The Normative Economics of Gorvernment in Market Economies

Seminar Paper, 2012

19 Pages, Grade: 2,3


Table of Contents

List of Abbreviations

List of Figures

1 Introduction

2 Market
2.1 Demand and Supply
2.2 Market Efficiency and Market Failure

3 Governments Intervention
3.1 Regulation
3.2 Corrective Taxes and Subsidies
3.3 Tradable Pollution Permits

4 Conclusion


Executive Summary

This assignment discusses the normative governmental intervention in the market. The aim is to decide if the government should intervene or not. Before deciding to intervene, two different economic views, which will be describe, are considered: “The invisible hand” by Adam Smith and the Keynesian approach, which will be followed up in this assignment.

The first step is to describe the market with its impacts, demand and supply, and how these two impacts arise. Later, the market efficiency and market failure will be exam- ined in relation to negative and positive externalities. Other influence such as public goods or common resources will not be describe, because this would blow the frame of this assignment.

After defining the principle views, the theme of government intervention will be discussed. There are different approaches, which will be demonstrated. These are command-and-control policies like regulation, market-based policies like corrective tax and subsidies and tradable pollution permits.

These opportunities will be accompanied by examples to clarify them show their pros and cons.

In the conclusion with the résumé of the assignment followed by an integrated ITM- checklist.

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of Figures

Figure 1: The Equilibrium of Supply and Demand

Figure 2: Negative Externalities

Figure 3: Positive Externalities

1 Introduction

Economy and policy often stay together in a close relationship, even if one often has the impression that they pursue opposing interests. The economy tries to enforce their interests, which are often not the interests of everyone, while the policy in democratic countries tries to cater for the interests of the majority of people. This begs the question, should the government intervene in matters regarding the economy and what are the impacts of such an intervention?1

Economists has different points of view, as to whether or not the government should intervene. The most famous economists in this case are Smith and Keynes. Adam Smith (1723-1790) was the founder of the “invisible hand”, which regulates the market. He was of the opinion that individuals should be left to their own devices, without the gov- ernment directing their actions. The government should not intervene, because the mar- ket participants are motivated by self-interest and the invisible hand guides this self- interest into economic well-being.2 The economist John Maynard Keynes (1883-1946), had a different theory. He believed that the government should intervene to regulate the market, because in the short run the market needs stability and in the long run the mar- ket could stabilize itself,3 but he also said, “in the long run we are all dead.”4 In the fol- lowing text the Keynesian approach will be pursued.

In which situations should the government intervene? One approach is, that a market failure is the most important argument for governmental intervention.5 According to this statement the market will first be describe by demand and supply and by market effi- ciency and market failure in the second chapter. In the third chapter the methods and tools of government intervention will be described. These are regulation, corrective tax and subsidies and tradable pollution permits. The last chapter is the conclusion, which summarize this assignment.

2 Market

When the weather turns warm in Germany every summer, the price of hotel rooms in the Mediterranean falls. The price of olive oil rises, when there is a drought in southern Europe. These are just two impacts of the demand and supply theory, which are the forces that make market economies work.6

“A market is a group of buyers and sellers of a particular good or service.”7 The demand for the good is determinate by the group of buyers and the supply of the good is deter- minate by the group of sellers. Markets have many different forms, such as the market for many agricultural commodities, which is highly organized. Buyers and sellers meet each other at a specific time and place and an auctioneer helps set prices and organizes sales.8 But the markets are often not that organized, e.g. the market for bread in a partic- ular town. Buyers of bread do not meet together at a specific time and place. The sellers of bread are in different locations and offer different products. There is no auctioneer who calls out the prices. Each seller decides the price for bread and the buyers decides how much bread they buy at each bakery. Although the market is not organized, the groups of buyers and sellers form a market.9

2.1 Demand and Supply

The demand is determinate by the purchases of the buyers, what they are willing and able to purchase. The most important determinate is the price; if the price for a good is too high, people buy less of this good. E.g. if the price for one loaf of bread rose to € 200 people would buy less bread, but they might buy cheaper toast bread. If the price for one loaf fell to € 0,20, people would by more bread.10

The demand curve is negative related to the price, because if the price rises the quantity demand falls and vice versa.11 This relationship is true for most goods and it is called the law of demand: “Other things equal, when the price of a good rises, the quantity demand of the good falls, and when the price falls, the quantity demanded rises.”12

After this explanation of demand, the supply side will now be defined. The supply is determined by the amount of a good that sellers are willing and able to sell. The price is the most important factor regarding the supply. When the price for bread is high, than more bread will be supplied, because it is profitable for the supplier. But when the price for bread is low, than the quantity of supplied bread decreases because it is not very profitable.13

The price rises with the supplied quantity; it is positively related to the price.14 Similar to the law of demand, there is the law of supply: “Other things equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as well.”15

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: The Equilibrium of Supply and Demand16

If these two curves, the demand curve and supply curve, are compared to each other in one graph, there is a point where these two curves intersect. This point is called the market’s equilibrium; cf. Figure 1. The price P is called the equilibrium price and the quantity Q is called the equilibrium quantity. At the equilibrium price all buyers have bought the quantity they wanted and the sellers have sold the quantity they wanted. So this equilibrium is called the market-clearing price, everyone in the market has been satisfied.17

2.2 Market Efficiency and Market Failure

Every year at Christmas the price for geese rises in Germany. The buyers may be disap- pointed that the price of geese is so high. The farmers who raise and sell the geese would like the price to be even higher. Buyers always want to pay less for their goods to maximize their consumer surplus18. Sellers always want to sell their goods for more money to maximize their producer surplus19. But does the right price for geese exist?20

Economists use tools to study the welfare of buyers and sellers in a market. The basic tools are consumer surplus and producer surplus. These tools help the economists to address the question of whether the allocation of resources determinate by free markets is desirable. To answer this question it is necessary to measure the economic well-being of a society. One possible way is to look at the total surplus, which is the difference between the value to buyers and the costs to sellers. An allocation exhibits efficiency if an allocation of resources maximize total surplus.21 But this assumption does not prove that markets are efficient, because the markets are in reality not perfectly competitive. Besides the text assume that the outcome in a market matters only to the buyers and sellers in that market. But the buyers and sellers often affect people who are not partici- pants in the market at all. One example is pollution; such side effects are called exter-


1 Cf. Bevc (2007), p. 112.

2 Cf. Smith (1776), p. 273

3 Cf. Bevc (2007), p. 115, Wienert (2008), p. 34.

4 Mankiw (2007), p. 766

5 Cf. Cowen (1988), p. 1.

6 Cf. Mankiw (2007), p.63; Mankiw/Taylor (2011), p. 68.

7 Mankiw (2007), p. 64.

8 Cf. Mankiw (2007), p. 64; Krugman/Wells (2009), p. 62.

9 Cf. Mankiw (2007), p. 64. The following text assumes, that market is perfectly competitive. That means, that all offered goods are all exactly the same and one buyer or seller has any influence over the market price.

10 Cf. Mankiw (2007), p. 65; Krugman/Wells (2009), p. 63f.; Wessels (2000) p. 32; Tucker, (2007 b),p. 54; Baumol/Blinder (1999), p. 71; Kotler/Armstrong/Wong (2011), p. 748.

11 Cf. Mankiw (2007), p. 65; Krugman/Wells (2009), p. 63; Wessels (2000), p. 33; Varian (2007), p. 6.

12 Mankiw (2007), p. 65.

13 Cf. Mankiw (2007), p. 71; Krugman/Wells (2009), p. 71 f.; Wessels (2000), p. 32, Tucker (2007 b),p. 61, Baumol/Blinder (1999), p. 73f.

14 Cf. Mankiw (2007), p. 70; Krugman/Wells (2009), p. 72; Wessels (2000), p. 33; Varian (2007), p. 6 f.

15 Mankiw (2007), p. 70.

16 Cf. Mankiw (2007), p. 75.

17 Cf. Mankiw (2007), p. 75 f.; Krugman/Wells (2009), p. 78 f.; Wessels (2000), p. 39f.; Varian (2007),p. 8 f.; Casajus/Tutic (2008), p. 885.

18 Cf. Mankiw (2007), p. 139; Krugman/Wells (2009), p. 94; Tucker (2007 a), p. 52. The consumer surplus is the difference between the amount a buyer is willing to pay for a good and the amount the buyer actually pays for the good.

19 Cf. Mankiw (2007), p. 144; Krugman/Wells (2009), p. 101; Tucker (2007 a), p. 83. The producer surplus is the difference between the amount a seller is paid for a good and the seller’s cost of providing the good.

20 Cf. Mankiw (2007), p. 137.

21 Cf. Mankiw (2007), p. 147 f.; Krugman/Wells (2009), p. 105; Tucker (2007 a), p. 82. Total surplus is the sum of consumer surplus and producer surplus. The customer surplus is value to buyers minus amount paid by buyers, and producer surplus is amount received by sellers minus cost to sellers. The terms amount paid by buyers and amount received by sellers cancel each other, so the total surplus is value buyers minus cost to sellers.

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The Normative Economics of Gorvernment in Market Economies
University of applied sciences Dortmund
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Demand and Supply, Market Efficiency, Market Failure, Government Intervention, Regulation, Corrective Taxes and Subsidies, Tradable Pollution Permits
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Irena Stotz (Author), 2012, The Normative Economics of Gorvernment in Market Economies, Munich, GRIN Verlag,


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