CHAPTER

SUMMARY

1. In mixed economies, such as the United States, economic activity is carried on by both private enterprise
and the government.
2. Since the time of Adam Smith, economic theory has emphasized the role of private markets in the
efficient supply of goods. However, economists and others have come to recognize important limitations
in the ability of the private sector to produce efficient outcomes and meet certain basic social needs. The
attempt to correct these market failures has led to the growth of government’s role in the market
economy.
3. The government, however, also has its limitations when intervening to mitigate market failures. These
government failures sometimes result in government programs with unintended adverse consequences.
4. The United States has a federal government struc- ture, with certain activities primarily the respon-
sibility of states and localities (e.g., education) and other activities primarily the responsibility of the
federal government (e.g., defense).
5. Economics is the study of scarcity—how resources are allocated among competing uses. Public sec- tor
economics focuses on choices between the public and private sectors and choices within the public
sector. It is concerned with four basic

issues: what gets produced, how it gets produced, for whom it gets produced, and the processes by which these decisions
are made.

6. In studying the public sector, positive econom- ics looks at the scope of government activity and the
consequences of various government policies. Normative economics attempts to evaluate alter- native
policies that might be pursued.
7. Disagreements about the desirability of policies are based on disagreements about the appropriate
assumptions for describing the economy, such as how competitive the economy actually is, disagree-
ments about how strongly the economy will respond to policy initiatives, and disagreements about
values.

KEY CONCEPTS

Deregulation
Economic models
Full Employment Act of 1946 Laissez faire
Mercantilists
Mixed economy
Normative economics
Positive economics
Privatization
Production possibilities schedule

CHAPTER 2

SUMMARY

1. The government performs many roles:

a. It provides the basic legal framework within which we live.

b. It regulates economic activities. It encourages some activities by subsidizing them and dis- courages others by taxing
them.
c. It produces goods and provides credit, loan guarantees, and insurance.

4. It purchases goods and services, including many that are produced by private firms, such as weapons
manufacturers.
5. It redistributes income, transferring income from some individuals to others.
6. It provides social insurance, for retirement, unemployment, disability, and medical care for the aged.

2. The size of the government relative to GDP is much larger now than it was forty years ago. Much of this
increase is accounted for by increased payments for social insurance.
3. The relative size of the public sector in the United States is smaller than in most western European
countries.
4. The three major areas of government expen- ditures are defense, education, and transfers. Together,
these accounted for 72 percent of gov- ernmental expenditures in 2009.
5. The major source of revenue for the federal gov- ernment is the payroll tax, followed by the indi- vidual
income tax, corporation tax, and customs and excise taxes.
6. The major sources of revenue for state and local government are the sales tax, the property tax, and the
income tax.
7. The Constitution provides the basic framework for the government of the United States. It pro- vides
some restrictions on the taxes that can be imposed, but no effective restrictions on what the government
can spend its money on.
8. The deficit—the difference between the gov- ernment’s expenditures and revenues—grew enormously,
beginning in 1981, with the total real debt accumulated from 1981 to 1988 alone equaling the total real
debt accumulated over the first two hundred years of the country’s existence. Deficit reduction
measures, begun in 1990 and extended in 1993, combined with a growing economy, enabled a surplus to
be achieved in 1998. Subsequent tax cuts and the cost of the Iraq and Afghanistan con- flicts, together
with the recent recession, have resulted in a doubling of the publicly held real

Review and Practice 57 debt since then, and a 2009 deficit equal to

10 percent of GDP.

KEY CONCEPTS

Corporate income tax Customs tax

Deficit
Excise tax

Income tax
In-kind benefits
Middle-class entitlement programs Nationalization
Payroll tax
Social insurance
Transfer payments
Value-added tax

CHAPTER 3

SUMMARY

1. Resource allocations that have the property that no one can be made better off without someone else
being made worse off are called Pareto effi- cient allocations.
 2. The Pareto principle is based on individualistic values. Whenever a change can make some indi- viduals
better off without making others worse off, it should be adopted. Most public policy choices, however,
involve trade-offs, under which some individuals are better off and others are worse off.
3. The principle of consumer sovereignty holds that individuals are the best judges of their own needs and
pleasures.
4. Pareto efficiency requires exchange efficiency, production efficiency, and product mix efficiency.
5. The fundamental theorems of welfare econom- ics provide conditions under which a competitive
economy is Pareto efficient, and under which every Pareto efficient allocation can be obtained through
markets, provided that the appropriate redistribu- tion of initial endowments (incomes) occurs.

6. Exchange efficiency means that, given the set of goods available in the economy, no one can be made
better off without someone else being made worse off; it requires that all individuals have the same
marginal rate of substitution between any pair of commodities. Competitive markets in which
individuals face the same prices always have exchange efficiency.
7. Production efficiency requires that, given the set of resources, the economy not be able to produce more
of one commodity without reducing the output of some other commodity; the economy must be
operating along its production possibili- ties curve. Production efficiency requires that all firms have the
same marginal rate of technical substitution between any pair of inputs; compet- itive markets in which
firms face the same prices always have production efficiency.
8. Product mix efficiency requires that the marginal rate of transformation—the slope of the produc- tion
possibilities curve—equal individuals’ mar- ginal rate of substitution. Competitive markets have product
mix efficiency.

80

CHAPTER 3 MARKET EFFICIENCY KEY CONCEPTS

Centralized allocation mechanism

Consumer sovereignty
Exchange efficiency
Fundamental theorems of welfare economics Indifference curves

Invisible hand
Isocost line
Isoquants
Marginal (additional) benefit
Marginal (additional) cost
Marginal rate of substitution
Marginal rate of technical substitution Marginal rate of transformation Pareto efficiency

Pareto improvement Pareto principle Production efficiency Product mix efficiency Trades

Utility possibilities curve

CHAPTER 4

SUMMARY

1. Under certain conditions, the competitive market results in a Pareto efficient resource allocation. When
the conditions required for this are not satisfied, a rationale for government intervention in the market
is provided.
2. Government is required to establish and enforce property rights and enforce contracts. Without this,
markets by themselves cannot function.
 3. There are six reasons why the market mecha- nism may not result in a Pareto efficient resource
allocation: failure of competition, public goods, externalities, incomplete markets, information failures,
and unemployment. These are known as market failures.
4. Even if the market is Pareto efficient, there may be two further grounds for government action. First, the
competitive market may give rise to a socially undesirable distribution of income. And second, some
believe that individuals, even when well informed, do not make good judgments con- cerning the goods
they consume, thus providing a rationale for regulations restricting the consump- tion of some goods,
and for the public provision of other goods, called merit goods.

5. Even though the presence of market failures implies that there may be scope for government activity, it
does not imply that a particular gov- ernment program aimed at correcting the market failure is
necessarily desirable. To evaluate gov- ernment programs, one must take into account not only their
objectives, but also how they are implemented.
6. The normative approach to the role of govern- ment asks: How can government address mar- ket
failures and other perceived inadequacies in the market’s resource allocation? The positive approach
asks: What is it that the government does, what are its effects, and how does the nature of the political
process, including the incentives it provides bureaucrats and politicians, help explain what the
government does and how it does it?

KEY CONCEPTS

Adverse selection Incomplete markets Libertarianism Marginal revenue Market failures

100

CHAPTER 4 MARKET FAILURE

Merit goods
Monopolistic competition Monopoly
Natural monopoly
Negative externalities
Oligopoly
Paternalism
Perfect competition
Positive externalities
Pure public goods
Research and development (R&D) Tragedy of the anticommons Tragedy of the commons