EQUITY
– a progressive tax and transfer system
redistributes income from rich to poor
EFFICIENCY
– correction of market failure may
improve resource allocation
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Chapter 17
Taxes and government spending
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
17.1
Government spending in the UK
0
10
20
30
40
50
% of
GDP
UK
Government spending
1956 1976 1999
The scale of
government
spending has
changed over the
past four decades.
It is now running at
just under 40%.
17.2
Government spending
EQUITY
– a progressive tax and transfer system
redistributes income from rich to poor
EFFICIENCY
– correction of market failure may
improve resource allocation
We may justify government spending on two grounds:
17.3
Private and public goods
A private good
– if consumed by one person, cannot be
consumed by another person.
e.g. dental treatment
A public good
– even if consumed by one person, can
still be consumed by other people.
e.g. street lighting
There are strong externalities associated with public goods,
so government intervention may be justified to ensure
appropriate provision.
17.4
Merit goods and bads
Merit goods (bads)
– goods (bads) that society thinks
everyone ought to have (ought not to
have) regardless of whether they are
wanted by each individual.
e.g. Education, health services, cigarettes
– The government may spend money on
compulsory education or compulsory
vaccination because it recognizes that
otherwise individuals act in a way they will
subsequently regret.
17.5
Varieties of taxes
Direct taxes
– taxes on earnings from labour, rents,
dividends and interest.
e.g. income tax, corporation tax
Indirect taxes
– taxes levied on expenditures on goods
and services
e.g. VAT, duty on alcohol
Wealth taxes
– capital transfer tax, tax on property
17.6
Employers pay the green
area, and workers the blue.
A tax on wages
Hours workedL
W
DD
SS
With no tax, the labour
market is in equilibrium
at wage W, hours L.
L'
SS'
W'
W''
With a tax, labour supply
is effectively at SS',
workers receive W'',
but firms pay W', the
difference being the tax.
The red area is a welfare
loss for society.
17.7
The incidence of a tax
Who pays a tax depends upon the
elasticity of demand and supply for
the product.
This also affects the size of
distortion caused by the imposition
of a tax.
17.8
A tax to offset an externality
Quantity
DD
SS
Given private demand DD
and supply SS, free market
equilibrium is at Q.
Q
A tax of E*F enables
this optimum to be
reached.
F
SS'
DD'
E*
Q*
But if there is a negative
consumption externality
(e.g. from smoking), the
social optimum is at Q*.
17.9
The Laffer curve
shows how much tax revenue is raised at each
possible tax rate. Beyond t*, higher tax rates reduce
revenue because of disincentive effects.
t* 100%Tax rate
17.10
Economic sovereignty
Increasing integration of countries in
the world economy reduces the
economic sovereignty of individual
nations.
Co-operation is needed to cope with
transnational externalities.
17.11
Chapter 18
Industrial policy and
competition policy
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
18.13
Industrial policy and
Competition Policy
Competition policy
– aims to enhance economic efficiency by
promoting or safeguarding competition
between firms.
Industrial policy
– aims to offset externalities that affect
production decisions by firms
18.14
Industrial policy
Inventions and the patent system
– designed to provide a sufficient
incentive for invention without
suppressing competition for ever
Research and Development (R&D)
– the social return on risky projects may
exceed the private return
Dynamic change
– coping with sunset and sunrise
industries
18.15
Consumer surplus
D
Q
P
Quantity
Consider the demand curve D
and suppose price is at P with
quantity demanded being Q.
P represents the value placed
on the good by the marginal
consumer
so D can be seen to
represent marginal social
benefit
With all consumers paying the same price P for the good, the
triangle APC represents consumer surplus – benefit received
by consumers in excess of the amount they need to pay.
A
C
18.16
Producer surplus
D
LAC = LMC
QuantityQ
P
Producer surplus is the
excess of total revenue
over total costs
– as shown by the
rectangle.
18.17
Consumer surplus is
the area of the big
green triangle.
The social cost of monopoly:
comparing perfect competition and monopoly
D
LAC = LMC
Qc
Pc
Quantity
For simplicity, suppose as
industry with horizontal
long-run average and
marginal costs.
Under perfect competition,
long-run equilibrium would
be with industry output
Qc selling at price Pc.
18.18
and the red triangle shows
the welfare loss – the
social cost of monopoly
The monopoly receives
producer surplus (profit)
of the blue rectangle.
Consumer surplus is now
the smaller green triangle.
The social cost of monopoly:
comparing perfect competition and monopoly
D
LAC = LMC
Qc
Pc
Quantity
MR
Qm
Pm
If taken over by a monopolist, profit
maximization is at the lower output
Qm and higher price Pm.
18.19
must be balanced against the gains from efficiency
(the pink rectangle).
In comparing the two situations, the loss of consumer
surplus under monopoly (the red triangle)
Perfect competition and monopoly
under differing cost conditions
D
Quantity
Suppose that monopoly
enjoys lower cost
conditions than under
perfect competition
Qc
Pc
LRSSpc Under perfect competition
equilibrium is at Pc, Qc.
LAC = LMC
MR
Pm
Qm
Compared with Pm, Qm
under monopoly
18.20
Counting the cost of monopoly
The size of the social cost of monopoly is difficult
to evaluate
– in part it depends upon the elasticity of demand
– which influences the size of the ‘red triangle’ of welfare
loss
Furthermore, firms may use up resources to
defend their monopoly position
– implying that costs are higher than under perfect
competition
– there may also be X-inefficiency under monopoly
if incentives to be cost-efficient are lower in the absence of
competition.
18.21
Competition law in the UK
The Competition Commission (formerly
the Monopolies and Mergers Commission)
is the body responsible for administering
competition policy in the UK.
A company can be referred to the
Commission if it supplies more than 25%
of the total market for a good
– or where there is collusion between firms
The Commission is charged to investigate
whether or not the monopoly acts against
the public interest.
18.22
Mergers and acquisitions
Firms can grow through merger and
acquisition (M&A) activity
– horizontal mergers
mergers between firms at the same stage of
production in the same industry
– vertical mergers
mergers between firms at different stages of
production in the same industry
– conglomerate mergers
a way for firms to diversify into a new
activity
18.23
M&A
Size may enable:
– economies of scale
– competition on a global scale
The late 1990s saw record levels of
M&A activity.