Fundamental Questions

1. How does the government interact with the other sectors of the economy?

2. What is the economic role of government?

3. Why is the public sector such a large part of a market economy?

4. What does the government do?

5. How do the sizes of public sectors in various countries compare?

Teaching Objectives

The primary objective of this chapter is to outline the dimensions of the public sector, show how the public sector interacts with the other sectors of the economy, and describe the economic role of the public sector.

The unique features of this chapter are the discussion of rent-seeking behavior and public choice theory, and the description of institutional details of the U.S. government and other governments.

Spend extra time analyzing market failures. Students should be advised that market failures provide an opening for government intervention into the market.

This chapter links up with the supply and demand analysis presented in Chapter 3 and with later discussions of fiscal and monetary policy, public choice theory, and microeconomic policy.

Key Term Review

economic efficiency
technical efficiency
market imperfection
externalities
public goods
private property right
free ride
monopoly
business cycles
rent seeking
public choice
monetary policy
Federal Reserve
fiscal policy
transfer payments
budget surplus
budget deficit
centrally planned economy

Lecture Outline and Teaching Strategies

1. The Circular Flow

When the government is added to the circular flow model, total output is still equal to total income, that is, the flows in the upper portion of the model equal those in the bottom portion, but the government is now a source of income and a producer of income.

Teaching Strategy: You may wish to use the taxing and spending powers of the government, as they are illustrated in the circular flow diagram, to give your students a preview of the effect of fiscal policy on income and output.

2. The Role of Government in the Market System

In the Wealth of Nations, Adam Smith argued that individuals acting in their own interest through markets will create a social outcome in which no one can be made better off without making someone else worse off.

2.a. Government as the guardian of efficiency: Government intervenes in the economy when the market does not result in economic efficiency or when it is felt that the market outcome should be changed.

Teaching Strategy: Ask your students for examples of the various types of efficiency outlined in the section. How do markets enforce efficiency in each of these cases?

2.b. Information and the price system: Market prices serve as signals to individuals and businesses as long as adequate information is available.

Teaching Strategy: In his article "The Market for Lemons," George Ackerlof argues that the used car market is inefficient because of asymmetric information. That is, sellers have more information about the condition of cars than do the buyers and the buyers are aware of this. Consequently, buyers tend to believe that all cars in the market are "lemons"-otherwise their owners wouldn't want to sell them. As a result, cars that are not lemons receive bids that are below their true value.

2.c. Externalities: These are the costs or benefits of a market activity borne by someone who is not a direct party to the market transaction.

Teaching Strategy: Use examples of student-oriented situations. For example, a negative externality is created when a roommate plays her stereo late into the night.

2.d. Public goods: A public good cannot be denied to any individual because no one has a private property right to a public good.

Teaching Strategy: Give examples of student-oriented situations, for example, fire extinguishers placed on each floor of the dormitory; those who try to unscramble cable TV programs, thus acting as free riders; class projects and free riders.

2.e. Monopoly: Because monopolies are not economically efficient, the government is often called on to regulate them and sometimes to run them as government enterprises.

2.f. Business cycles: The government intervenes in the economy to attempt to smooth out the business cycle.

2.g. The public choice theory of government: When people use resources to create income transfers to themselves, they are involved in rent-seeking behavior. Public choice economists believe that government intervention in the market is more the result of rent seeking than of market failure.

3. Overview of the United States Government

3.a. Microeconomic policy: Microeconomic policy deals with internalizing external costs.

3.b. Macroeconomic policy: The government's macroeconomic policy involves using monetary and fiscal policy to achieve maximum economic growth while minimizing inflation.

3.c. Government spending: The federal budget deficit grew rapidly in the 1980s through the early 1990s.

Show how, since the late 1970s, government expenditures as a share of real GDP have grown while taxes as a share of national income have not increased.

4. Government in Other Economies

The extent of government involvement in the economy varies considerably across different economies.

4.a. Overview of major market economies

Teaching Strategy: If you are fortunate enough to have international students in your class, you may wish to ask them to give brief presentations on how economic decisions are made in their countries.

4.a.1. France: When compared to the United States, France has a much larger public sector with resource allocation influenced by an economic plan.

4.a.2. United Kingdom: The British concept of an appropriate role for the public sector is more limited than that prevailing in France.

4.a.3. Germany: The public sector intervenes a great deal to foster social programs.

4.a.4. Japan: The public sector plays an important role through the keiretsu.

4.a.5. Sweden: The government accounts for nearly 45 percent of total purchases.