Government Intervention in the Economy Notes

Government Intervention in the Economy

• Governments intervene because free markets don't always achieve desirable economic and social outcomes.
• Free markets prioritize private economic interests, often ignoring broader community needs.
• Consequences of unregulated free markets:
  • Unmet community needs (e.g., parks).
  • Insufficient income for some individuals.
  • Potential for economic instability.
• Government intervention aims to:
  • Improve resource allocation.
  • Provide essential goods and services.
  • Promote a more equitable income distribution.
• However, excessive intervention may hinder innovation, efficiency, and economic growth.

Market Failure and Provision of Goods & Services

• Public Goods
  • Difficult to prevent people from using them once provided (non-excludable).
  • Private sector lacks incentive due to lack of profit.
  • Examples: lighthouses, parks, streetlights.
  • Non-rival: One person's consumption doesn't diminish availability for others.
  • Some public goods can be excludable (e.g., a crowded bus).
• Private Goods
  • Excludable and rival.
  • Non-payers are excluded, and consumption by one prevents consumption by another.
  • Example: food.
• Merit Goods
  • Benefits extend beyond the individual consumer to the broader community.
  • Examples: higher quality health care, Opera House.
  • Often undervalued and under-supplied by the free market.
  • Governments provide these directly or incentivize private sector supply through subsidies.
• Demerit Goods
  • Undesirable goods that the free market overproduces.
  • Example: tobacco.
  • Governments discourage production through various measures.
• Collective Goods
  • Benefit the entire community.
  • Example: national army.
  • Private sector may provide some, but often in insufficient quantities.
  • Government often provides essential collective goods (e.g., water), leading to natural monopolies.
  • Natural Monopoly: A market where a single supplier is most efficient due to high investment costs.

Market Failure

• Occurs when market forces lead to unfavorable outcomes.
• Often results from economic inefficiency, limited allocative efficiency, and unminimized waste.
• Government intervention aims to achieve allocative efficiency through the provision of goods and services.

Market Failure in the Provision of Goods and Services

• Public Goods: Markets fail to provide sufficient quantities due to 'free rider' problem.
• Merit Goods: Markets fail to produce goods beneficial to society.
• Collective Goods: Markets fail to produce goods that benefit the whole community (e.g., defense force).

Market Failure in Externalities/Spillovers

• Unintended consequences of private actions on external parties.
• Not reflected in market prices.
• Example: Petrol price doesn't account for environmental damage.
• Form of market failure as price mechanism fails to represent true costs or benefits.
• Negative Externalities: Harmful spillover effects.
  • Example: Large trucks damage roads instead of building railways.
• Positive Externalities: Beneficial spillover effects.
  • Example: Private schools increasing national intelligence.

The Problem of Commons

• Governments balance economic growth with environmental protection.
• Lack of proper pricing can lead to resource exploitation.
• Addressed by government implementing licenses and permits.
• Example: exploitation of mining with licences to mine.

Market Failure in Income Distribution

• Free markets tend toward income inequality without government intervention.
• Absolute Poverty: Insufficient income for basic survival, measured by the 'Henderson Poverty Line'.
• Relative Poverty: Living standards of the poor compared to the rest of the population.
• Government reduces income inequality through:
  • Free education.
  • Welfare benefits.
  • Tax transfer systems (redistributing income).

Market Failure in the Abuse of Market Power

• Industries often have only a few dominant firms, leading to imperfect competition.
  • Oligopoly: Few large firms dominate the market.
  • Monopoly: One large firm dominates the market.
  • Monopolistic Competition: Many small sellers with differentiated products.
• These markets may produce fewer goods at higher prices compared to free market outcomes.
• Firms in concentrated industries can abuse market power through:
  • Monopolization: Eliminating competition through price cutting.
  • Price Discrimination: Selling the same product at different prices in different markets based on willingness to pay.
    • Example: Peak and off-peak prices for public transport.
  • Exclusive Dealings: Restricting retailers from dealing with competitors (illegal).
  • Collusion and Market Sharing: Firms agree on pricing and market sharing (illegal, also known as cartels).

PTEs and Natural Monopolies

• Public Trading Enterprises (PTEs) are government-owned businesses.
• Can become natural monopolies if they efficiently supply the entire market, making it hard for new firms to enter.
• Example: Sydney Water.
• Considered better than private monopolies as they are less likely to abuse market power.

Other Market Failures

• Fluctuations in Economic Activity: Excessive volatility leading to unemployment or inflation.
• Public Interest: Market forces creating prices that are too low or too high, requiring government intervention.

Role of the Government in Australia

• Three levels of government:
  • Federal: Responsible for the economy and matters in the Constitution (e.g., defense, immigration, trade).
    • Funded by taxes (income tax, GST).
    • Spends on national defense, Medicare, and allocates funds to states/territories.
  • State: Delivers government services on issues not exclusively federal (e.g., education, transport, justice).
    • Funded mainly through federal grants, but also collects state taxes (e.g., land tax).
    • Spends on public hospitals, schools, public transport.
  • Local: Focuses on local planning and services (e.g., waste collection, local roads, parks).
    • Funded through property taxes and state/federal grants.
    • Spends on roads, waste services, libraries, and community projects.
• Exclusive Powers: Only exercised by the federal government.
• Concurrent Powers: Shared by federal and state governments.
• Residual Powers: Only exercised by state governments or delegated to local governments.
• The Public Sector: Consists of all levels of government and PTEs.
  • Example: Sydney Water, Australia Post.
  • Public sector outlays as a percentage of GDP indicate the proportion of total annual expenditure by the public sector.
    • Currently 41.6% of GDP, with transfer payments as the largest spending component.

Reallocation of Resources

• Government changes the pattern of production, directing resources towards desirable goods and services, and away from less desirable ones.
• Methods:
  • Taxation: Influencing prices and demand through taxes on producers.
    • Direct Tax: Paid by the individual or firm levied upon (e.g., income tax).
      • Impact of the tax = incidence of the tax, the person who actually pays the tax through cause and effect.
    • Indirect Tax: Can be passed onto another party, imposed on goods/services (e.g., GST).
  • Spending: Influencing decisions through government spending.
    • Examples: Funds for arts, grants for businesses, subsidies.
  • G&S Production: Producing goods/services that would otherwise not be produced.
    • Example: Streetlights, parks.
  • Government ownership of natural monopolies instead of private sectors ensures consumers are not exploited.
  • Regulatory Policies:
    • Prohibiting or limiting the sale of certain goods (e.g., guns and cigarettes).
    • Price ceilings and price floors.
    • Laws against certain business actions (e.g., against exclusive dealings).

Redistribution of Income

• Using tax policies and government spending to achieve economic objectives (employment, price stability, economic growth).
• Examples: Age pension, welfare payments.
• Taxation used to redistribute income by taxing individuals at different rates based on income.
  • Tax Base: Items that are taxed (income, wealth, consumption).
  • Average Rate of Tax (ART):
    • Proportion of total income paid as tax.
    • Tax paid ÷ initial income * 100\% = ART
  • Marginal Rate of Tax (MRT):
    • Proportion of any increase in income paid as tax.
    • How many cents in every extra dollar earned that must be paid to the government.
    • Highest tax bracket income falls in.
    • Progressive Tax:
      • Higher income earners pay a greater proportion of their income as tax than lower-income earners.
    • Regressive Tax:
      • Higher income earners pay a smaller proportion of income as tax than lower income earners.
    • Proportional Tax:
      • All income earners pay the same proportion of their income as tax.

Stabilization of Economic Activity

• Using macroeconomic policies to achieve economic objectives (employment, price stability, economic growth).
• Examples: Monetary and Fiscal policy.

Competition Policy

• Governments aim to promote workable competition (maximum level of competition compatible with market structures).
• More competition leads to:
  • More efficient use of resources.
  • Lower production costs.
  • Product innovation.
  • Lower prices.
• Achieved through policies like the Competition and Consumer Act 2010, overseen by the ACCC.

Environmental Policy

• Two underlying issues:
  • Use of renewable and non-renewable resources.
    • Concern for climate change.
    • Net zero emissions by 2050 goal.
  • Price does not reflect negative externalities involved in production.

The Business Cycle

• In a market economy, economic activity fluctuates in cycles.
• Characterized by:
  • Expansion/Upswing: Expenditure, output, income, and employment increase.
  • Peak/Boom: Expenditure, output, income, and employment reach a maximum point.
  • Contraction/Downswing: Expenditure, output, income, and employment decrease.
  • Recession/Trough: Expenditure, output, income, and employment reach a minimum point.
• Causes of recessions and booms:
  • Volatility of private investment spending.
  • Changes in technology.
  • Seasonal influence on production (floods).
  • International events (US stock market crash).
• To smooth fluctuations, the government employs:
  • Macroeconomic Policies: Influence the entire economy and counterbalance the business cycle (fiscal and monetary policy).
  • Microeconomic Policies: Influence individual firms and industries to improve work practices and productivity.
    • Example: Competition policies.

Fiscal Policy

• Countercyclical macroeconomic policy by the Commonwealth government through the Federal Budget.
• Aims to:
  • Stabilize economic activity.
  • Change resource use.
  • Change income distribution.
• Works by changing government spending (G) and taxes (T) for the coming financial year.
• Is a forecast of spending and tax revenue.

Budget Stance

• Aim of impact of the budget on economic activity.
  • Expansionary: Stimulates economic activity.
  • Contractionary: Slows down economic activity.
  • Neutral: No change in budget outcome, so no change in economic activity.

Budget Outcome

• Calculation of Government’s bank balance at the end of each financial year.
• Economic activity is affected by the impact of fiscal policy on the level of AD.
  • T > G: budget surplus.
  • T < G: budget deficit.
  • T = G: balanced budget.

Budget Mechanisms

• Structural/Discretionary component:
  • Deliberate changes to Government spending(G) or Taxes(T).
    • Example: Increasing Job Seeker payments.
• Cyclical/Non-Discretionary component:
  • Automatic changes in government spending(G) or Taxes(T) responding to economic cycle changes.
    • Example: Increase in income (↑Y) leads to Increase in Tax revenue (↑Tax revenue).
  • Regardless of government decisions:
    • Budget moves naturally towards surplus during upswing (↑T and ↓G).
    • Budget moves naturally towards deficit during downswing (↓T and ↑G).
  • Automatic stabilisers naturally stabilize economic activity.
    • Progressive personal income tax system.
      • As income rises so does Marginal Rate of Tax (MRT) and Average Rate of Tax (ART).
      • In a boom: Increase in Tax Revenue (↑T revenue), increases leakages and reduces economic activity.
      • In a recession: Decrease in Tax Revenue (↓T revenue), decreases leakages and stimulates economic activity.
    • Social welfare system.
      • As income changes, social welfare spending changes.
      • In a boom: Decrease in Social Welfare (↓social welfare), decreasing injections and reducing economic activity.
      • In a recession: Increase in Social Welfare↑social welfare), increasing injections and expanding economic activity.
    • These work counter-cyclically.
    • Important:
      • Cyclical component reacts to change by moving budget towards deficit when economic activity is Decrease and towards a surplus when economic activity is Increase.
      • Automatic stabilisers smooth fluctuations in the economy by impacting leakages and injections.

Limitations of Fiscal Policy

• Factors that limit the effectiveness of Fiscal Policy.
  • Current business cycle.
    • Example: The end of the mining investment boom slowed down the economy by reducing how much tax revenue the government collects.
  • Global business cycle.
    • Example: The GFC significantly narrowed Australia’s policy choices.
  • Current borrowing and saving position.
    • Status of government debt.
      • Too much debt leads to reduced future borrowing.
  • Demographics.
    • Ageing population puts social welfare pressure on budget.
  • Political constraint.
    • The budget is a plan which requires legislation to be passed into place.
    • In recent Australian political history, the party in office (controls the house of reps) has not controlled the Senate. This means that disputed legislation can never become law if the Senate refuses to pass them.

Examples of Government Influencing the Economy

• Influencing Aggregate Demand:
  • Expansionary fiscal policy will lead to a growth in aggregate demand.
    • $8.4bn to increase doctor's incentives to boost bulk billing rates in Australia.
    • Government investing $330bn in the Defence Integrated Investment Program.
    • $1.8bn to extend energy bill relief with households and small businesses.
• Resource Allocation:
  • Investing in infrastructure is the main way.
    • Investing in education using subsidies to aid the quality of childhood education and funding public schools.
    • Continuing $120bn 10-year infrastructure investment on national roads and rail projects.
    • $33bn plan to build more homes and make it easier for Australians to buy or rent a home.
• Changing Income Distribution:
  • Mainly through social welfare.
    • Government is advocating further increases in National Minimum Wage.
    • $1.5bn through Housing Support Program to increase social housing by 55000 homes.
    • $3.9bn to states and territories to reduce homelessness.

The Simple Multiplier

• Definition: explains how a small change in spending can lead to a larger change in total income.
• Key to economic growth was in increases of the level of AD.
• Higher national income → economic growth, explained through the multiplier.
• Occurs because spending will result in more spending depending on MPC and MPS of the recipients of the additional income.
• Shown in the Keynesian Cross.

Example of The Simple Multiplier

Aggregate demand is total spending in the economy on Goods and Services (C+I+G+(X-M)). Income is GDP.

• I make and sell dry pasta in the USA.
  • Receive $1000 AUS.
    • Injection to the economy as Y from X.
  • Decide to spend some money and save some money.
    • Spend 80% and save 20%.
    • Take my wife for fancy dinner + get her flowers. Spend all $800.
      • The $800 spent is Y in the hands of the restaurant and florist and waiters who will also spend 80% and save 20%.
        • This means $640 is again Y for the next person.
          • So far, the initial injection of $1000 has created $2440 and this will continue forever, getting smaller and smaller.
    • The more that is spent, the bigger the multiplier, and the less that is spent the smaller the multiplier.

Macroeconomic Policy

• Includes:
  • Fiscal policy – controlled by government
  • Monetary policy – controlled by RBA
• 3 Goals:
  • Stabilising economic activity
  • Maintaining low inflation (2-3%)
  • Achieving full employment

The Unemployment/Deflationary Gap

• Sometimes the economy will operate below the full level of efficiency. There will be cyclical unemployment (lack of AD for Goods and Services leads to a lack of jobs available).
• In these times there will be a deflationary/unemployment gap as shown in the graph below.
• It is governments job to thus increase spending or RBA’s job to reduce cash rate to stimulate economic activity and close the gap.
• Ye (equilibrium level of GDP) is below the full employment level of Yf.
• Government may need to ↑G to increase AD and raise income to full employment level to close the gap.

Inflationary Gap

• Sometimes the economy will operate above the full level of employment of resources, resulting in high inflationary pressure.
• These times result in an inflationary gap as seen below.
• Government and RBA’s job to slow economic activity and close the gap.
• Equilibrium level of GDP Ye is above the full employment level Yf.
• Government may need to Decrease G(↓G) to Decrease AD(↓AD) and reduce income to full employment level to close the gap.

RBA vs Keynesian Perspectives of Fiscal Policy

• RBA
  • Looks only at a change in stance to determine impact.
• Keynesian
  • Looks only to discretionary spending and taxation decisions of the government and ignores the cyclical component.

Example of RBA vs Keynesian Perspectives of Fiscal Policy

• E.g. 2019-2020 budget forecast change from $0.7bn deficit to $7.1bn surplus
  • RBA views as mildly contractionary
  • Keynesian views as mildly expansionary due to deliberate spending measures contained within including $100bn on infrastructure

Influences on Government Policies

• Political Parties
  • For government to pass major policy changes it must go in a form of a Bill through parliament.
  • For the bill to be passed it goes through the House of Representatives and then the Senate.
  • Both consist of members from different political parties, therefore, need their support to pass bills, and make agreements to get their Bills passed.
  • Also try gain public support by making Bills seem appealing to public so they get re-elected.
• Business
  • Businesses have significant voices in decisions as:
    • Successful businesses are crucial in the economy
      • Government wants them to do well
    • Businesses have financial influence over parties
      • Parties accused of changing policies because of businesses' financial contributions
  • Also dedicate resources to lobbying government, advocate for interests of those specific firms.
• Unions
  • Represent interests of their members from individual workplaces
  • Consult with government on policy issues
• Environmental Groups
  • Groups that advocate for action on environmental protection
  • Provide information and lobby governments and companies on wide range of issues
• Welfare Agencies
  • Represent disadvantaged people in the community.
    • Aged, people with disabilities, charities.
  • Lobby government as well as use media to broadcast their message.
• Media
  • Decide how issues are presented to public.
  • Political leaders try to anticipate how media will report their policies and change their plans to try get more positive coverage.
• Interest Groups
  • People with specific relating issues often form organisations to work together.
    • Strong local focus
    • Formed around a specific issue
    • Represent a particular group in the community
• International Influences
  • Policy decisions may be unpopular with international financial markets.
  • If an international financial market loses confidence with the government's economic management, the government could face a fall in the money exchange rate, higher interest rates on government borrowing, and negative media coverage.
  • Financial markets also force governments to change their policies
    • E.g. Global Financial Crisis 2008