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Adam Gore
The Government in a Mostly Market Economy
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The Government in a Mostly Market Economy
The government plays a role in all economies . This can range from a very small part to a
very large part. In mostly market economies, the government may provide only the most basic
services, while in economies that are mostly command, it may provide almost everything that a
person needs. In the United States, which is mostly a market economy, the government
provides many public goods and services, in addition to regulating and influencing many
aspects of the economy. Thus, while not as pervasive as a government in a mostly command
economy, the government of the United States still plays a major role in the economy.
No economy can be entirely a market economy. Every government in history has provided
some common goods and services, such as defense and justice. These government-provided
goods and services are called "public." A public good or service is one that is shared by all the
people and cannot be sold. The most common and obvious examples are national defense,
police, and court systems. Other public goods are food and drug inspection, parks, and most
highway systems.
Why Does the Government Provide Some Goods and Services?
Services like national defense and police protection cannot be entirely supplied by the
market -- either because they are too expensive or it is too difficult to assess the costs to
those that benefit. For example, some people may be able to afford a bodyguard for
personal protection. However, society as a whole benefits when no one needs to have
serious fears for themselves , their loved ones, and their belongings. Everyone benefits from
police protection, so the government takes care of it.
For centuries, governments have found it to be in their interest to protect their citizens.
Most people agree that society as a whole benefits from public schools, basic health
services, fire protection, product safety, garbage collection, and a clean and secure water
supply. Thus, in many countries, these are public goods.
Other goods and services are provided by the government because the people believe
that the government can supply these services better than private businesses can. Police
protection, public transportation , basic health services, schools, and utilities (water,
sanitation, electricity, and gas), often cannot be supplied through markets as efficiently as
by the government (or, at least under government regulation). If the government did not
supply or fund these services, only the wealthy would have them. If large cities did not have
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efficient public transportation, workers could not get to their jobs. Without public funding of
some health services and schools, only the wealthy would get medical treatment or
Government actions can influence the economy tremendously . For instance, the
government can regulate monopolies, punish collusion, and ensure fair competition . The
government can also take action to either eliminate or reduce unintended negative effects of
market actions. Governments also play a role in the economy just by purchasing the goods
and services that they use. The money that the government spends can be a major influence
in the economy, contributing to either growth or a slowdown.
Market Power
Market power is when a participant in a market has the ability to ignore competition and
can demand and receive a price above the market price. For example, if there is only one
supplier of a product, that supplier can demand a price higher than would occur if perfect
competition existed in that market. If anyone wishes to purchase that product, they must pay
the demanded price. That supplier would enjoy "above normal profits" due to the monopoly.
("Normal profits" are those earned under perfect competition.) Market power leads to
"market failure." Market failure is when a market fails to establish fair prices and use
resources efficiently or properly.
One of the best examples of market power occurred in 1973. The Organization of
Petroleum Exporting Countries (OPEC) arbitrarily raised their prices 70% in October of that
year in retaliation for support given to Israel in the Yorn Kippur War. OPEC represents
almost all of the oil-producing nations outside of the United States. They therefore have
substantial market power over the supply and price of oil. In December 1973, OPEC raised
prices another 130% and placed an embargo on sales to the United States. At that time, oil
imports represented 40% of American oil consumption. Thus, the amount of oil available in
the United States dropped substantially and prices of gasoline and other oil-based products
jumped substantially.
Laws to Regulate Competition and Market Power
While governments can do little to control OPEC, they can step in and regulate
business firms within their boundaries to regulate competition and market power. Laws
can be passed to regulate or break up monopolies, punish collusion, ensure fair
competition, control production, or to protect consumers.
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For instance, Americans have antitrust laws that enable the government to break up
firms that it determines to be monopolistic. There are also anti-collusion laws that enable
it to punish firms that are found to be illegally working together to control prices. In recent
years, for example, the U.S. federal government has done two investigations into
Microsoft Corp. to determine whether or not antitrust and fair competition laws had been
violated. In 1994, the first investigation ended when a settlement was reached in which
Microsoft agreed to change some sales practices. The second investigation ended in
1998 with the federal government filing suit against Microsoft alleging violations of
antitrust laws. In April 2000, a federal judge ruled that Microsoft was in violation and
ordered the company split up. Microsoft immediately appealed this decision. In
November 2001, Microsoft and the government reached a settlement.
Governments also can control which foreign goods are able to be imported, and which
domestic goods can be exported . This can influence competition, prices, and which
goods and services are available. When the U.S. raised tariffs on imported steel,
domestic producers faced less competition. They kept the price of steel above the world
market price, thus making automobiles and other goods that use steel less affordable to
the American consumer.
"Externalities" (or "spillovers") are indirect effects of markets that are not corrected within
the markets. They can be both positive and negative. Positive externalities are not a
problem. For example, a positive externality is when a housing development opens near a
store and the store gains new customers. Negative externalities are a problem. For
example, a negative externality is that the quality of life and property values will be adversely
affected if a pig farm opens in the midst of a suburban housing development.
Governments regulate businesses so that those who gain by such actions are made to
pay for the damage they do or they are prevented from causing such damage in the first
place. This is called "correcting negative externalities" or just "correcting externalities."
Reasonable Distribution of Income
In a market economy, some people may become very wealthy and other people very
poor. A market economy may be very efficient in producing consumer goods, but everyone
may not benefit from that production efficiency. In cases such as this, the government will
step in with programs such as Social Security, health insurance (such as Medicare and
Medicaid), and various welfare programs.
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Influence on the Economy
The government is a significant part of a nation's economy. Individuals and firms provide
the government with resources that the government needs to provide public goods and
services. Thus, governments play a role in the economy just by purchasing the goods and
services that they use.
The government influences the economy in many other ways. Governments can change
the amount of money that individuals and firms have available to spend by raising or
lowering the fees and taxes that they collect. They can encourage entrepreneurship by
guaranteeing financing, encouraging investment, and providing business incubators. They
influence the amount of human capital available through providing public schools and low
-cost student loans for higher education. They build and maintain infrastructure, such as
highways, airports, communication systems, and public transportation systems. They issue
money, control the money supply, and establish laws and regulations governing banking and
Increases in any part of the economy can cause the entire economy to grow (decreases
can also cause contraction). Thus, the government can influence the economy significantly,
contributing to either growth or a slowdown. For example, a tax decrease or rebate can give
consumers more money to spend, which will increase sales for businesses. Businesses will
then hire more people and purchase more capital goods and services. An increase in
government spending will also give people more money, and will allow businesses to sell
more goods and services. The reverse is true also -- if the government cuts back on its
spending, people have to find other jobs and businesses have to find other purchasers for
their goods and services. Depending on how strong the economy is, this could cause a
slowdown in the economy, possibly even a recession.
Anything that governments do, of course, is not free. They incur costs when they provide
goods and services. All government spending is paid for by money received from taxes or by
borrowing money. But even borrowed money must eventually be repaid with money collected
in taxes. Assessing taxes is a way to ensure that everyone contributes to paying for public
goods and services.
Types of Taxes
Most taxes can be classified based on who is required to pay the taxes and their ability to
pay them. The two categories are usually called "progressive" and "regressive." A
progressive tax is one that taxes the wealthy or higher income people at a higher tax rate
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than what poorer people pay. A regressive tax is the opposite -- it requires poorer people to
pay a higher percentage of their earnings than wealthy people pay.
In the United States, there are many different kinds of taxes, including sales taxes, real
estate taxes, excise taxes, and income taxes.
Sales Taxes
A sales tax is a general tax on purchases. Usually, a percentage of the price is added
to the purchase as a tax. If there is a 10% sales tax and a chair costs $500, the consumer
must pay $550 for that chair -- $500 for the chair itself and $50 in sales tax. Even though
the store collects the extra $50, they do not get to keep it -- they are required to turn it
over to the government.
A sales tax would seem to be a very fair way to raise taxes, but it actually is not. It is
actually a very regressive tax. Poor people must use all of their income to purchase
necessities. Therefore, they cannot afford some items if they have to pay sales tax on
others. Wealthy people, on the other hand, are often able to easily buy what they need,
even with the sales tax included. Poor people pay a higher percentage of what they earn
in sales taxes.
Some governments try to compensate for this unfairness by not taxing necessities like
food. Some may not tax clothing valued under $100 or they may tax take-out or
restaurant food, but not food sold in grocery stores.
Real Estate Taxes
A real estate tax is a tax on the value of property (buildings and land) paid every year
by the owner of the property. Real estate taxes are not considered progressive or
regressive. This is because poor people seldom own real estate of any value. Wealthy
people may own a lot of property, but they can more easily afford the taxes. If you
calculate real estate taxes as a percentage of income, the middle class spends the most.
Real estate taxes are mostly borne by the middle class.
Excise Taxes
Excise taxes are taxes on particular goods or services. Excise taxes usually are
assessed on two types of goods or services. One type is generally referred to as "luxury"
goods -- although some of them may not seem like luxury goods. Generally the
government believes that people who purchase these goods are better able to afford
paying taxes. Excise taxes on theater tickets, airline tickets, fur coats, cars, and boats
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are examples of this type of excise tax. The other goods and services that have excise
taxes are those that the government is trying to discourage people from consuming.
Excise taxes on gasoline, tobacco, and alcohol are examples.
Income Taxes
Income taxes are taxes that are assessed on the income of people and businesses.
Income taxes are usually considered to be progressive taxes, because the tax rate
increases as the income increases. For example, a typical family earning $40,000 a year
will pay less than 10% in U.S. federal income taxes, but a family earning $400,000 will
probably pay over 30% of that in federal taxes.
Different levels of government in the United States both assess different types of taxes and
provide different types of services.
Federal Level
Federal taxes are collected by the national government. They include an income tax,
some excise taxes, and a Social Security tax.
In return, the federal government provides for national defense, handles Social Security,
enforces and coordinates interstate law, maintains safety in food and drugs, and regulates
interstate communications and transportation. It also subsidizes many programs that are
primarily accomplished locally or by the states.
State Level
State taxes are collected by state governments . Usually, they include an income tax,
sales taxes, and some excise taxes. Revenues from special excise taxes on automobiles
and gasoline are usually used specifically for road and highway construction and
The states provide for law enforcement (highway patrols) and transportation within each
state. In most states, education is regulated by the state, but mostly funded by local
government. Some states both fund and regulate education. Local services such as
commuter transportation are provided by either the state or local communities.
Local Level (Town, County, City, and/or Village)
Local towns, counties, cities, and villages also assess taxes -- mostly on real estate and
sales. Some cities also assess an income tax. The revenue from most real estate taxes is
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used to support public schools, libraries, and local recreation.
Of the 20 most industrialized nations, the United States has one of the lowest tax rates and
the fewest government services. In comparison to these same 20 most industrialized nations,
the United States has the most efficient economy, but also the greatest difference in individual
wealth. In other words, the United States has some of the richest people in the world, as well
as some of the poorest people.
Taxation and Public Goods and Services
Every nation taxes differently and provides different public goods and services. For
instance, all West European nations pay higher taxes than Americans. Their costs are
higher because those countries provide more public goods and services than does the
United States. They have free higher education and health care, subsidized arts, and
transportation. The citizens of these nations are willing to pay higher taxes in order to have
the greater economic security that comes with more government services.
American citizens, in comparison, tend to dislike taxation and are willing to pay
individually for these services, rather than pay higher taxes. Of the 20 most industrialized
nations, the United States has one of the lowest tax rates and the fewest government
services. For years, the United States had the lowest tax rates -- it is only recently that
Japan's tax rates became lower than ours. Most Americans still believe they pay too much
in taxes and they are often unaware that they pay lower taxes than most other industrialized
countries. Americans tend to think that peoples' earnings are their own and spending on
public services, except perhaps for national defense, should be kept to a minimum.
Efficiency and Distribution of Income
In Adam Smith's "The Wealth of Nations" (1776), he explained why economies should be
the most efficient when the forces of supply and demand were allowed to set prices and the
quantities produced and purchased. He concluded that markets alone could answer
economic needs better than any government could by regulating commerce. Smith called
his idea of unrestricted markets, "laissez-faire capitalism."
"Laissez-faire" is a French term which means "to let [people] do [as they choose]." Thus,
laissez-faire capitalism is a fairly pure market economic system where the government
interferes in the economy very little, if at all. In pure laissez-faire capitalism, the government
exists simply to maintain law and order and guard property rights. People are allowed to "do
as they choose" in business with little government regulation or control.
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The United States has followed Smith's advice for most of its existence. It was not until
the 20th century (and somewhat reluctantly) that Americans allowed significant government
regulation and more government services. Thus, because the United States allows firms
more freedom to compete in the market, it has a very efficient economy. But that economic
freedom and low taxes have allowed a portion of our population to become very wealthy,
while other Americans are very poor.
In recent years, the United States has had most of its expanding Gross Domestic
Product (GDP) being earned by the richest 20% of the population. While its GDP and per
capita GDP have grown, the poorest 20% have actually become poorer, while the richest
20% have grown richer. In comparison, in some West European nations, the richest 5% of
the population earn two or three times what the poorest 5% earns. The poorest people in
those nations have more income and wealth than the poorest people have in the United
States. In some poor countries, the situation is even worse -- all of their economic growth
has gone to the top 1%.
Governments that are elected by people in democratic elections sometimes follow bad
economic policies. This can occur when the voters are not educated fully in economics and
politicians are too eager to remain in power by promising everything to everyone. Citizens
should learn to understand basic economics so that they do not believe such promises. They
should encourage politicians to follow sound economic policies.
Taxation and Debt
Voters may want more benefits from the government, but not want to pay the taxes
necessary to pay for them. In order to get elected and re-elected, politicians may tell them
that they will receive the added benefits without increased taxes. However, all government
spending must be paid for by taxes or borrowing. If the benefits are not paid for using
current income from taxes, the government must go into debt and borrow the money
needed. Eventually, that debt must be repaid with interest. To pay those debts and the
interest, the government might have to raise taxes more than if they had just paid for the
benefits at the time the benefits were created.
Price Controls
Voters in a particular industry may want price floors to protect their jobs and income or
price ceilings to enable them to continue to purchase goods and services that they are used
to. Price controls can benefit some groups, while increasing the costs of goods for the
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entire population. Politicians can become popular by voting in such price controls, but after
time passes, the price controls make the economy less efficient by limiting the supply of
goods produced for consumers.
For instance, price ceilings will limit the profits on these products. These lower profits will
discourage firms from producing those products. That reduction of supply will eventually
create shortages , and drive prices higher when the price ceilings are removed.
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