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Public choice theory

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The study of collective decision making, or the process through which voters, politicians and other interested parties influence nonmarket choices is known as

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Subsidizing medical services through Medicare

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Raises the price per unit of medical care received by producers.

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One reason the collective and private decision making differ is

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Individual working in the government sector face a different incentive structure than those in the private sector.

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The theory of public choice is the study of

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The process through which voters, politicians, and other interested parties interact to influence non market choices.

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Market failure

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• A situation in which the market economy leads to too few or too many resources going to a specific economic activity. • They prevent the price system from attaining economic efficiency and individual freedom. And it offers one of the strongest arguments in favor of certain economic functions of government.

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Theory of public choice

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The study of collective decision making

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Opportunity Cost

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Total spent by all levels of the government plus everything that is spent by the private sector must add up to the total income available at any point in time.

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Competition

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• Collective action- bureaucrats, appointed officials, and elected representatives will always be in competition for available government funds. • Private sector- individuals want higher wages, better working conditions, and highest job-level classification.

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Incentive Structure

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• The systems of rewards and punishments individuals face with respect to their own actions. • The costs and benefits of being efficient or inefficient differ in the private and public sector.

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Similarities in market and public-sector decision making

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• Self-interest • Opportunity cost • Competition • Similarity of individuals, but different incentive structures

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Differences between market and collective decision making

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• Voting versus spending o Political system versus market system • Political system run by majority rule • Market system run by proportional rule

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Government or Political Goods

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Goods (and services) provided by the public sector

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Majority Rule

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Collective decision making, decisions based on more than 50%

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Proportional Rule

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If 10% of "dollar votes" cast for blue cars, 10% of output is blue

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Differences between market and collective decision making

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• Voting versus spending o Spending of dollars can indicate intensity of want o Votes cannot; each vote counts with the same intensity

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Three sources of government funding

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• Fees for government services, or user charges • Taxes • Borrowing

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Government Budget Constraint

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• The limit on government spending and transfer payments • Imposed by the fact that every dollar spent must be provided for by taxes

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Tax Base

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The value of goods, services, wealth, or incomes subject to taxation

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Tax Rate

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The proportion of a tax base that must be paid to a government as taxes

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Marginal Tax Rate

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The change in the tax payment divided by the change in income Marginal tax rate = change in taxes due change in taxable income

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Tax Bracket

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A specified interval of income to which a specific and unique marginal tax rate is applied

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Average Tax Rate

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The total tax payment divided by total income

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Proportional Taxation

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• A tax system in which, regardless of an individual's income, the tax bill comprises exactly the same proportion • Taxpayers at all income levels pay the same percentage of their income in taxes • Marginal tax rate = Average tax rate

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Progressive Taxation

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A tax system in which, as income increases, a higher percentage of the additional income is paid as taxes

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Regressive Taxation

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• A tax system in which as more dollars are earned, the percentage of tax paid on them falls • A smaller percentage of income is taken in taxes as income increases

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What types of taxes do federal, state and local governments collect?

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o Federal government: individual income taxes, corporate income taxes, Social Security taxes, import and excise taxes o State and local governments: sales taxes, property taxes, personal and corporate income taxes

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The federal personal income tax

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• Accounts for almost 44% of all federal revenue • All U.S. citizens, resident aliens, and most others required to pay (includes income earned abroad) • Rates paid rise as income increases

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Arguments for the progressive tax

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• Redistribution of income • Ability to pay • Benefits received

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Counter argument for the progressive tax

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no strong evidence of redistribution

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Capital Gain

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• The positive difference between the purchase price and the sale price of an asset o You buy a share of stock for $5 and sell for $15: you have a capital gain of $10

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Capital Loss

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The negative difference between the purchase price and the sale price of an asset

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The corporate income tax

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• Accounts for 12% of federal tax revenue and 2% of all state and local taxes collected • Corporations are generally taxed on the difference between total revenues and expenses

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Double taxation

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• Corporation pays taxes on its profits • Corporation declares a dividend on after-tax profits • Dividend income is taxed

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Retained Earnings

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• Earnings that a corporation saves, or retains, for investment in other productive activities • Earnings that are not distributed to stockholders

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Tax Incidence

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• The distribution of tax burdens among various groups in society

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Who really pays the corporate income tax?

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• Tax incidence is distributed among o Consumers o Stockholders o Employees

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Social Security taxes

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• Social Security rates today are imposed on earnings up to roughly $106,800 • Contributions are 6.2% for employers and 6.2% for employees

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Unemployment taxes

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• Paid by employer • 0.8% of first $7,000 of wages for employees earning more than $1,500 • States may levy an additional tax up to 3% based on record of the employer

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State and local governments

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• Taxes imposed on goods and services yield more revenues than income taxes • A fundamental issue is how to set tax rates to extract the largest possible payments

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Sales Taxes

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Taxes assessed on the prices paid on a large set of goods and services

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Ad Valorem Taxation

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Assessing taxes by charging a tax rate equal to a fraction of the market price of each unit purchased

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Static Tax Analysis

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Based on the assumption that changes in the tax rate leave the tax base unaffected

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Dynamic Tax Analysis

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Recognizes that higher tax rates may shrink the tax base

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Maximizing tax revenues

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• Dynamic tax analysis predicts ever-higher tax rates bring about declines in the tax base • At sufficiently high rates the government's tax revenues begin to fall off

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Excise Tax

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A tax levied on purchases of a particular good or service

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Unit Tax

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A constant tax assessed on each unit of a good that consumers purchase

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Excise taxes on gasoline become added costs of production

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• This shifts the supply curve up by the amount of the unit tax • Consequently, the equilibrium price of gasoline rises and the equilibrium quantity declines

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Who Pays the Tax?

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• In our example, the price that each consumer pays is $0.30 per gallon higher • Therefore, consumers pay three-fourths of the excise tax and producers absorb the remainder

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Unemployment

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• Total number of adults (aged 16 years or older) willing and able to work and who are actively looking for work but have not found a job • Unemployment creates a cost to the entire economy in terms of lost output - often ranging in the billions of dollars

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Labor Force

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• Individuals aged 16 years or older who either have jobs or who are looking and available for jobs; the number of employed plus the number of unemployed 3. The unemployment rate is the percentage of the measured labor force that is unemployment

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What are the costs of unemployment?

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• Lost output o At the end of 2000s, unemployment rate rose by 4 percentage points o Firm output was 80% of potential o Lost output was equivalent to $700 billion of goods and services that could have been produced • Personal psychological impact o Hardship, failed opportunities and a lack of self respect

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Labor force = Employed + Unemployed

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Unemployment rate = (Unemployed/Labor force) x 100

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Stock

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The quantity of something, measured at a given point in time—for example, an inventory of goods

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Flow

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A quantity measured over time, such as the income you make per year, or the number of individuals fired every month

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Categories of individuals without work

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• Job loser • Reentrant • Job leaver • New entrant

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Job Loser

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• An individual whose employment was involuntarily terminated or who was laid off o 40-60% of the unemployed

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Reentrant

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• An individual who has worked a full-time job before but left the labor force and has now reentered it looking for a job o 20-30% of the unemployed

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Job Leaver

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• An individual who voluntarily quit o 10 to 15% of the unemployed

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New Entrant

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• An individual who has never worked a full-time job for two weeks or longer o 10 to 15% of the unemployed

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Duration of unemployment

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• More than a third of job seekers find work within one month • Approximately another third find employment within a second month • About a sixth are still unemployed after six months • Average duration varied between 10 and 20 weeks since the mid-1960s

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What is likely to happen to the duration of unemployment during a downturn in the economy?

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o Why Not ... provide job losers with unemployment benefits indefinitely? • When the government provides unemployment benefits to unemployed individuals, it reduces the incentive for them to search seriously for a job. • So, providing government unemployment benefits indefinitely would boost the average duration of unemployment.

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Discouraged Workers

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Individuals who have stopped looking for a job because they are convinced they will not find a suitable one

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Labor Force Participation Rate

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The proportion of non-institutionalized working-age individuals who are employed or seeking employment

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The major types of unemployment

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• Frictional • Structural • Cyclical • Seasonal

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Frictional Unemployment

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• Results from the fact that workers must search for appropriate job offers • This takes time, so they remain temporarily unemployed

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Structural Unemployment

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• Results from a poor match of workers' abilities and skills with current requirements of employers • Considerable evidence shows that government labor market policies influence how many jobs businesses wish to create, thereby affecting structural unemployment

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Cyclical Unemployment

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Results from business recessions that occur when aggregate (total) demand is insufficient to create full employment

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Seasonal Unemployment

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• Results from the seasonal pattern of work in specific industries • Due to seasonal fluctuations in demand or changing weather conditions that affect agriculture, construction, tourism industries and so on

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Full Employment

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An arbitrary level of unemployment that corresponds to "normal" friction in the labor market

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Natural Rate of Unemployment

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• The unemployment rate that is estimated to prevail in the long-run macroeconomic equilibrium • Should not reflect cyclical unemployment • When seasonally adjusted, the natural rate should include only frictional and structural unemployment

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Inflation

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A sustained increase in the average of all prices of goods and services in an economy

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Deflation

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A sustained decrease in the average of all prices of goods and services in an economy

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Purchasing Power

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• The value of money for buying goods and services • Varies with prices and income, e.g., if your money income stays the same but the price of one good goes up, your effective purchasing power falls

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Nominal value

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Price expressed in today's dollars

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Real value

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Value expressed in purchasing power, adjusted for inflation

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Measuring the Rate of Inflation

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• Market Basket o Representative bundle of goods and services • Base Year o The point of reference for comparison of prices in other years Price index = cost of market basket today/cost of market basket in base year X100

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Price Index

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The cost of today's market basket of goods expressed as a percentage of the cost of the same market basket during a base year

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Real-world price indexes

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• Consumer Price Index (CPI) • Producer Price Index (PPI) • GDP deflator • Personal Consumption Expenditure (PCE)

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Consumer Price Index (CPI)

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• A statistical measure of a weighted average of prices of a specified set of goods and services purchased by wage earners in urban areas • Market basket of goods and services of typical consumer

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Producer Price Index (PPI)

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• A statistical measure of a weighted average of prices of goods and services that firms produce and sell • Used as a short-run leading indicator (before CPI) • Producer Price Indexes for: o Foodstuffs o Intermediate goods o Finished goods

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GDP Deflator

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• A price index measuring the changes in prices of all new goods and services produced in the economy • Broadest measure of prices; reflects both price changes and the public's market responses to those price changes

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Personal Consumption Expenditure (PCE) Index

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• A statistical measure of average price using annually updated weights based on consumer spending • Primary inflation indicator used by the Federal Reserve

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Anticipated versus unanticipated inflation

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• To determine who is hurt by inflation we distinguish between the two types • The effects of inflation on individuals depend upon which type of inflation exists

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Anticipated Inflation

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The inflation rate that we believe will occur

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Unanticipated Inflation

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Inflation at a rate that comes as a surprise

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Inflation and interest rates

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• Nominal Rate of Interest o The market rate of interest expressed in today's dollars • Real Rate of Interest o The nominal rate of interest minus the anticipated rate of inflation

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Real interest rate

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• Nominal interest rate = 5% • Expected inflation rate = 3% • Real rate = 5% - 3% = 2%

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Does inflation necessarily hurt everyone?

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Inflation affects people differently

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Unanticipated inflation

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• Creditors lose • Debtors gain

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Protecting against inflation

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• Cost-Of-Living Adjustments (COLAs) o Clauses in contracts that allow for increases in specified nominal values to take account of changes in the cost of living

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The resource cost of inflation

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• Repricing or Menu Cost of Inflation o The cost associated with recalculating prices and printing new price lists when there is inflation

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Business Fluctuations

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The ups and downs in business activity throughout the economy

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Expansion

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A business fluctuation in which the pace of national economic activity is speeding up

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Contraction

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A business fluctuation during which the pace of national economic activity is slowing down

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Recession

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A period of time during which the rate of growth of business activity is consistently less than its long-term trend or is negative

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Depression

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An extremely severe recession

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Leading Indicators

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• Events that have been found to occur before changes in business activity o Economic downturns often follow • Reduction in the average work week • Rise in unemployment insurance claims • Decrease in prices of raw materials • Drop in the quantity of money circulating

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National Income Accounting

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A measurement system used to estimate national income and its components; one approach to measuring an economy's aggregate performance.

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Total income

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The yearly amount earned by the nation's resources (factors of production). Total income therefore includes wages, rent, interest payments, and profits that are received by workers, landowners, capital owners, and entrepreneurs, respectively

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Final goods and services

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Goods and services that are at their final stage of production and will not be transformed into yet other goods and services. For example, wheat ordinarily is not considered a final good because it is usually used to make a final good, bread.

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Product markets

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$ value of output= total monetary value of all final goods and services. Final consumer goods and services.

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Factor markets

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Factor services: labor, land, capital, entrepreneurial activity.

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Gross Domestic Product (GDP)

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The total market value of all goods and services produced during a year by factors of production located within a nation's borders.

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intermediate goods

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Goods used up entirely in the production of final goods.

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Value added

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The dollar value of an industry's sales minus the value of intermediate goods (for example, raw materials and parts) used in production.

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Flow of expenditures

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Consists of consumption, investment, government purchases of goods and services, and net expenditures in the foreign sector.

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Expenditure approach

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Computing GDP by adding up the dollar value at current market prices of all final goods and services.

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Flow of income

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Consists of looking at the income received by everybody producing goods and services.

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Income approach

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Measuring GDP by adding up all components of national income, including wages, interest, rent, and profits.

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Durable consumer goods

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Consumer goods that have a life span of more than three years.

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Nondurable goods

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Consumer goods that are used up within three years.

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Services

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Mental or physical labor or help purchased by consumers. Examples are the assistance of physicians, lawyers, dentists, repair personnel, housecleaners, educators, retailers, and wholesalers; things purchased or used by consumers that do not have physical characteristics.

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Gross Private Domestic Investment

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the creation of capital goods, such as factories and machines, that can yield production and hence consumption in the future. Also included in this definition are changes in business inventories and repairs made to machines or buildings.

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Investment

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Any use of today's resources to expand tomorrow's production or consumption.

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Producer durables or Capital goods

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Durable goods having an expected service life of more than three years that are used by businesses tp produce other goods and services.

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Fixed Investment

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Purchases by businesses of newly produced producer durables, or capital goods, such as production machinery and office equipment.

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Inventory investment

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Changes in stocks of finished goods and goods in process, as well as changes in the raw materials that businesses keep on hand. Whenever inventories are decreasing, inventory investment is negative. Whenever they are increasing, inventory investment is positive.

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GDP=

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Consumption expenditures + Investment expenditures + Government expenditures + Net exports ( total exports - total imports)

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Depreciation

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Reduction in the value of capital goods over a one-year period due to physical wear and tear and also to obsolescence; also called capital consumption allowance.

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Net Domestic Product

answer

GDP minus depreciation.

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Capital consumption allowance

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Another name for depreciation, the amount the businesses would have to save in order to take care of deteriorating machines and other equipment.

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Net investment

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Gross private domestic investment minus an estimate of the wear and tear on the existing capital stock. Net investment therefore measures the change in the capital stock over a one-year period.

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Gross Domestic income

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The sum of all income-wages, interest, rent, profits-paid to the four factors of production.

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Indirect business taxes

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All business taxes except the tax on corporate profits. Indirect business taxes include sales and business property taxes.

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Nonincome expense items

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The total of indirect business taxes and depreciation.

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National Income

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The total of all factor payment to resource owners. It can be obtained from net domestic product (NDP) by subtracting indirect business taxes and transfers and adding nets U.S. income earned abroad and other business income adjustments.

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Personal income

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The amount of income that households actually receive before they pay personal income taxes.

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Disposable personal income

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Personal income after personal income taxes have been paid.

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Nominal values

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The values of variables such as GDP and investment expressed in current dollars, also called money values; measurement in terms of the actual market prices at which goods and services are sold.

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Real values

answer

Measurement of economic values after adjustments have been made for changes in the average of prices between years.

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Constant dollars

answer

Dollars expressed in terms of real purchasing power using a particular year as the base or standard of comparison, in contrast to current dollars

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Real GDP =

answer

Nominal GDP/ Price level X 100

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Foreign exchange rate

answer

The price of one currency in terms of another

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Purchasing power parity

answer

Adjustment in exchange rate conversions that takes into account differences in the true cost of living across countries.

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Economic growth

answer

is the approximated by the percentage change in real GDP.

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Labor productivity

answer

Total real domestic output (real GDP) divided by the number of workers (output per worker)

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New growth theory

answer

A theory of economic growth that examines the factors that determine why technology, research, innovation, and the like are undertaken and how they interact.

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Patent

answer

A government protection that gives an inventor the exclusive right to make, use, or sell an invention for a limited period of time.

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Innovation

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Transforming an invention into something that is useful to humans

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Development economics

answer

The study of factors that contribute to the economic growth of a country

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