13. Market failures and the economic role of the government.

1. Externalities are additional costs or benefits to society, over and above those experienced by the individual producer or consumer.

External effect can be negative and positive. Negative effects refer to external costs of production and consumption. Positive effects are the external benefits of production and consumption.

Whenever there are external costs, the market will lead to a level of production or consumption above the socially efficient level.

Whenever there are external benefits there will be too little produced or consumed.

Public sector solutions to externalities include:

• Pigouvian taxes and subsides

• Laws

2. Public goods. Properties: socially desirable, but privately unprofitable; indivisible; non-excludable; there is non-rival consumption of public goods.

3. Market power. There is no productive efficiency under imperfect competition. Under imperfect competition Pareto optimality will not be achieved. Deadweight welfare loss is the loss of consumers’ plus producers’ surplus in imperfect markets (when compared with perfect competition).

4. Ignorance and uncertainty

5. Immobility of factors and time lags in response

6. Protection of people’s interests

7. Conflict of objectives

Aims of government policy are efficiency; equity and justice.

Functions of government:

1. Strengthening and facilitating the operation of market:

• setting legal and social framework (setting and supporting the rules of the game),

• maintaining competition (pursuing anti-monopoly and anti-trust policy).

2. Modifying the operation of the market:

• redistributing income and wealth

• reallocating resources

• stabilizing the economy

• protecting people’s interest.

Indirect intervention: economic or moral, physic.

Direct intervention. 1)Administrative. Instruments: licensing, goods and resources rationing, import quotas and tariffs, anti-trust laws, legislation of labour relations and trade units, foreign exchange control. 2) Economic. Instruments: government entrepreneurial activity, redistribution of the national income.

14. Distribution and redistribution of income and wealth.

Distribution of income by size, or personal distribution of income, shows how total income is distributed among households. 10% groups (deciles), or 20% groups (quintiles), or 25% groups (quatriles). A special decile coefficient is estimated statistically. It shows to what extent the incomes of the richest 10% group exceed the incomes of the poorest 10% group of the population.

Wealth is a stock of assets, such as houses, land, furniture, personal possessions, investments.

Causes of inequality in the distribution of wealth:

1) Inheritance

2) Income inequality

3) Different propensities to save

4) Different entrepreneurial and investment talent/luck

Disposable income = income minus taxes and plus benefits.

15. Social equilibrium. The Edgeworth box. Pareto efficiency.

The well-being of one person increases, when the well-being of another person decreases.

But it’s still possible to increase the utility for two people.

P areto optimality (social efficiency) takes place where:

•it is not possible to make someone better off without making worse off. Or,

•there is no way to make all the people involved better off. Or,

•there are no mutually advantageous trades to be made.

The achievement of private efficiency will result in social efficiency as well if two conditions are fulfilled: 1) there must be perfect competition throughout the economy; 2) there must be no externalities, or private marginal costs (benefits) should equal social marginal costs (benefits).

← Edgeworth box

16. AD-AS model: aggregate demand, aggregate supply and their non-price-level determinants; equilibrium in the AD-AS model.

Aggregate demand (AD) – the total level of spending in the economy. Formula: C+I+G+Xn

C – the consumer spending; I – firm’s spending on capital goods and services (used in further production in order to produce another goods and services), investments; G – government spending on goods and services; Xn – net export (difference between exports and imports) expenditure of foreigners on our goods and services minus our expenditure on import goods and services (X-M).

AD curve – model showing the real national output which is desirable to purchase by consumers, firms, government and foreigners at each possible price level.

Shift of the AD curve – movement to the left or right of interest rate according non-price factors; when no shift – movement along the curve. Non-price level determinants of AD (these determinants lead to shift AD curve):

1) determinants of consumer

• consumer wealth (physical and financial);

• consumer expectations of the future price of income (the higher expected P and the more expected I the more consumption the greater AD);

• consumer indebtendence;

• personal or income taxes;

• availability and price of consumer credit av↑, consumption↓, interest rate↑, consumer credit↓);

2) determinant of investment

• interest rate: the higher interest rate, the more AD and vice versa;

• profit expectations: the more investment, the greater profit expectations , the more invest, the more AD;

• business taxes: the more the taxes, the less investment and AD;

• technological progress P↑, I↑, AD↑;

• the degree of excess capacity; the higher the degree, the less investments);

3) determinants of government

• current situation

• non-economic events;

• the aim of the government policy;

4) determinants of the net export

• national increase abroad: the greater it, the more goods and services can be sold abroad, export↑, AD↑;

• exchange rate: export↑, import↓, Xn↑, AD↑).

Aggregate supply (AS) – is the total amount of output in the economy. AS curve is a model shows the real national output at each possible price level. It depends on: economic development and the effective use of resources. 1^st range (I) – horizontal Keynesian range of AS curve, it is characterized by the low level of development and great amount of excess resources, no increase in the price level, for the SR. 2^nd range (II) – up sloping, is characterized by the development economy and growing deficit of some resources, increase in production, company with increase of the price level. 3^rd range (III) – vertical (classical), is characterized by the achievement of potential output that is max. for the current level and the great deficit of all resources, production↑, price↑, for the LR. Non-price level determinants of AS: they influence on average cost of production AC=TC/Q. 1) the availability of resources: the more the quantity of resources, the less their prices, the less average cost of production, the more AS; 2) prices of resources↑, the higher average cost of production, the less AS; 3) market power of firms: the stronger it, the less production, cause firms try to keep high prices, production↓; 4) market power of trade unions: the stronger it, the higher the wages, the more average cost, the less AS; 5) productivity of resources↑ the less AC of production: productivity=output/input; 6) business taxes and subsides: taxes↑, subsides↓, AC↑, AS↓; 7) government regulation: price regulation can discourage firms to produce more, may cause AS↓.