes are calculated based on the wage or salary

Social Security tax - paid by employees and employers
• Medicare tax - paid by employees
• Unemployment insurance tax - paid by employers
• Employees fund part (or all) of the employer’s contribution to payroll taxes through
reduced wages

At the state and local levels, the largest source of revenue are

Sales, excise, and gross receipts taxes

Sales tax

a tax on the price paid for most goods and services

Excise tax

a tax on the purchase of a specific good or service (gasoline, tobacco, etc.)

Unemployment

total number of adults (16 years or older) who are willing and able to work and are actively looking for work but have not found a job

Labor force

he number of employed plus the number of unemployed, 16 years or older;
people who are either looking for a paying job or working for pay

The U.S. unemployment rate has been

as low as 2% during WWI and WWII and as high
as 25% during the Great Depression

Discouraged workers

people who have stopped looking for a job because they don’t
think they will find a suitable one

Frictional unemployment

due to workers searching for an appropriate job (recent
college graduates and those changing jobs); there is always some

Structural unemployment

due to a mismatch between workers’ skills and the
requirements of available jobs (auto worker replaced by a robot)

Cyclical unemployment

due to an economic downturn or recession/depression; (to
reduce the chance, we try to keep business activity at the right level)

Natural rate of unemployment

rate of unemployment expected to prevail in long-run
macro equilibrium

Full employment

a low level of unemployment compatible with price stability; the economy is operating at its full potential; it’s producing at a point on the PPC

• Cyclical unemployment is zero; there is only frictional and structural unemployment
• Unemployment level equals the natural rate of unemployment

Inflation

an increase in the average level of prices of goods and services; causes a decline in purchasing power of money

Purchasing power

value of money for buying goods and services

Price index

measure of the average change in prices over time

CPI

Consumer Price Index; goods and services purchased by consumers

PPI

Producer Price Index; goods and services purchased by producers; changes in PPI
typically precede changes in the CPI

GDP Deflator

all U.S. produced goods and services (GDP is gross domestic product)

PCE Index

Personal Consumption Expenditure Index; used by the Federal Reserve to
measure inflation

Nominal rate of interest

interest rate that is quoted

Real rate of interest

nominal rate of interest minus inflation (can be negative)

Does Inflation Necessarily Hurt Everyone?

Borrowers (debtors) are better off during inflation
• Lenders are worse off during inflation
• Cost of living adjustments (COLAs) – wage rates increase as the price level increases

Business fluctuations

ups and downs in business activity; alternating periods
of economic expansion and contraction

order of business influctions

Contraction(recession), trough, expansion

Total income

= $ value of output

Equal to wages + rent + interest + profit

Intermediate goods

goods used in the production of final goods (flour sold to a bakery)

GDP

market value of all final goods and services produced within a country during a year

GO (gross)

market value of all goods and services produced within a country during a year
• Includes intermediate goods

Some activities are excluded from GDP

• Purchase of existing stocks
• Government transfer payments
• Sale of secondhand goods
• Activities people perform for their own household
• Legal underground transactions (cash payments that aren’t reported)
• Illegal underground activities