Download Ch04 -- The Market System and the Private Sector

Private Sector Circular Flow
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Private and Public Sectors
Private sector: households,
businesses, & the international sector.
Household spending “consumption”.
Business spending on capital goods
and inventories  “investment”.
Sales of goods and services to
foreigners “exports.”
Purchases from foreigners  “imports.”
Public sector: government activities.
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Wisdom of Adam Smith:
The Invisible Hand at Work
Private sector responds to consumer
 Consumer sovereignty
It is not from the benevolence of the
butcher, the brewer, or the baker that
we seek our dinner, but from their
regard to their own interest.
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Income Distribution in Market Economy
What you own  What you get
Firms pay the factors of production
according to their marginal products
– Workers get wages equal to the marginal
product of labor.
– Capitalists get interest equal to the
marginal product of capital.
– Landlords get rents equal to the marginal
product of land.
– Entrepreneurs get profits equal to the
excess of revenues over costs (payments
to other factors).
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Household
Spending
and
Income
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Income in Industrial Market Economies, 2001
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Direction of U.S. Trade
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U.S. Net Exports
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Open
Economy
Circular
Flow
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The Government’s Role
Correct for:





Imperfect Information
Externalities
Public Goods
Lack of Competition
Business Cycles
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Externalities: External Benefits
Someone outside a transaction
benefits from the transaction ... and
doesn’t pay
–Less than the socially optimal
amount will be produced and bought.
–Examples: Mowing your lawn,
painting your house, getting
educated.
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Externalities: External Costs
Someone outside a transaction incurs
costs because of it ... but isn’t paid
–If buyers don’t bear all the costs of
their purchase, they buy too much.
–If producers don’t bear all the costs
of production, they produce too
much.
–Examples: A nightclub next door to
your house, pollution by a
manufacturer.
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Public Goods

Consumption by one person does not
diminish the quantity or quality available to
others.
Public goods can be jointly consumed
Public goods are non-excludable
No one has a private property right to a
public good.
• Everybody has incentive to be a free rider
• When everyone free rides, too little (or
none) is produced.
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Microeconomic Policy
Government provides public goods to
avoid the free rider problem in the
private production of certain goods.
Government taxes or subsidizes
activities that create externalities.
Government ensures competitive
markets where possible and regulates
noncompetitive industries in the public
interest.
But there’s problem of regulatory capture. 14
Macroeconomic Policy
Monetary Policy
– Policies that influence money and credit
(money supply and interest rates).
– In the U.S., the Federal Reserve Board
(“the Fed”) is responsible for this.
Fiscal Policy
– Policies that control government
spending and taxation.
– In the U.S. federal government,
Congress enacts these policies and the
President signs them into law.
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Federal, State, and
Local Government
Expenditures for
Goods and
Services
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U.S.
Federal
Budget
Deficits
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