MARKETS & GOVERNMENTS - CHAPTER 1- CONCEPTS - Hillman's book +

supplemental current info

OECD nations 2019 - The OECD is an acronym for the Organisation for Economic Cooperation
and Development. Essentially, the OECD is a united front for countries to share about their
common eco-social problems, as well as collaborate on finding solutions.

Founded in 1941, the organization scope is to boost world trade and economic progress. There
are thirty-four member countries from all around the world, and they have all joined the OECD
as a sign of their commitment to the market economy and personal democracy. In alphabetical
order, the initial founding member countries of the OECD are: Austria, Belgium, Canada,
Denmark, France, Greece, Iceland, Ireland, Italy, Luxembourg, The Netherlands, Norway,
Portugal, Spain, Sweden, Switzerland, Turkey, The United Kingdom, The United States, West
Germany., Australia, Finland, Japan, New Zealand

Real GDP is lower than nominal. In 2018, it was $18.566 trillion

Calculating GDP

Expansionary and Recessionary Policy

During recessionary periods the Federal Reserve and government policy makers look to the GDP
equation when deciding how to offset the negative consequences of a recession. During these
times the Federal Reserve may react by (1) lowering the interest rate it charges to banks to
borrow money, (2) reducing the required reserve ratio (the percentage of a bank’s deposits that
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must be saved rather than invested), and (3) purchasing bonds currently circulating in the market
(quantitative easing).

During these times the Federal Government will generally react by implementing expansionary
fiscal policy. Expansionary fiscal policy takes the form of (1) increased government spending (2)
lowered taxes and (3) deregulation. In recessionary periods government revenues tend to
decrease, so increased spending is typically fueled by debt. As a result, in recessionary years the
annual deficit tends to increase significantly.

RGDP - Real gross domestic product (GDP) is an inflation-adjusted measure that reflects the
value of all goods and services produced by an economy in a given year, expressed in base-year
prices, and is often referred to as "constant-price," "inflation-corrected" GDP or "constant dollar
GDP."

Real gross domestic product is a macroeconomic assessment that measures the value of the
goods and services produced by an economic entity in a specific period, adjusted for inflation.
GDP is derived by valuing all production by an economy using a specific year's average prices.
Governments use GDP as a comparison tool to analyze an economy's purchasing power and
growth over time. This is done by looking at the economic output of two periods and valuing
each period with the same average prices and comparing the two together.

What Is Purchasing Power?

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Purchasing power is the value of a currency expressed in terms of the amount of goods or
services that one unit of money can buy. Purchasing power is important because, all else being
equal, inflation decreases the amount of goods or services you would be able to purchase.

Federal Receipts as Percent of Gross Domestic Product (FYFRGDA188S)

2018: 16.18012 (+ more)

Updated: Jul 26, 2019

Units: Percent of GDP, Not Seasonally Adjusted

Frequency: Annual

Federal Receipts as Percent of Gross Domestic Product (FYFRGDA188S) was first constructed
by the Federal Reserve Bank of St. Louis in January 2013. It is calculated using Federal Receipts
(FYFR) and Gross Domestic Product (GDPA):

FYFRGDA188S = ((FYFR /1000)/GDPA)*100

FYFR /1000 transforms FYFR from millions of dollars to billions of dollars.

Federal Reserve Bank of St. Louis and U.S. Office of Management and Budget, Federal Receipts
as Percent of Gross Domestic Product [FYFRGDA188S], retrieved from FRED, Federal Reserve
Bank of St. Louis; https://fred.stlouisfed.org/series/FYFRGDA188S, September 14, 2019.

While FRED can’t address your personal situation, it can look at the big picture. The graph
shows aggregate U.S. federal tax receipts as a percentage of national income (GDP). Federal
Receipts as Percent of Gross Domestic Product (FYFRGDA188S)

2018: 16.18012 (+ more)

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Updated: Jul 26, 2019

Units: Percent of GDP,

Not Seasonally Adjusted

Frequency: Annual

Federal Receipts as Percent of Gross Domestic Product (FYFRGDA188S) was first constructed
by the Federal Reserve Bank of St. Louis in January 2013.

It is calculated using Federal Receipts (FYFR) and Gross Domestic Product (GDPA):

FYFRGDA188S = ((FYFR /1000)/GDPA)*100

FYFR /1000 transforms FYFR from millions of dollars to billions of dollars.

How GDP Affects You: Real GDP is lower than nominal. In 2018, it was $18.566 trillion

Growth Rate: The GDP growth rate is the percentage increase in GDP from quarter to quarter.
It tells you exactly whether the economy is growing quicker or slower than the quarter before.
Most countries use real GDP to remove the effect of inflation.

GDP impacts personal finance, investments, and job growth. Investors look at a nations' growth
rate to decide if they should adjust their asset allocation. They also compare country growth rates
to find their best international opportunities. They purchase shares of companies that are in
rapidly growing countries.

The U.S. central bank, the Federal Reserve, uses the growth rate to determine monetary policy. It
implements expansionary monetary policy to ward off recession and contractionary monetary
policy to prevent inflation. Its primary tool is the federal funds rate.

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For example, if the growth rate is increasing then the Fed raises interest rates to stem inflation. In
this case, you should lock in a fixed-rate mortgage. Your payments on an adjustable-rate
mortgage will rise along with the fed funds rate.

If growth slows or becomes negative, then you should update your resume. Slow economic
growth leads to layoffs and unemployment. That can take several months. It takes time for
executives to compile the layoff list and prepare exit packages.

Problems With GDP

One of the biggest criticisms of GDP it that it doesn't count the environmental costs. For
example, the price of plastic is cheap because it doesn't include the cost of pollution. GDP
doesn't measure how these costs impact the well-being of society. A country will improve its
standard of living when it factors in environmental costs.

Another criticism is that GDP doesn't include unpaid services. It leaves out child care and unpaid
volunteer work. As a result, the economy undervalues these contributions to the quality of life.

GDP also does not count the shadow or black economy. GDP underestimates economic output
in countries where a lot of people receive their income from illegal activities. These products
aren't taxed and don't show up in government records. The government estimates, but cannot
accurately measure, this output. Global Financial Integrity estimated the black market
contributed up to $2.2 trillion to the $128 trillion global economy in 2017.

The Consumer Price Index (CPI) is an indicator that measures the average change in
prices paid by consumers for a representative basket of goods and services over a set
period. It is widely used as a measure of inflation, together with the GDP deflator (see also GDP
Deflator vs CPI). This allows economists and policymakers to describe the economic
performance and guide macroeconomic policy. Calculating Consumer Price Index (and the
inflation rate) follows a four-step process: 1) Fixing the market basket, 2) calculating the
basket’s cost 3) computing the index 4) computing the inflation rate. We will look at all
four steps in more detail below.

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Gross national product (GNP) is an estimate of total value of all the final products and services
turned out in a given period by the means of production owned by a country's residents. Net
exports represent the difference between what a country exports minus any imports of goods and
services

GNP includes income earned by citizens and companies abroad, but does not include income
earned by foreigners within the country.

The formula for GNP is: Consumption + Government Expenditures + Investments + Exports
+ Foreign Production by U.S. Companies – Domestic Production by Foreign Companies
= Gross National Product

GNP is commonly calculated by taking the sum of personal consumption expenditures, private
domestic investment, government expenditure, net exports and any income earned by residents
from overseas investments, minus income earned within the domestic economy by foreign
residents

The Difference Between GNP and GDP

GNP and GDP are very closely related concepts, and the main differences between them comes
from the fact that there may be companies owned by foreign residents that produce goods in the
country, and companies owned by domestic residents that produce goods for the rest of the world
and revert earned income to domestic residents. For example, there are a number of foreign
companies that produce goods and services in the United States and transfer any income earned
to their foreign residents. Likewise, many U.S. corporations produce goods and services outside
of the U.S. borders and earn profits for U.S. residents. If income earned by domestic corporations
outside of the United States exceeds income earned within the United States by corporations
owned by foreign residents, the U.S. GNP is higher than its GDP.

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Calculating both GNP and GDP can produce different results in terms of total output. For
example, in 2017, the U.S. estimated its GDP $19.39 trillion, while its GNP was estimated at
$19.61 trillion. While GDP is the most widely followed measure of a country's economic
activity, GNP is still worth looking at because large differences between GNP and GDP may
indicate that a country is becoming more engaged in international trade, production or financial
operations. The larger the difference between a country's GNP and GDP, the greater the degree
of incomes and investment activity in that country involve transnational activities such as foreign
direct investment one way or another.

MCNY EXAMPLE: Paying for Metropolitan College of New York

The 2019 undergraduate tuition & fees of Metropolitan College of New York (MCNY) are
$19,454 for their students and the 2019 graduate school tuition & fees are $28,840. 610 students
(78.51% of the enrolled undergraduate students) have received grant or scholarships aid and the
average amount is $8,500. After receiving the financial aid, the net price for Metropolitan
College of New York is $24,654 including tuition, fees, books & supplies costs, and living
costs.The undergraduate tuition and fees at Metropolitan College of New York are lower than the
average amount of similar schools' tuition ($31,394 - Private (not-for-profit) Master's College
and University (larger programs)).

Pell Grants and other Grant Aid

94% of Metropolitan College of New York students received grant aid in 2014/2015. The
average total aid amount was $8,158. 82 percent of students received aid in the form of Pell
Grants from the U.S. Federal Government. The average Pell Grant awarded for 2014/2015 was
$4,772. To apply for a Pell Grant to attend Metropolitan College of New York, the first step is to
fill out the Free Application for Federal Student Aid (FAFSA).

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1. MARGINAL BENEFIT

Marginal benefit is the incremental increase in the benefit to a consumer caused by the
consumption of one additional unit of a good or service. As a consumer's consumption level
increases, the marginal benefit tends to decrease (which is called diminishing marginal utility).

As a manufacturer, marginal benefit is the amount over/under your market price at which you
can sell one additional unit. Marginal benefit is expressed in the exchange unit used to acquire
one additional unit of a good or service.

marginal benefit is the change in total benefit divided by the change in quantity or:

Change in TB / Change in Q = MB

2. MARGINAL COST

The marginal cost formula is: Change in total cost divided by change in quantity or:

Change in TC / Change in Q = MC

3. CONSUMER SURPLUS & PRODUCER SURPLUS

The consumer surplus is the difference between the highest price a consumer is willing to pay
and the actual market price of the good or service. The producer surplus is the difference
between the market price and the lowest price a producer would be willing to accept

This is the difference between what the consumer pays and what he would have been willing to
pay. Example: If you would be willing to pay $50 for a book; but you can buy the book from the
2nd market for $30. In this case, your consumer surplus is $ 20.

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PRODUCER SURPLUS

This is the difference between the price a firm receives and the price it would be willing to sell it
at.If a firm would sell a good at $4, but the market price is $9, the producer surplus is $5.

4. EXCESS BURDEN

When taxes are used to finance public goods, an efficiency loss known as the excess burden of
taxation is present. The excess burden arises for both direct and indirect taxes:

A direct tax is paid when income is earned. An indirect tax is paid when income is spent.

The excess burden of an income tax

In figure 4.1, SL is the labor-supply function of an individual who receives a given hourly wage
determined in a competitive labor market as w. If there is no taxation, the person chooses to
work L2 hours. A proportional income tax at a rate of t percent reduces the net-of-tax wage per
hour to w(1 − t), and hours worked decline to L1.2

The tax affects market behavior through the reduction in labor supply from L2 to L1. The change
in market behavior is a substitution response. Free time or leisure is substituted for productive
time.3

The tax leaves unchanged the individual’s given competitively determined gross (before-tax)
market wage w. Because of the change in labor supply, gross (before-tax) income in figure 4.1
has declined from AEHO to ABJO. Net-of-tax income is DCJO. The difference between gross
income and net-of-tax income is ABCD, which is paid as taxes to the government.

The excess burden of the income tax in figure 4.1 is revealed by asking the person being taxed
one of the following two questions:

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(1) How much are you prepared to pay to avoid the government levying the tax on you?

(2) If the tax is levied, how much does the government have to give you to compensate you
for the tax?

The first question presumes that the tax is not levied and asks how much the person would have
been willing to pay to avoid the tax. The second question presumes that the tax is in place and
asks how much the person requires as compensation for the tax having been levied. The answers
to both questions are, of course, subjective information.

In seeking answers to questions (1) and (2), we need to know whether the person in figure 4.1
feels that he or she is deriving benefit from the taxes paid to the government. If there is benefit,
the taxes paid are not a personal loss but are the consequence of delegation to government of the
responsibility to finance public goods. Indeed, the payment of taxes could happen to be the
amount (of course, this is unlikely) that the person would pay voluntarily in the Lindahl
consensus outcome for personal payments for public goods.

According to Musgrave (1959), there are three major fiscal or

budgetary functions of the governments; they are:
a) A proper Allocation of Resources
b) Attainment of a fair distribution of income , and
c) To secure economic stability.
Those functions remain useful conceptual framework for discussing, analyzing, and
evaluating fiscal policies.
5. EXCISE TAX

Sales and value-added taxes, in general, are levied at a uniform rate, although sometimes with
exceptions – for example, for food or schoolbooks (the exemptions are implicit subsidies).
Excise taxes are indirect taxes levied at higher than the general rates that apply for sales and
value-added taxes, usually on goods for which demand is perceived to be quite inelastic, such as
alcohol and tobacco.

ADDICTION AND TAXES

Governments that levy excise taxes on legal addictive goods such as tobacco and alcohol may
declare that the intent of the taxes is to deter consumption; however, for people who are addicted,
the taxes have low or no substitution effects.

Because of addiction, the tax base is assured when taxes are levied and also the excess burdens
of the taxes are low.

Tax evasion can take the form of exchange of services: a dentist may do “free” dental work for a
lawyer who, in return, provides “free” legal services. Indirect taxes (sales taxes, excise taxes, and
import tariffs) can be evaded. Evasion of excise taxes and import duties through smuggling
usually requires the complicity of corrupt, cooperating customs inspectors.

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Multinational firms can attempt to use internal accounting prices to evade taxes. Internal
accounting prices are used to value shipments between subsidiaries or branches in different
countries; because the sales are within the same firm or conglomerate, the prices are known as
transfer prices, for internal transfers. Through the appropriate setting of transfer prices, profits
are moved from high- to low-tax jurisdictions. Within-firm transfer prices can also be used to
evade indirect taxes. If there are import duties, low prices declared for intermediate goods
shipped between subsidiaries reduce the duties paid. To counter transfer pricing, governments
may not accept internal accounting prices as true prices.

In principle, everyone should pay the taxes that are due (this is, of course, a normative
proposition). However, given that people evade taxes, unequal opportunities for tax evasion are a
source of social injustice.

7. TAX BASE:

A tax base is a total amount of assets or income that can be taxed by a taxing authority, usually
by the government. It is used to calculate tax liabilities. This can be in different forms, including
income or property.

Tax Liability = Tax Base x Tax Rate

Let's take personal or corporate income as an example. In this case, the tax base is the minimum
amount of yearly income that can be taxed. This is the taxable income. Income tax is assessed on
both personal income and the net income generated by businesses.

Using the formula above, we can calculate a person's tax liability with some figures using a
simple scenario. Say Mary earned $10,000 last year and the minimum amount of income that
was subject to tax was $5,000 at a tax rate of 10 %. Her total tax liability would be $500 —
calculated using her tax base multiplied by her tax rate:$5,000 x 10% = $500

8. MARGINAL TAX RATE

A marginal tax rate is the tax rate incurred on each additional dollar of income. The marginal tax
rate for an individual will increase as income rises. This method of taxation aims to fairly tax
individuals based upon their earnings, with low-income earners being taxed at a lower rate than
higher income earners.

New tax rates went into effect in the United States as of January 1, 2018, with the passage of the
Tax Cuts and Jobs Act (TCJA). Under the previous law, the seven brackets were 10 %, 15 %, 25
%, 28 %, 33 %, 35 % and 39.6 %. The new plan, signed into law by President Donald Trump in
December 2017, keeps the seven bracket-structure. However, adjustments were made to the tax
rates and income levels. Under the TCJA, the new rates are 10 %, 12 %, 22 %, 24 %, 32 %, 35 %
and 37 %. The tables below show the rates and income levels for each type of filer: single,
married filing jointly and heads of household.

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Individuals who make the lowest amount of income are placed into the lowest marginal tax rate
bracket, while higher earning individuals are placed into higher marginal rate tax brackets.
However, the marginal tax bracket in which an individual falls does not determine how the entire
income is taxed. Instead, income taxes are assessed on a progressive level. Each bracket has a
range of income values that are taxed at a particular rate.

So, under the new plan, if an individual taxpayer earned $150,000 in income, they would owe the
following income taxes, as shown below:
10% Bracket: ($9,525 - $0) x 10% = $952.50
12% Bracket: ($38,700 - $9,525) x 12% = $3,501.00
22% Bracket: ($82,500 - $38,700) x 22% = $9,636.00
24% Bracket: ($150,000 - $82,500) x 24% = $16,200.00
32% Bracket: Not applicable
35% Bracket: Not applicable
37% Bracket: Not applicable
If you add these up, the entire tax liability for this individual would be $30,289.50. Though the
actual marginal tax rate brackets remain constant regardless of a person's filing status, the dollar
ranges at which income is taxed at each rate can change depending on whether the filer is a
single person, married joint filer or head of household filer.

9. PURE PUBLIC GOODS

The 4 Different Types of Goods

Private Goods, Public Goods, Congestible Goods, and Club Goods

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Because a pure public good is a natural monopoly, the advantage is with centralized government
in avoiding replication of payment for public goods. Nonetheless, decentralized government may
be preferred by a majority of voters.

Public goods and natural monopoly

Monopoly (or a single supplier) is “natural” or cost-efficient when there are fixed costs of
supply; the single supplier avoids unnecessary duplication of fixed costs.

For a private good, as shown in figure 3.2, natural monopoly arises when average cost, which is
equal to fixed cost F divided by total quantity supplied, is declining.3

For a public good, also shown in figure 3.2, declining average cost is equal to the fixed cost
divided by the number of people to whom the public good is available.

A lighthouse is an often-used example of a pure public good. The benefit from a lighthouse is
collective. There is a fixed cost of constructing a lighthouse; it is wasteful and unnecessary to
incur the fixed cost of an identical lighthouse situated next to an existing one. A lighthouse is
therefore at the same time a pure public good and a natural monopoly. All pure public goods are
natural monopolies. Often, the monopoly supplier is government – for example, for law
enforcement and natural security.

PRIVATE GOODS

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Public goods are goods that are neither excludable nor rival in consumption.

A notable feature of public goods is that free markets produce less of them then is socially
desirable. This is because public goods suffer from what economists call the free-rider problem:
why would anyone pay for something if access is not restricted to paying customers? In reality,
people do sometimes voluntarily contribute to public goods, but generally not enough to provide
the socially optimal quantity.

Furthermore, if the marginal cost of serving one more customer is essentially zero, it is socially
optimal to offer the product at a zero price. Unfortunately, this doesn't make for a very good
business model, so private markets don't have very much of an incentive to provide public goods.

COMMON RESOURCES

Common resources (sometimes called common-pool resources) are like public goods in that they
are not excludable and thus are subject to the free-rider problem. Unlike public goods, however,
common resources exhibit rivalry in consumption. This gives rise to a problem called the tragedy
of the commons.

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Since a non-excludable good has a zero price, an individual will keep consuming more of the
good as long as it provides any positive marginal benefit to him or her. The tragedy of the
commons arises because that individual, through consuming a good that has a high rivalry in
consumption, is imposing a cost on the overall system but not taking that into account her
decision-making processes.

The result is a situation where more of the good is consumed than is socially optimal. Given this
explanation, it's probably not surprising that the term "tragedy of the commons" refers to a
situation where people used to let their cows graze too much on public land.

Luckily, the tragedy of the commons has several potential solutions. One is to make the good
excludable by charging a fee equal to the cost that using the good imposes on the system.
Another solution, if possible, would be to divide up the common resource and assign individual
property rights to each unit, thereby forcing consumers to internalize the effects that they are
having on the good.

CONGESTIBLE GOODS

It is probably clear by now that there is somewhat of a continuous spectrum between high and
low excludability and high and low rivalry in consumption. For example, cable television is
intended to have high excludability, but the ability of individuals to get illegal cable hookups
puts cable television into somewhat of a grey area of excludability. Similarly, some goods act
like public goods when empty and like common resources when crowded, and these types of
goods are known as congestible goods.

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Roads are an example of a congestible good since an empty road has a low rivalry in
consumption, whereas one extra person entering a crowded road does impede the ability of
others to consume that same road.

CLUB GOODS

The last of the 4 types of goods is called a club good. These goods exhibit high excludability but
low rivalry in consumption. Because the low rivalry in consumption means that club goods have
essentially zero marginal cost, they are generally provided by what is known as natural
monopolies.

Property Rights and Types of Goods

It's worth noting that all of these types of goods except for private goods are associated with
some market failure. This market failure stems from a lack of well-defined property rights.

In other words, economic efficiency is achieved only in competitive markets for private goods,
and there is an opportunity for the government to improve upon market outcomes where public
goods, common resources, and club goods are concerned. Whether the government will do this
in an intelligent matter is, unfortunately, a separate question!

10. EXTERNALITY

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An externality is a cost or benefit not expressed in a market and therefore not internalized in
buyers’ or sellers’ market decisions.

Whereas externalities arise when people’s behavior or decisions affect others: Paternalistic
public policies are a response to the perception that people are making decisions that harm
themselves or are failing to make decisions from which they would benefit.

Robinson Crusoe alone on the island fishes in a stream. Crusoe has no formal property rights to
the fish in the stream. Absence of property rights does not matter as long as Crusoe is alone on
the island. When another person arrives and sets up a factory upstream that pollutes the water in
the stream in which Crusoe fishes, the stream no longer supports the same number of fish and
Crusoe incurs a loss. The owner of the factory has imposed a negative externality on Crusoe.

There would be a positive externality if the factory were to discharge nutrients on which fish
feed.

Whether imposing a negative or positive externality, the owner of the factory behaves – as the
“invisible hand” requires – with the intent of maximizing personal utility or personal profits. The
factory owner produces output for sale in a market. The factory owner, however, is not
accounting for (or internalizing) the costs imposed on Crusoe (or is not accounting for any
benefits provided). The market outcome based on the personal self-interested decisions of the
factory owner, as a consequence, is inefficient. W = B− C is not maximized because all benefits
or costs have not been included in the factory owner’s self-interested personal calculations.

Externalities involving consumers

The case of the factory affecting Crusoe’s fishing and the depletion of the fish are externalities
between producers. Often, producers’ decisions affect not different producers but rather the
public at large. Air quality or the quality of water in river or lake or at a beach deteriorates
because of effluents. Or, people are disturbed by noise from trucks or airplanes. Emissions into
the atmosphere may affect global warming, causing climate change. An adverse externality can
be aesthetic: people may be disturbed by the unkempt garden of neighbors. Externalities can also
be between different consumers: depletion of the ozone layer occurred because of gases that
were used in people’s refrigerators. Externalities between consumers include automobile
pollution. Some people may dump trash on other people’s property.

11. CLUB GOODS

Club goods (also artificially scarce goods) are a type of good in economics, sometimes classified
as a subtype of public goods that are excludable but non-rivalrous, at least until reaching a point
where congestion occurs. Often these goods exhibit high excludability, but at the same time low
rivalry in consumption. Because of that low rivalry in consumption characteristic, club goods
have essentially zero marginal costs and are generally provided by what is commonly known as

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natural monopolies.Furthermore Club goods have artificial scarcity. Club theory is the area of
economics that studies these goods. One of the most famous provisions was published by
Buchanan in 1965 "An Economic Theory of Clubs", in which he addresses the question of how
the size of the group influences the voluntary provision of a public good and more fundamentally
provides a theoretical structure of communal or collective ownership-consumption arrangements.

A non-congested toll road is an example of a club good. It is possible to exclude someone from
using it by simply denying them access but it is not a rival good since one person's use of the
road does not reduce its usefulness to others.

12. FREE RIDER PROBLEM

A free rider is a person who benefits from something without expending effort or paying for it. In
other words, free riders are those who utilize goods without contributing their fair share.

The Free Rider Problem

The free rider problem is an economic concept of a market failure that occurs when people are
benefiting from resources, goods, or services that they do not pay for. If there are too many free
riders, the resources, goods, or services may be underprovided. Therefore, this would create a
free rider problem. The problem is commonly seen with public goods (goods with non-
excludable benefits).
Here are two examples of the free rider problem:
1. John builds a lighthouse on the coast to serve as a navigational aid. As a result, all sailors are
now able to benefit from the lighthouse even if they are not paying towards its upkeep. If too
many sailors are free riding, there would be no incentive for John to build more lighthouses as he
is the only person contributing to its upkeep.
2. Wikipedia, a free encyclopedia, faces a free rider problem. Hundreds of millions of people use
Wikipedia every month but only a tiny fraction of users pay to use it. A large majority of
Wikipedia users do not pay to use the site but are able to benefit from the information provided
by the website.

PUBLIC GOODS AND FREE RIDER PROBLEM

Public goods commonly face a free rider problem due to the two characteristics of a public good:
1.Non-rival: Consumption of the good or service by one individual does not reduce the
availability of the good to others.
2.Non-excludable: It is impossible to prevent other consumers from consuming the good or
service.
Examples of public goods include: National defense; Fresh air; Lighthouses; Street lighting
Public goods create a free rider problem because consumers are able to utilize public goods
without paying for them.
Understanding Why People are Free Riders Through a Prisoner’s Dilemma Game

The free rider problem can be illustrated through a prisoner’s dilemma game. Imagine there are
two people, Tom and Adel, who are considering a contribution to a public good. The personal

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cost of contributing is $6 and the benefit of the contribution is $10. This is a good idea for
society as a whole, as the benefit is greater than the cost (each person contributing $6 would
receive a benefit of $10). However, individuals see an incentive to free ride as the benefit of this
public good is divided equally among the members of society.

If Tom and Adel both contribute, the total benefit would be $20. Each person gains $10 for a net
gain of +$4 ($10 – $6).

If one person contributes but the other does not, the total benefit would only be $10. Each person
gains $5 and the person who contributes would realize a net gain of -$1 while the person who
does not contribute would realize a net gain of +$5. For example, if Adel contributes and Tom
does not contribute, Abel would be contributing $6 for a net gain of -$1 and Tom would be
contributing $0 for a net gain of +$5. (This is because the benefit of the public good is divided
among all members of society). If neither Adel or Tom contributes to the public good, there
would be no costs and no benefits of the public good (net gain of $0).

In the prisoner’s dilemma game above, we can see that both Tom and Adel would attempt to free
ride (not contribute).

The rationale is as follows: if Adel thinks that Tom will not contribute, she would lose $1 for
contributing. On the other hand, if Adel thinks that Tom will contribute, she would gain more by
not contributing. Therefore, both people would come to the conclusion that it would be unwise to
contribute. The public good, therefore, does not get built and thus a free rider problem is created.

Possible Solutions to the Free Rider Problem

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Taxes: By requiring all consumers to pay taxes, there would be no free riders. For example, the
cost of national defense in the United Kingdom is over $30 billion. By requiring everyone to pay
taxes, the cost of national defense can be sustained. As taxes are paid by everyone, there would
be no free riders. Also, the benefit would be enjoyed by everyone. (Think about the example
above: If Tom and Adel were required to contribute to the public good, the public good would be
built and they would both enjoy a net gain of $4).

Making a public good private: If a public good can be limited (requiring a payment to
consume the good), there would be no free riders.

Soliciting donations: Soliciting donations is only effective for low-cost public goods. The
voluntary donations by consumers could make up for the free riders. For example: asking for
donations in a garden or museum. Although there would still be free riders, the donation amounts
would help cover the cost of the garden/museum.

13. NORMATIVE STATEMENT

What are positive statements? Positive statements are objective statements that can be
tested, amended or rejected by referring to the available evidence. Positive economics deals
with objective explanation and the testing and rejection of theories. Examples:
A fall in incomes will lead to a rise in demand for own-label supermarket foods
If the government raises the tax on beer, this will lead to a fall in profits of the brewers.
The rising price of crude oil on world markets will lead to an increase in cycling to work
A reduction in income tax will improve the incentives of the unemployed to find work.
A rise in average temperatures will increase the demand for sun screen products.
Higher interest rates will reduce house prices
Cut-price alcohol has increased the demand for alcohol among teenagers
What are Normative Statements?

A value judgement is a subjective statement of opinion rather than a fact that can be tested
by looking at the available evidence.

Normative statements are subjective statements – i.e. they carry value judgments. For example:

Pollution is the most serious economic problem

Unemployment is more harmful than inflation
The government should increase the minimum wage to 15 $/hour to reduce poverty.
Focusing on the evidence is called adopting an empirical approach – evidence-based work is
becoming more and more important in shaping different government policies and how much
funding to give to each.

14. PIGOVIAN TAX

A Pigovian tax is a tax on any market activity that generates negative externalities. The tax is
intended to correct an undesirable or inefficient market outcome, and does so by being set equal

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to the social cost of the negative externalities. Pollution is an externality, for example. The driver
of a non-compliant vehicle doesn't necessarily suffer immediately from the exhaust it releases as
they drive down the road, but everyone behind them may suffer. Their exhaust may also increase
pollution for everyone in the community.

The government imposes a Pigouvian tax on non-compliant vehicles to make the driver take on
more of the cost of the suffering they may cause. The revenue from the tax is often used to help
ameliorate the external cost.

Noise Taxes

France levies a Pigouvian noise tax on airplanes at its nine busiest airports. It ranges from 2
euros to 35 euros depending on the airport and the weight of the aircraft. The government uses
the revenue to soundproof houses that are exposed to noise levels beyond 70 decibels.

Carbon Taxes

About 40 countries impose carbon taxes on companies that burn coal, oil, or gas, which produce
greenhouse gas emissions. These emissions cause climate change, which can bring about more
natural disasters, raises sea levels, and increase droughts. Pros: Pigouvian taxes discourage
behaviors that create negative externalities

Cons: Pigouvian taxes can also be considered regressive when they impose a harsher burden
on the populations with lower incomes compared to those with higher incomes. Some Pigouvian
taxes, such as the gas tax or cigarette tax, are considered regressive because they're flat, or the
same for everyone. That means they end up taking take a greater percentage of income from
people who make less money.

15. LINDAHL TAX

A Lindahl tax is a form of taxation conceived by Erik Lindahl in which individuals pay for
public goods according to their marginal benefits. In other words, they pay according to the
amount of satisfaction or utility they derive from the consumption of an additional unit of the
public good

16. RAMSEY TAX

Ramsey Taxation is an attempt to minimize the distortative effects of taxes. the imposition
of taxes by the government can lead to a decrease in overall welfare. the imposition of taxes
by the government can lead to a decrease in overall welfare. As shown in the section on excess
burden, $1 of taxation may cost society more than $1 due to the changes in behavior resulting
from the possible reduction in price received by the supplier, and the possible increase in price
received by the buyer. Thus, when demand is less responsive to changes in prices, then the
imposition of a tax results in a smaller dead weight loss. According to this argument, politicians

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will generate a smaller cost to society if they tax necessities such as milk, which people will
continue to buy in the face of an increase in prices. A simplified version of the Ramsey rule is
the “inverse-elasticity rule.” This rules states that tax rates on goods should be inversely
related to their elasticity of demand.

17. PROGRESSIVE TAX

A progressive tax is a tax in which the average tax rate increases as the taxable amount increases.
The term "progressive" refers to the way the tax rate progresses from low to high, with the result
that a taxpayer's average tax rate is less than the person's marginal tax rate

18. RICARDIAN EQUIVALENCE

This is the idea that consumers anticipate the future so if they receive a tax cut financed by
government borrowing they anticipate future taxes will rise. Therefore, their lifetime income
remains unchanged and so consumer spending remains unchanged.Similarly, higher government
spending, financed by borrowing, will imply lower spending in the future.

If this theory is true, it would mean a tax cut financed by higher borrowing would have no
impact on increasing aggregate demand because consumers would save the tax cut to pay the
future tax increases.

ASSUMPTIONS OF RICARDIAN EQUIVALENCE:

Income Life-cycle hypothesis – Consumers wish to smooth their consumption over the course of
their life. Thus, if consumers anticipate a rise in taxes in the future, they will save their current
tax cuts to be able to pay future tax rises.

Rational expectations on behalf of consumers. Consumers respond to tax cuts by realizing it will
probably mean future taxes have to rise.

19. VOTING PARADOX:

The Condorcet paradox (also known as voting paradox or the paradox of voting) in social
choice theory is a situation noted by the Marquis de Condorcet in the late 18th century, in which
collective preferences can be cyclic, even if the preferences of individual voters are not cyclic.
This is paradoxical, because it means that majority wishes can be in conflict with each other:
Majorities prefer, for example, candidate A over B, B over C, and yet C over A. When this
occurs, it is because the conflicting majorities are each made up of different groups of
individuals.

Suppose we have three candidates, A, B, and C, and that there are three voters with preferences
as follows (candidates being listed left-to-right for each voter in decreasing order of preference):

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 First Second Third
Voter
preference preference preference

Voter
A B C
1

Voter
B C A
2

Voter
C A B
3

If C is chosen as the winner, it can be argued that B should win instead, since two voters (1 and
2) prefer B to C and only one voter (3) prefers C to B. However, by the same argument A is
preferred to B, and C is preferred to A, by a margin of two to one on each occasion. Thus the
society's preferences show cycling: A is preferred over B which is preferred over C which is
preferred over A.

20. FISCAL ILLUSION

Failure to accurately perceive the amount of government expenditure. Fiscal illusion occurs
when government revenues are not completely transparent or are not fully perceived by
taxpayers; then the cost of government is seen to be less than it actually is. Since some or all
taxpayers benefit from government expenditures from these unobserved or hidden revenues, the
public's appetite for government expenditures increases, thus providing politicians incentive to
expand the size of government. Governments find it easy to raise tax revenues because of
consumer ignorance about the way the tax system works. For example, fiscal drag is a way that
more tax payers can end up in a higher tax rate.

Public Choice theorist often argue that more needs to be done to limit the governments ability to
collect higher tax revenues otherwise government spending has a tendency to rise crowding out
the more efficient private sector.

On the other hand, very high income earners are often very skilled in avoiding tax through
exploiting tax loopholes such as offshore accounts

21. FISCAL FEDERALISM

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Fiscal federalism is an economic framework for understanding the relationship among federal,
state, and local governments that focuses on the division of spending and taxing powers among
these governments.

Fiscal federalism is primarily an economic, rather than political, theory of relationships among
central and noncentral governments. One focus is the division of responsibilities among
different types of governments. For example, the traditional theory of fiscal federalism argues
that the central government should be responsible for macroeconomic policies but local
governments should be primarily responsible for fire protection services. Another focus of fiscal
federalism is the division of revenue-raising powers among various governments, often
referred to as “tax assignment.” Here the traditional theory of fiscal federalism argues that
taxes on highly mobile entities should be assigned to the central government, and taxes on less
mobile entities to state or local governments. Finally, grants-in-aid become an important topic in
fiscal federalism because of the potential mismatch between a government’s expenditure
responsibilities and its tax capacity.

In the United States, there exists a complex and highly bureaucratic relationship between states
and the federal government to fund such vital aspects of daily life, as roads, schools, and health
care. States can ask for (or be granted) money through federal 'grant-in-aids,' an example of
fiscal federalism at work.

22. TIEBOUT MODEL:

The Tiebout model, also known as Tiebout sorting, Tiebout migration, or Tiebout hypothesis, is
a positive political theory model first described by economist Charles Tiebout in his article "A
Pure Theory of Local Expenditures" (1956). The essence of the model is that there is in fact a
non-political solution to the free rider problem in local governance. Specifically, competition
across local jurisdictions places competitive pressures on the provision of local public goods
such that these local governments are able to provide the optimal level of public goods.

The Tiebout model relies on a set of basic assumptions. The primary assumptions are that
consumers are free to choose their communities, enjoying perfect mobility and perfect
information. This essentially means that they can move from community to community at no
cost, and that they know everything they need to know about services provided by local
governments and the tax rates of all local governments. The Tiebout model has been shown to be
most accurate in suburban areas with many different independent communities. Moving between
communities in these areas tends to have the lowest costs, and the set of possible choices is very
diverse. In areas subject to rural flooding, Tiebout sorting explains why more affluent residents
live in communities protected by river levees, while poorer residents tend to live without those
expensive and rarely utilized protections.

The exact assumptions Tiebout made in his first statement of the model were:

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1. Mobile consumers, who are free to choose where they live. There are no costs associated
with moving.
2. Complete information.
3. Many communities to choose from.
4. Commuting is not an issue.
5. Public goods do not spill over in terms of benefits/costs from one community to the next.
6. An optimal city size exists: economies of scale.
7. Communities try to achieve "optimal size".
8. Communities are rational and try to keep the public "bad" consumers away.

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