Economics

Diminishing marginal utility helps to explain why lower prices are needed to increase the quantity demanded. Since your desire for a second cone is bound to be less than it was for the first, you are not likely to buy more than one, except at a lower price. At even lower prices you might be willing to buy additional cones and give them away.

The demand curve illustrates the demand for ice cream cones that day in April. It also enables us to estimate what the demand would be for those prices falling in between the prices we surveyed. Although the students were not questioned about how many cones they would buy if the selling price were $1.60, the curve lets us estimate the number would be about 55.

Demand for Ice Cream Cones Near Your School

Price per cone

Number of cones

Elasticity of Demand

The shape and slope of demand curves for different products are often quite different. If, for example, the price of a quarter of milk were to triple, from $.80 to $2.40 a quart, people would buy less milk. Similarly, if the price of all cola drinks were to jump from $1 to $3 a quart (an identical percent increase), people would buy less cola. But even though both prices changed by the same percentage, the decrease in milk sales would probably be far less than the decrease in cola sales. This is because people can do without cola more easily than they can do without milk. The quantity of milk purchased is less sensitive to changes in price than is the quantity of cola. Economists would explain this by saying that the demand for cola is more elastic than the demand for milk. Elasticity describes how much a change in price affects the quantity demanded.

How Elasticity is Measured. When the demand for an item is inelastic, a change in price will have a relatively small effect on the quantity demanded. When the demand for an item is elastic, a small change in price will have a relatively large effect on the quantity demanded.

Elasticity can also be measured by the "revenue test." Total revenue is equal to the price times the number of units sold. If, following a price increase, total revenue falls, the demand would be described as elastic. If total revenue were to increase following a price increase, the demand would be inelastic.

Similarly, if total revenue increased following a price decrease, demand would be elastic. If the price decrease led to a decrease in total revenue, the demand for the item would be described as inelastic.

Super Sally's Supermarket sells 500 quarts of milk and 100 quarts of cola daily. At $.80 a quart she grosses $400 on her milk sales, and at $1 a quart she grosses $100 on her cola. Last week she increased the prices on the milk and cola by 50 percent-- milk sold for $1.20 a quart, and cola for $1.50. Following the price increases, milk sales slipped to 350 quarts daily, while soda sales dropped to 35 quarts.

Total revenue from the sale of milk increased (to $420) following the price increase because the demand for milk is inelastic. Total revenue from the sale of cola fell (to $52.50), and for that reason we can say that the demand for cola is elastic.



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Why the Demand for Some Goods and Services Is Inelastic. The demand for some goods and services will be inelastic for one or more of the following reasons:

Ш They are necessities.

Ш It is difficult to find substitutes. Cola drinkers can switch to other soft drinks, but there are few substi tutes for milk.

Ш They are relatively inexpensive. People are less apt to change their buying habits when the price of some thing that is relatively inexpensive is increased or decreased. If, for example, the price of an item were to double from 10 cents to 20 cents, it would have less of an effect on demand than if the price had gone from $250 to $500.

Ш It is difficult to delay a purchase. When your car is running out of gas, it is not always possible to shop for the best deal.

Changes in Demand. Until now, we have been describing the relationship between an item's price and the quantity of an item people will purchase. Sometimes things happen that change the demand for an item at each and every price. When this occurs, we have an increase or a decrease in demand.

What are some of the factors that would cause the demand for ice cream, or any other product, to increase or decrease at each and every price?

Substitutes. When two goods satisfy similar needs, they are described as substitutes. A change in the price of one item will result in a shift in the demand for a substitute. Black and brown shoes are close substitutes. If the price of black shoes goes up, then people will tend to substi tute brown shoes for black shoes, and the demand curve for brown shoes will shift out at every price. If the price of black shoes goes down, then people will tend to substi tute black shoes for brown shoes, and the demand curve for brown shoes will shift in at every price.

Complementary goods. Goods that are often consumed together, like peanut butter and jelly, are complements. If the price of peanut butter should increase, the quantity of peanut butter consumed will decrease. Since peanut butter and jelly are consumed together, the quantity of jelly demanded at each and every price will also decline, and the demand curve for jelly will shift in.

What are some other factors that might cause the demand for ice cream your friends are selling to increase or decrease at each and every price? How would these changes be reflected in the demand curve? The following is a brief list of factors that might affect the curve:

Ш Change in the environment. It is a much hotter month than usual.

Ш Change in the item's usefulness. The Surgeon General of the United States issues a report that states ice cream is good for you and enhances your attractiveness.

Ш Change in income. Allowances are raised as an economic boom sweeps your community.

Ш Change in the price of a substitute product. The price of candy decreases.

Ш Change in the price or availability of complemen tary products.

Ш Change in styles, taste, habits, etc.

Price per Cone

If any of these events occurred, the demand schedule would change in such a way that the quantity demanded at any particular price would be higher or lower than our original demand schedule indicates. If the demand were to increase, the curve would shift outward (Figure). If demand were to decrease, the curve would shift inward.

Demand for Ice Cream Cones Near Your School

0 50 100 150 200 250 300

Number of cones

Supply

Thus far we have only spoken about the effects of prices on buyers. But it takes two parties to make a sale: buyers and sellers. To the economist supply refers to the number of item that sellers will offer for sale at different prices at a particular time and place. A supply schedule is a table summarizing this information. Table below is the supply schedule that was in effect that day in April when your friends conducted their survey.

The Law of Supply

As the supply schedule indicates, more ice cream cones would be offered for sale at higher prices than at lower ones. This is in keeping with the law of supply which states that sellers will offer more of a product at a higher price and less at a lower price. Why does the quantity of a product supplied change if its price rises or falls? The answer is that producers supply things to make a profit. If ice cream prices around your school are high, your friends may buy a larger ice cream maker so they can produce and sell more ice cream. Addi tionally, if word gets out that ice cream sells for a relatively high price near your school, other vendors will be tempted to leave their present locations and come to your high school in the belief that they can make more profit.

Table

Supply Schedule for Ice Cream Cones Near Your School, April 1
Price Per Cone	Quantity Supplied
$.50	50
$.75	80
$1.00	125
$1.25	175
$1.50	235
$1.75	265
$2.00	300

Our supply schedule is based on holding variables other than price at some fixed or constant level. On this basis we can use the supply schedule to draw the supply curve (Figure below).

Supply for Ice Cream Cones Near Your School

Price per coneprice per Cone

Number of cones

0 50 100 150 200 250 300

Number of cones

As in the case of demand, supply curves need not be straight lines. Unlike demand, the typical supply curve slopes upward from left to right.

Changes in Supply. When supply changes, the entire supply curve shifts either to the right or to the left. This is simply another way of saying that sellers will be offering either more (if supply has increased) or less (if supply has decreased) of an item at every possible price. Any or all of the following changes are likely to affect the quantities supplied.

Ш Changes in the cost of production. If it costs sellers less to produce their products, they will be able to offer more of them for sale. An increase in production costs will have the opposite effect -- supply will decrease.

Ш Other profit opportunities. Most producers can make more than one product. If the price of a product they have not been producing (but could if they chose to) increases, many will shift their output to that product. For example, as personal computers increased in popularity, a need developed for computer stands. As a result, many furniture manufacturers began to produce desks and carts specifically designed for the computer market. |

Ш Future expectations. If producers expect prices to increase in the future, they may increase their production now to be in position to profit later. Similarly, if prices are expected to decline in the future, producers may reduce production, and supply will fall.

Changes in supply are illustrated graphically in Figure 6.

Price per Cone

The price at which supply exactly equals demand is known as the market price, or the point of equilibrium. In the table above, the market price would be $1.00 because at that price the quantity of ice cream cones demanded and the quantity supplied are exactly equal. Figure 8 represents this information graphically.

Supply of and Demand for Ice Cream Cones Near Your

School

Number of cones

Equilibrium

Supply and demand schedules tell us how many items buyers would purchase and how many items sellers would offer at different prices. By themselves they do not tell us at what price goods or services would actually change hands. When the two forces are brought together, however, something quite significant takes place. The interaction of supply and demand will result in the establishment of an equilibrium or market price. The market price is the one at which goods or services will actually be exchanged for money.

Types of Markets

Economists often speak of the “structure” of a market. By that they mean the number and the relative power of the buyers and sellers. In certain industries, such as automobile manufacturing, three or four American firms and a few major foreign manufacturers meet the needs of millions of buyers. By contrast, the military aircraft industry consists of only a few manufacturers and a handful of buyers (such as the United States and a few foreign governments). In the stock and bond markets there are both many buyers and sellers. In what follows we will be describing the principal kinds of market structures: perfect competition, monopolistic competition, oligopoly and monopoly.

Perfect Competition: Many Buyers and Sellers

The laws of supply and demand operate as we have described them only under conditions of perfect competition. A perfectly competitive market, according to economists, requires all of the following conditions:

· Many buyers and sellers; no individual or group can influence the behaviour of the market.

· Identical goods or services offered for sale.

· No buyer or seller knows more than any other about the market.

· Buyers and sellers are able to enter or leave the market at will.

Few markets have all these characteristics. The New York Stock Exchange, the American Stock Exchange and other similar securities markets, however, are good examples of perfect competition.

· There are so many buyers and sellers of stocks and bonds, that (with few exceptions) no individual or group can control the market for any single security.

· The individual securities of a particular firm are totally interchangeable.

· All securities transactions are recorded and the information is made available to the general public.

· Traders can buy or sell individual securities at will.

Can you think of other examples of competitive markets?

Monopolistic Competition: Many Unique Products

Perfect competition and perfectly competitive markets exist in only a few businesses or industries. In fact, most businesses work very hard to make consumers believe that their products and services are special or unique. When many firms are selling similar products and services while explaining how they are “new and improved” or “used by professionals', or “ the best value for the lowest price” the market is no longer competitive. Economists describe a market with many sellers providing similar but not identical products as monopolistic competition.

Mary Lou and Hot Dog Harry operate competing sidewalk stands fairly close to one another on the same street in town. At lunchtime both Mary and Harry do a brisk business, and they both have their steady customers. Ask Mary's regulars why they prefer her hot dogs and they might tell you that they think the sauerkraut she serves with them is something special or that they like the courteous way in which she treats her customers. Harry's customers are equally enthusiastic about his frankfurters and about Harry. Harry charges $.90 for his hot dogs. Mary Lou charges $.95. There is another stand a few blocks away where the frankfurters sell for $.85, but that one does not do as well as Mary Lou or Hot Dog Harry.

Although Mary Lou and Hot Dog Harry sell similar products, they are not the same in the minds of those who prefer one over the other. The effort to make a product more attractive than the competition's distinguishes monopolistic competition from perfect competition.

Although stock market trading is as close to perfect competition as anything you can find, stockbrokers provide an example of monopolistic competition in a service industry. Stockbrokers will not claim that the shares of General Motors stock they buy and sell for you are any different from the shares that anyone else buys or sells. But stockbrokers do compete with one another or the public's business. They try to make their services more attractive than the competition's so potential customers will think of them the next time they think of investing.

The process of creating uniqueness in products is known as product differentiation. Product differentiation, when it is successful, enables a firm to create product loyalty so its customers prefer its products over the competition's.

Oligopoly: A Few Sellers

Oligopoly is a term applied to markets dominated by a few (roughly three to five) large firms. Breakfast cereals, automobile and computer hardware are examples of industries dominated by oligopolies. As the market structure of an industry changes from many firms selling differentiated products to a few firms dominating an industry, economists say that the “concentration ratio" is changing. The concentration ratio is determined by the percentage of an industry's output accounted for by its four largest firms.

Oligopolies exist because it is difficult for competing firms to enter the market. Circumstances that make it difficult to enter the market are described as "barriers to entry." One such barrier is the high cost of entry. The capital needed to enter the automobile manufacturing business, for example, would run to billions of dollars.

Another barrier to trade is created by patent protections. The products of certain industries, such as aluminum, chemicals and electronics, are protected by patents. Competing firms cannot enter those industries unless they pay the patent holders for permission to use the process or find a new method of production not covered by existing patents.

Price competition is less effective where there is oligopoly. Firms know that if they reduce their prices the competition will do the same. Therefore, instead of increased sales (as would be the case in a competitive market), price reductions would simply reduce revenue. In place of competition, oligopolies often look to price leadership, collusion, and custom to determine their pricing policies.

Ш Price leadership is the practice of one firm in the industry, usually the largest, setting a price which other firms follow.

Ш Collusion is a secret arrangement between two or more firms to fix prices or share the market. These agreements are usually illegal.

Ш A Custom is the prac tice of establishing prices and market shares based on long standing tradition. Sometimes the courts have found such practices to be unlawful; in other instances they were found to be legal.

Monopoly: One Seller

Economy tax firm market

A market in which there is only one seller is a monopoly. You will recall that under conditions of perfect competition market price could be found at the intersection of the supply and demand curves. In those circumstances both supply and demand reflect the thinking of many buyers and sellers; no individual or group could affect the market price. In a monopoly, however, supply is determined by a single firm. This gives that firm the power to select any price it chooses along the demand curve. Which price will it choose? The one that yields the greatest profit.

Monopolies have the following characteristics:

· A single seller or monopolist.

· No close substitutes. The product sold by a monopoly is different from those offered by other firms. Buyers must either pay the monopolist's price or do without.

· Barriers to entry. Competing firms are unable to enter a market where a monopoly exists.

Legal Monopolies

Although monopolies are generally illegal in this country, the law does provide for a variety of legal monopolies such as: public utilities, patents, copyrights and trademarks.

Public Utilities are privately owned firms that provide an essential public service. They are granted a monopoly because it is felt that competition would be harmful to the public interest. Your local electric, gas and water companies are public utilities. Utilities are subject to extensive government regulation and supervision.

Imagine the complications that one electric company served your community. Each would have its own power lines, maintenance organization and generating plant.

Competition, however, provides businesses with the incentive to keep prices down and improve services. In place of competition, government protects the public by regulating the activities of the utilities. Government supervision is carried out by regulatory commissions which determine the services the utilities provide and how much they are permitted to charge for them.

Patents as Monopolies. How would you like to come up with a new idea - something that could be turned into a new product or service that would make you rich and famous? To encourage you, the federal government grants patents to cover new products and processes. In a sense, a patent is a monopoly. It gives the inventor exclusive use of a product or idea for 17 years. You may sell your idea or give it away, but it is yours to do with as you wish. Eventually, someone will develop a product or service that will be acceptable alternative to yours. It, too, might qualify for a patent and perhaps compete with yours.

Copyright and Trademarks as Monopolies.

Though the Federal Copyright Office, the government gives the authors of original writing and artistic work a copyright - the exclusive right to sell or reproduce their works. That copyright is a special monopoly for the lifetime of the author plus fifty years.

Trademarks are special designs, names or symbols that identify a product, service or company. “Coke” is a trademark of the Coca-Cola Company. Competitors are forbidden from using registered trademarks or ones that look so much like trademarks consumers will confuse them with the originals.

How Competition Benefit Us All

In a competitive market, producers constantly strive to reduce their production costs as a way to increase profits. The increased efficiency that allows them to reduce their costs also enables producers to sell their goods at a lower price. Thus, by promoting efficiency, competition leads to lower prices.

Competition also motivates producers to improve the quality and increase the variety of goods and services. Consumers soon learn which brand offers the best value, and that firm will earn greater profits than its competitors. Similarly, producers in a competitive market must constantly look for new and attracting goods and services to win a larger share of the market.

As firms compete for the consumer's dollar in a market, their efforts lead to the production of a variety of better-quality products at the lowest possible prices. And since we are all consumers, it follows that competition benefits us all.

Federal Regulation: The Antitrust Laws.

The American free enterprise system is based on the belief that competition is in the best interest of everyone. When competitors agree to fix prices, rig bids or divide the market, the public loses the benefits of competition. The prices that result are artificially high. This is unfair to consumers who must pay more for the things they buy. It is damaging to an economy that looks to the price system to signal what goods and services are in demand and the most cost-effective way of producing them.

For that reason, the federal governments and many state governments have enacted legislation known as antitrust laws - laws designed to safeguard competition. The major federal antitrust laws are The Sherman Antitrust Act, the Clayton Act, the Federal Trade Commission Act, and the Celler Antimerger Act. Nevertheless, many businesses are naturally interested in growing and controlling as much of a market - or several markets - as possible. One way to accomplish this goal is through merger.

Do Antitrust Laws Help or Hurt?

Many of those who favor competition, however, also feel that government interference in the marketplace is inappropriate. They are especially concerned about the effect of antitrust laws on the ability of corporations to compete with their foreign coun terparts. They argue that many foreign companies operating in countries that have no antitrust laws have an unfair advan tage. For example, Japanese computer firms can assist each other in developing and marketing new software. Such cooperation by American companies might violate antitrust laws. While the intent of the law is to protect American consumers against price-fixing and other conspira cies, its effect in this situation may limit the American compa nies' ability to compete.

Those favoring strict enforcement of the antitrust laws say that the foreign competition argument is simply a smoke screen by firms looking to eliminate their competition. The key to outperforming foreign competitors, they say, lies in a more efficient operation rather than ever-increasing size.

Table

Characteristics of Economic Markets
Number of firms	Many independent firms. None able to control the market.	Many firms providing similar goods and services.	A few large firms providing similar goods and services.	A single large firm.
Control over price	None. Market determines price.	Influence limited by the availability of substitutes.	Often influenced by a “price leader.”	Much control.
Product different-tiation	None. Products uniform and of equal quality.	Products and services differentiated to meet the needs of specific markets.	Significant for some products like automobiles. Little for standardized products like gasoline.	None.
Ease of entry	Relatively easy to enter or leave the market.	Relatively easy to enter or leave the market.	Difficult. Often requires large capital investments	Very difficult.

Government in the Mixed Economy. What do Governments Do?

Most resources in Western economies are allocated through markets in which individuals and privately owned firms trade with other individuals or firms. However, governments also play a major role. They set the legal rules; in the marketplace they buy goods and services, from paper clips to aircraft carriers; they produce some services, such as defence; and they make payments such as social security benefits. In financing themselves through taxation and borrowing, governments exert a major influence on prices, interest rates, and production.

Governments in modern industrial economies collect between one-quarter and one-half of GNP in taxes each year and typically spend a little more than they receive in taxes. Because governments play so large a part in economic life, to understand the operation of a modern economy we have to understand not only how markets work but also how government affects the operation of the economy.

This chapter addresses three basic questions about the government's role in economic life. What do governments actually do? How can governments in principle improve the allocation of resources in the economy? How do governments decide what to do? Our aim here is to develop an overview of the role of government as a basis for our continuing discussion of government policy in later chapters.

What Do Governments Do?

Table 3-2 shows how the scale of government activity has grown steadily over the last century. It now ranges from a third of national income in Japan to two-thirds of national income in Sweden. What do governments actually do?

Create Laws, Rules and Regulations

Governments determine the legal framework that sets the basic rules for the ownership of property and the operation of markets. If the legal framework outlaws private ownership of businesses, the economy is socialist; if businesses are owned by individuals and operated for private profit, the economy is capitalist. Even in the most capitalist economies, there are limits to the rights of ownership. Not everyone can own a gun, for instance. Nor are people entirely free to use their property as they please; it is usually illegal to build a factory on land in a residential area.

In addition, governments at all levels regulate economic behaviour, setting detailed rules for the operation of businesses. Regulations include planning permission (how land can be used and where businesses can locate), health and safety regulations, and attempts to prevent some types of business, such as the sale of heroin. Some regulations apply to all businesses; examples include laws against fraud and laws that prohibit competitors from agreeing to fix prices. Some regulations apply only to certain industries, such as requirements that barbers and doctors have appropriate training.

Buy and Sell Goods and Services

Governments buy and produce many goods and services, such as defence, education, parks, and roads, which they provide to firms and households. Most of these goods, such defence and education, are provided to users free of direct charge. Some, such as local bus rides and government publications, are paid for directly by the user.

Governments, like private firms, must decide what to buy and what to produce themselves. For instance, governments typically buy com puters but write the programs they need to operate them. In order to do this, governments must act as buyers in the markets for the services of computer programmers.

Governments also produce and sell goods. In some countries, the phone company is government-owned; in most countries, the government owns and operates urban transport such as buses and the underground.

Make Transfer Payments

Governments also make transfer payments, such as social security and unemployment benefits, to individuals. Transfer payments are payments for which no current direct economic service is provided in return. A fireman's salary is not a transfer payment; a social security cheque is, as are unemployment benefits and interest payments on government borrowing.

Government spending is the sum of government purchases of goods and services and transfer payments. Table 3-1 gives a breakdown of government and welfare activity for several countries.

The scale of government activity is much bigger in a country like Sweden than in a country such as the United States.

Table 3-1. Government activity as a percentage of national income in the mid-1980s

	UK	USA	GERMANY	SWEDEN
Goods and services bought	24.1	19.9	21.2	30.4
Debt interest	3.5	2.5	2.2	3.1
Other transfer payments	19.2	14.5	20,6	30.3
Total spending	468	36.9	44.0	63.8
Tax revenue	44.1	336	42.9	60.0
Deficit	2.7	3.3	1.1	3.8
Source: OECD National Accounts

Impose Taxes

Governments pay for the goods they buy and for the transfer payments they make by levying taxes or by borrowing. Taxes raised at national level, such as income tax or VAT, are usually supplemented by local taxes assessed on property values or household size.

Spending, Taxes, and Deficits Table 3-2 shows that the scale of government activity has risen over a long period. For much of this time, governments have been reluctant to meet this extra cost in full by raising taxes. They have run budget deficits financed by borrowing. Budget deficits add to the government's debt. Table 3-3 shows how government debt has changed over the 1980s. Only in the UK has the debt-income ratio fallen during the 1980s.

Table 3-2. Government spending, as percentage of national income

	1880	1929	1960	1985
Japan	11	19	18	33
USA	8	10	28	37
Germany	10	31	32	47
UK	10	24	32	48
France	15	19	35	52
Sweden	6	8	31	65
Source World Bank. World Development Report. 1908

Table 3-3. Government debt as a percentage of national income, 1980-89.

	1980	1989
USA	37.9	51.2
Japan	52.0	65.1
Germany	32.5	43.8
France	37.3	43.8
Italy	58.5	96.7
UK	54.6	40.1
Sweden	44.8	53.0
Netherlands	45.9	82.5
Ireland	78.0	132.2

In countries like Italy and Ireland it has now grown to very high levels indeed. In later chapters we shall address several questions. Will government spending continue to increase? Should it? Can government debt be allowed to increase indefinitely?

Try to Stabilize the Economy

Every market economy suffers from business cycles. The business cycle consists of fluctuations of total production, or GDP, accompanied by fluctuations in the level of unemployment and the rate of inflation.

Governments, through their control of taxes and government spending and through their ability to control the quantity of money in the economy, often attempt to modify fluctuations in the business cycle. The national government may reduce taxes in a recession in the hope that people will increase spending and thus raise the GDP. The central bank (in the UK the Bank of England), which controls the quantity of money, may increase the quantity of money more rapidly in a recession to help bring the economy out of the recession. When inflation is high, the central bank may reduce the rate of money growth with the aim of reducing inflation.

These are macroeconomic policies through which the government attempts to stabilize the economy, keeping it as close as possible to full employment with low inflation.

Affect the Allocation of Resources

By spending and taxing, the government of course plays a major part in allocating resources in the economy. In terms of what, how, and for whom, government chooses much of what gets produced, from defence expenditures to education to its support for the arts. It affects how goods are produced through regulation and through the legal system. It affects for whom goods are produced through its taxes and transfers, which take income away from some people and give it to others.

Beyond these direct effects, the government also affects the allocation of resources indirectly through taxes (and subsidies, which are negative taxes) on the price and level of production in individual markets. When government taxes a good, such as cigarettes, it generally reduces the quantity of that good produced; when it subsidizes a good, such as milk, it generally increases the quantity of the good produced.

The power to tax is thus the power lo affect the allocation of the economy's resources, or to change what gets produced. By taxing cigarettes, the government can reduce the amount of cigarettes smoked and thereby improve health. By taxing income earned from work, the government affects the amount of time people want to work. Because they affect the allocation of resources indirectly, through their effects on relative prices, as well as directly, taxes loom large in the workings of the market system and have a profound effect on the way society allocates its scarce resources.

The Role of Government

Having mentioned the effect of government tax policy on the income distribution, we now examine in greater detail the role of the government in society. In every society governments provide such services as national defense, police, firefighting services, and the administration of justice. In addition, governments make transfer payments to some members of society.

Transfer payments are payments made to individuals without requiring the provision of any service in return.

Examples are social security, retirement pensions, unemployment benefits, and, in some countries, food stamps. Government expenditure, whether on the provision of goods and services (defense, police) or on transfer payments, is chiefly financed by imposing taxes, although some (small) residual component may be financed by government borrowing.

Table 1 compares the role of the government in four countries. In each case, we look at four measures of government spending as a percentage of national income: spending on the direct provision of goods and services for the public, transfer payments, interest on the national debt, and total spending. Italy is a 'big government' country. Its government spending is large and it needs to raise correspondingly large tax revenues. In contrast, Japan has a much smaller government sector and needs to raise correspondingly less tax revenue. These differences in the scale of government activity relative to national income reflect differences in the way different countries allocate their resources among competing uses.

Table

Government spending as a percentage of national income in 1985
Country	Purchase of goods and services	Transfer payments	Debt interest	Total
	%	%	%	%
UK	23.0	17.2	5.1	45.3
Japan	14.9	12.7	4.6	32.2
United States	20.1	12.2	4.8	37.1
Italy	27.0	23.0	9.2	59.4
Source: IMF, World Economic Outlook, 1986.

Governments spend part of their revenue on particular goods and services such as tanks, schools, and public safety. They directly affect what is produced. Japan's low share of government spending on goods and services in Table 1 reflects the very low level of Japanese spending on defense. Governments affect for whom output is produced through their tax and transfer payments. By taxing the rich and making transfers to the poor, the government ensures that the poor are allocated more of what is produced than would otherwise be the case, and the rich get correspondingly less.

The government also affects how goods are produced, for example through the regulations it imposes. Managers of factories and mines must obey safety requirements even where these are costly to implement, firms are prevented from freely polluting the atmosphere and rivers, offices and factories arc banned in attractive residential parts of the city.

The scale of government activities in the modern economy is highly controversial. In the UK the government takes nearly 40 per cent of national income in taxes. Some governments take a larger share, others a smaller share. Different shares will certainly affect the questions what, how, and for whom, but some people believe that a large government sector makes the economy inefficient, reducing the number of goods that can be produced and eventually allocated to consumers.

It is commonly asserted that high tax rates reduce the incentive to work. If half of all we earn goes to the government, we might prefer to work fewer hours a week and spend more time in the garden or watching television. That is one possibility, but there is another one: if workers have in mind a target after tax income, for example to have at least sufficient to afford a foreign holiday every year, they will have to work more hours to meet this target when taxes are higher. Whether on balance high taxes make people work more or less remains an open question. Welfare payments and unemployment benefit are more likely to reduce incentives to work since they actually contribute to target income. If large-scale government activity leads to important disincentive effects, government activity will affect not only what, how, and for whom goods are produced, but also how much is produced by the economy as a whole.

This discussion of the role of the government is central to the process by which society allocates its scarce resources. It also raises a question. Is it inevitable that the government plays an important role in the process by which society decides how to allocate resources between competing demands? This question lies at the heart of economics, and we return to it shortly when we examine the role of markets in economic life.

First, however, we must refine our notion of scarce resources. To do so, we introduce a useful tool of economic analysis, the production possibility frontier.

What Should Governments Do?

Why should governments intervene in a market economy? Adam Smith, the father of economics, argued in his 1776 classic, The Wealth of Nations, that people pursuing their own interests are led as if by 'an invisible hand' to promote the interests of society. If there is an invisible hand, if markets allocate resources efficiently so that consumers' wants are satisfied at minimum cost, why should governments intervene in the economy at all?

In this section we discuss theoretical justifications for government intervention in market economy. The general argument for government intervention is market failure. Sometimes markets do not allocate resources efficiently, and government intervention may improve economic performance. Economic theory identifies six broad types of market failure, which we describe below.

Very few economists dispute the idea that the government could in theory improve the allocation of resources by correcting market failures, but many dispute the idea that government in fact improves the allocation of resources. Conservative economists, including Nobel Prize winners Milton Friedman of the Hoover Institution and James Buchanan of George Mason University, argue that in practice the government is even more likely to fail to allocate resources efficiently than are markets. We take up their arguments in Part 3, but first we discuss the six reasons why government intervention may, at least in principle, improve the allocation of resources.

The Business Cycle

The business cycle has many external causes, from wars or oil price changes to bursts of new inventions. Government policies also affect the business cycle. Increases in taxes and reductions in government spending generally reduce GNP; increases in the money stock increase GNP and Prices. Government policy can make the business cycle worse, lengthening recessions and creating inflation, or it can reduce economic fluctuations.

There are major controversies in macroeconomics over whether and to what extent the government can stabilize the economy. Obviously, the government cannot control the economy perfectly or we would not have severe recessions and inflation. But since the government does control a large share of total spending and the quantity of money, it must make its decisions with their effect on the business cycle in mind. And it does: taxes may be cut when the economy is in a recession, and the growth rate of money may be reduced when the inflation rate is too high or be increased when the economy is in a recession.

Public Goods

Most of the goods supplied by businesses and demanded by consumers are private goods. A private good is a good that, if consumed by one person, cannot be consumed by another. Ice cream is a private good. When you eat your ice cream cone, your friend doesn't get to consume it. Your clothes are also private goods. When you wear them, everyone else is precluded from wearing them at the same time.

But there are goods we can all consume simultaneously, without anyone's consumption reducing anyone else's. These are called public goods. A public good is a good that, even if it is consumed by one person, is still available for consumption by others. Clean air is a public good. So is national defense, or public safety. If the armed forces are protecting the country from danger, your being safe in no way prevents anyone else from being safe.

It is no coincidence that most public goods are not provided in private markets. Because of the free-rider problem, private markets have trouble ensuring that the right amount of a public good will be produced. A free-rider is someone who gets to consume a good that is costly to produce without paying for it. The free-rider problem applies particularly to public goods because, if anyone were to buy the good, it would then be available for everyone else to consume.

For instance, suppose a market were set up for national defense. Even if each of us felt that we needed defense, we would not have the right incentives to buy our share of defense. Since the amount of national defense I will have is the same as the amount everyone else has, I have a strong incentive to wait for someone else to buy it rather than contribute my fair share. I will have a free ride on everyone else's purchases. But of course, if everyone is waiting for someone else to buy national defense, there will be no defense.

To get around the free-rider problem, the country has to find some way of deciding together how much to spend on defense. Governments are set up to make such collective decisions. Many of the goods provided by the government are in fact public goods. National defence and police services are certainly public goods. National parks are a mixed case, since the views in the parks are a public good, at least until congestion sets in, but use of the eating facilities is not.

It may seem from this discussion that the government should produce public goods and should not produce any other goods. Neither conclusion is correct. The government does not have to produce public goods; it only has to specify how much of each should be produced. It may rely on private contractors to do the actual production, as it does, say, with regard to defence equipment. Indeed, it used to be common for countries to have private con tractors provide armies on a commercial basis. It is increasingly common for municipalities to hire private contractors to remove the rubbish.

On the other hand, there is no general economic reason why governments should not produce private goods. There are government-owned firms or nationalized industries in most countries. Some government enterprises appear to be commercially successful and efficient. None the less, experience suggests that in many circumstances the government is less likely to produce efficiently than is the private sector.

Externalities

Markets work well when the price of a good equals society's cost of producing that good and when the value of the good to the buyer is equal to the benefit of the good to society. However, the costs and benefits of production are sometimes not fully reflected in market prices.

Consider the problem of pollution. A firm produces chemicals and discharges the waste into a lake. The discharge pollutes the local water supply, kills fish and birds, and creates an offensive smell. These adverse side effects represent costs to society of producing the chemical, and they should accordingly be reflected in its market price -- but they may not be. Unless the chemical company is charged for the damages caused by its pollution, the market price of its output will understate the true cost of production to society. In this case there is an externality in the production of the chemical.

An externality exists when the production or consumption of a good directly affects businesses or consumers not involved in buying and selling it and when those spillover effects are not fully reflected in market prices.

Externalities are not all negative. The homeowner who repaints her house provides spillover benefits for the neighbours; they no longer have to look at a peeling or dilapidated house. In all externalities, there exists something that affects firms' costs or consumers' welfare (such as pollution or views of newly painted houses) but is not traded in a market. Economists often speak of externalities as caused by 'missing markets'.

When externalities are present, market prices do not reflect all the social costs and benefits of the production of a good. Government intervention may improve the functioning of the economy, for example by requiring firms to treat their waste products in certain ways before dumping them. Since externalities involve missing markets, they can also be handled in principle by market-type solutions. The government might charge firms (an estimate of) the damages their pollution causes, or might permit a certain amount of total pollution and allow firms to buy and sell rights to pollute.

The presence of externalities can provide the justification for a number of government activities besides pollution control. Examples range from control of broadcasting (interference is an externality) to various restrictions on land use.

Information-related Problems

Unless firms and consumers are well informed, they may take actions that are not in their own interests. Unless decisions are made on the basis of good information, markets, will not work well. But in a free market economy, particularly a modern, complex free market economy, firms and consumers are not likely to be well informed about the consequences of all their decisions.

Private markets may not produce the right kinds and amounts of information. Firms have little incentive to study the long-term health hazards to which their workers are exposed, and if there were no penalties for fraud, producers of unsafe goods would have every incentive to conceal the flaws in their products. Furthermore, modern economies are so complex that few individuals can digest and evaluate all the information necessary to make fully informed decisions all the time. It may be efficient to have the government process some complex information on behalf of its citizens.