Economics Chapter 15

Question 1

The government or public sector in South Africa consists of the following

Answer 1

1.Central government, which is concerned mainly with national issues such as defense and our relationship with
the rest of the world (i.e foreign affairs)
2.Regional (or provincial) government, which is concerned mainly with regional issues such as housing, health services and education
3.Local government, which deals with local issues such as the provision of sewerage, local roads, street lighting
and traffic control
4.Public corporations and other government business enterprises such as Eskom, Transnet and Rand Water

Question 2

Explain the figure

Answer 2

The general departments (not business enterprises) of central, provincial and local government together form the general government. The general government plus the public corporations and other government enterprises form the public sector

Question 3

What does the gov do?

Answer 3

Gov provides public goods and services to household and firms
Make transfer payments to households(SASSA) and firms(subsidies)

Question 4

When is gov intervention justifiable

Answer 4

1) Government should not get involved in the production of goods and services that can be produced much more efficiently by the private sector
2)Second, it is generally accepted that free markets cannot function properly without government enforcement of
the rules under which private households and firms make contracts. Market economies cannot function without
well-defined property rights, the enforcement of contracts, and so on(law and order, national defense)
3)Third, cognizance should be taken of the fact that markets do not always produce efficient outcomes, government
intervention may be required in an attempt to correct market failure.
4)Fourth, market systems produce relatively efficient outcomes but they often do not produce equitable outcomes.

Question 5

Market Failure

Answer 5

Occurs when a market is not able to provide a mechanism that allows for efficient allocation of resources

Question 6

Allocative efficiency

Answer 6

Is efficient when it is impossible to reallocate the resources to make at least one person better off without making someone
else worse off, and that society’s welfare is maximised when the marginal cost of each product is equal to its price in the long run

Question 7

Five cases of market failure:

Answer 7

1)Monopoly and imperfect competition
2)Public goods
3)Externalities
4)Asymmetric information
5)Common property resources

Question 8

Monopoly and imperfect competition

Answer 8

What can be done?
Do nothing and hope large profits will attract competitors-price war
Impose price controls to prevent high prices-administrative issues
Tax the full excess profit of monopolists-incurred by consumers through higher prices
Regulate using competition policy

Question 9

Natural monopolies

Answer 9

To a situation where the required capital expenditure or scale of production is so great that a single supplier can satisfy the demand in a particular region

Question 10

Rivalrous

Answer 10

No two people can consume the same unit of a good(hot dog)

Question 11

Non-rivalrous

Answer 11

Consumption by one person does not diminish consumption by others(national defence)

Question 12

Excludable

Answer 12

Possible to prevent others from receiving benefits of a good or service once it is produced(buying chocolate)

Question 13

Non-excludable

Answer 13

It is impossible to prevent others from consuming a good/service once it is produced(free riding)

Question 14

Rivalry

Answer 14

Depends on nature of good/service

Question 15

Excludability

Answer 15

Depends on circumstances/technology

Question 16

Four quadrants to represent a different type of good or service

Answer 16

1)Goods and services that are both rivalrous in consumption and excludable. These are called normal goods/pure private goods preferably produced by the private sector
2)Goods that are rivalrous in consumption but non-excludable, common property resources, overused in the absence of the gov intervention
3)Goods that are excludable but non-rivalrous in consumption .Called mixed goods and can be produced by the private sector.Their efficient requires a zero price
4)Contains goods that are Non-rivalrous in consumption and non-excludable.Public goods. The non-production of
public goods is thus an example of market failure and, therefore, a justification for government intervention

Question 17

Free riding

Answer 17

Arises when some or all consumers believe that the product will be provided anyway, whether or not they pay for it

Question 18

What are the broad implications of this classification for the role of government in the economy?

Answer 18

1)The production of private (rival and excludable) goods should be left to the market. Private firms can produce and sell these goods. If the firms are price takers, they will also fulfill the condition for allocative efficiency by operating where marginal cost us equal to price
2)Private firms will not provide public goods because they are non-excludable .The provision of public(non-rivalrous and non-excludable)goods is thus ultimately the responsibility of gov, we refer to provision of public goods and not the production of public goods by the gov
3)(excludable but non-rivalrous) goods can be provided by private firms.
4)Common property resources are dealt with separately below(merit goods)

Question 19

Externalities

Answer 19

Externalities are costs or benefits of a transaction or activity that are borne or enjoyed by parties not directly
involved in the transaction or activity

Question 20

External costs of production

Answer 20

External costs-negative externalities
MSC>MPC
Welfare is not maximized as MSC>P-inefficient allocation of resources
Possible solutions :Coase theorem ,tax pollution, limit production, install anti-pollution equipment

Question 21

External benefits of production

Answer 21

External benefits-positive externalities
MSC<MPC
Underproduction therefore government ought to subsidize
resulting in a socially inefficient allocation of resources. Governments therefore often intervene by subsidizing activities that are subject to external benefits

Question 22

Coase Theorem

Answer 22

This theorem, however, supposes that the parties can bargain effectively and that there are no
transaction costs associated with the bargaining process

Question 23

Levying a tax

Answer 23

One possibility is to levy a tax on those causing the external
costs. If such a tax is equal to the difference between the marginal social cost (MSC) and the marginal private cost
(MPC), the socially efficient level of production will be achieved. By levying such a tax, the government tries to internalise the externality by increasing the industry’s private cost by the amount of the external cost

Question 24

Further possibilities

Answer 24

External costs result in a socially inefficient allocation of resources
Governments should try to improve the situation
All potential solutions are subject to serious practical problems

Question 25

Asymmetric information

Answer 25

Not all economic agents have perfect knowledge of market conditions-leads to asymmetric information. Leads to principal-agent problem. Inefficient allocation of resources .

Question 26

Possible gov solutions

Answer 26

Provide information, require full disclosure ,establish code of conduct, impose standards etc.

Question 27

Common property resources

Answer 27

Common property resources are those that are non-excludable but rivalrous in consumption. Instead, common resources tend to be overexploited, even to the extent of destruction. This is often referred to as the tragedy of the commons.

Question 28

Further reasons for government intervention in the economy

Answer 28

Income distribution
Macroeconomic growth and stability
Merit goods

Question 29

Income distribution

Answer 29

The free market tends to generate an unequal distribution of income. To affect/effect income distribution through progressive income taxes free or subsidized provision of certain goods and services for certain people/cash transfer payments to those in need/legislation

Question 30

Macroeconomic growth and stability

Answer 30

A number of economists argue that the free market system tends to fall short of achieving important macroeconomic
objectives such as rapid economic growth, full employment and price stability and that governments have to intervene in an attempt to achieve these objectives through fiscal and monetary policy

Question 31

Merit goods

Answer 31

Goods regarded as so beneficial to society that everyone should be in position to consume(excludable ,but social beneficial) independently from or to supplement the private sector

Question 32

The role of government in the economy can be summarized by distinguishing between three broad functions of government:

Answer 32

Allocative function: Correcting market failure and achieving a more efficient allocation of resources
Distributive function :Steps taken by the gov to achieve a more equitable/socially acceptable distribution of income
Stabilization function: Measures taken by gov to promote macroeconomic stability

Question 33

How does the government intervene?

Answer 33

Public provision
Market participant
Government spending
Taxation
Regulation

Question 34

Public provision

Answer 34

Public provision of goods and services (eg of public goods such as national defense, the justice system and infrastructure). This can be achieved by public ownership or public financing production undertaken by the private sector

Question 35

Market participant

Answer 35

government is the largest employer of labour in the economy and through its wage policy and other employment practices it can try to achieve certain objectives (eg price stability, redistribution of income) and also set an example for other employers to follow. Likewise, government is an important purchaser of goods and services from the private sector and can use its purchasing policy to achieve certain objectives (eg to stimulate particular firms and promote employment).

Question 36

Government spending

Answer 36

Is a powerful tool. Both the level and the composition (or structure) of government spending have a powerful impact on the economy. Apart from deciding which and what quantity of goods and services to purchase, government also makes transfer payments, that is, payments for which it receives nothing in return

Question 37

Taxation

Answer 37

Can be used to redistribute income, promote certain desirable activities and to penalize other socially undesirable activities

Question 38

Regulation

Answer 38

Regulation refers to all laws, rules and regulations that affect private behaviour. Examples include the labour laws (which govern the labour market); competition policy (which governs the goods market); the antitobacco law (which regulates smoking in public places); the law prohibiting shops from providing free plastic bags to customers;

Question 39

Gov failure

Answer 39

Examine the nature of government’s own objectives. Government is not merely an institution that automatically or mechanically serves the interests of society. Government consists of people (public officials) and while they undoubtedly do attempt to serve society to some extent, public officials are
human beings with their own motives, ambitions, objectives and faults. An examination of the role of government
thus requires an examination of the behaviour of decision makers in the public sector

Question 40

There are two broad groups of public officials:

Answer 40

Those who are elected (the politicians) and those who are
appointed (the bureaucrats or civil servants). These officials are the agents of the public but, as elsewhere in the economy, the agents do not always serve the interests of the principals (in this case the public)

Question 41

Politicians

Answer 41

They have their own motives that may lead to inefficient allocation of resources and welfare minimization. Vote maximizing agents who pursue vote-maximizing strategies might violate welfare maximization

Question 42

Bureaucrats

Answer 42

Bureaucrats are not necessarily the lazy or incompetent people they are often made out to be. They are rational economic agents who respond to a particular set of incentives and try to maximise their salaries, status, power or prestige. In their attempt to achieve this, they try to maximise the size of their budget allocations and staff complements

Question 43

Rent seeking

Answer 43

Attempts by private firms, households, organised business, organised labour and other interest groups to benefit at the expense of society at large.

Question 44

Economic rent

Answer 44

economic rent is that part of the remuneration of the owners of factors of production over and above the payment that the resource would receive in the best possible alternative employment (ie over and above the supply price or opportunity cost of the factor)

Question 45

Economic rent can be the result of

Answer 45

Favourable regulations
Direct subsidies
Special tax treatment
Profitable contracts
Import tariffs/quotas

Question 46

Principal agent problem

Answer 46

Where gov(through politicians) pursues its own economic objective at the expense of macroeconomic objectives

Question 47

Nationalization

Answer 47

Is the transfer of ownership from private enterprise to gov

Question 48

Privatisation

Answer 48

Opposite of nationalization is the transfer of public sector to private ownership

Question 49

Arguments for privatization

Answer 49

1.Privatization will attract foreign direct investment thereby augmenting the country’s foreign exchange reserves
2.The proceeds from privatization will make funds available for spending on housing, education and health
3.To the extent that public enterprises do not pay tax, privatization will broaden the tax base (since the privatized enterprises have to pay tax)

Question 50

Arguments against privatization

Answer 50

1)If there is not enough competition: replacement of state monopoly with private monopoly
2)Private enterprises do not take into account external costs and benefits
3)Private enterprises do not focus on the broader public but chase after profits

Question 51

Fiscal policy

Answer 51

The gov must therefore have a policy in respect of the level and composition of government spending, taxation and borrowing

Question 52

The budget

Answer 52

Is essentially a reflection of political decisions about how much to spend, what to spend it on and how to finance the spending

Question 53

What is fiscal policy used for?

Answer 53

It is often used to stimulate economic growth and employment ,redistribute income, control inflation, or address BoP problems

Question 54

Demand management

Answer 54

That is, as an instrument that can be used to manage or regulate the total demand for goods and services in the economy

Question 55

Monetary policy

Answer 55

Entails the manipulation of interest rates. Fiscal policy is controlled directly by the government, while monetary policy is conducted by the central bank

Question 56

What is national treasury responsible for?

Answer 56

National Treasury, which is responsible for the execution of fiscal policy, and the South African Reserve Bank, which applies monetary policy in South Africa

Question 57

What happens when the economy is in recession?

Answer 57

When the economy is in a recession, the tendency is therefore to apply expansionary fiscal and monetary policies to stimulate economic activity this usually means that government
spending is raised and taxes reduced (or not increased)

Question 58

Budget deficit/surplus

Answer 58

The difference between government spending and taxation

Question 59

Restrictive or contractionary fiscal and monetary policies

Answer 59

When the economy is expanding too rapidly and inflation and balance of payments problems are being experienced.As
far as fiscal policy is concerned, this means that government spending has to be reduced and/or taxes have to be
increased

Question 60

Government Spending

Answer 60

Government spending can be classified economically or functionally. Economically, we can distinguish between consumption spending and investment spending

Question 61

Factors that affect government expenditure

Answer 61

Changing consumer preferences- income growth is accompanied by a proportionally greater growth in the demand for public goods and services increasing gov spending.

Political and other shocks-Wars, the level and trend of government spending tend to be unaffected

Redistribution of income-The primary focus is on social spending, aimed at improving the living conditions of the poor and the previously disenfranchised members of South African society.Demand distribution of income G devoted towards such a cause

Question 62

Misconception and entitlement

Answer 62

Society often has certain misconceptions about the financial
and administrative capacity of the public sector. For example, many people do not realize the true cost of public services – some even think that they are free (in an absolute sense).Excessive demand leading to greater G

Question 63

Population growth and urbanisation

Answer 63

Increase demand for public goods and services, Increases in G

Question 64

Three ways of financing government spending

Answer 64

Income from property, taxes and borrowing.

Question 65

Income from property

Answer 65

Includes the interest and dividend income that is derived from government’s full or partial ownership of enterprises such as Eskom, Telkom and Transnet, profit earned from government production and the sale of agricultural,

Question 66

Budget deficit

Answer 66

The difference between government spending and current
revenue (including taxes) is called the budget deficit, financed by borrowing. Government borrows in the capital market by issuing government stock (ie bonds) on which it has to pay interest

Question 67

Inflationary financing

Answer 67

The alternative is to borrow from the central bank by using, as it were, its overdraft facilities. This type of financing increases the money stock and is potentially inflationary.

Question 68

What happens when the gov borrows

Answer 68

Government borrowing increases the public debt. In the early 1990s South African budget deficits were particularly high and large amounts had to be borrowed. As a result, the public debt grew significantly. This, in turn, led to substantial increases in the interest on public debt. Like any other borrower, government has to pay interest on all borrowed funds, and as its debt increases, its interest burden also increases

Question 69

Taxation

Answer 69

Taxes are compulsory payments to government and are the largest source of government revenue. In 2013 taxes
constituted 97,8 per cent of total budget revenue

Question 70

Criteria for a good tax

Answer 70

Neutrality
Equity
ADMINISTRATIVE SIMPLICITY

Question 71

Neutrality

Answer 71

Taxes affect prices and therefore also the decisions of the various participants in the economy. They can therefore
distort the allocation of resources and lower the welfare of society. Taxation can also act as a disincentive to the owners of the factors of production. Deadweight loss of taxation – have to
be kept as low as possible. Neutral taxes work if the market is functioning efficiently, if there are externalities a tax may be used to compensate for market failure

Question 72

Equity

Answer 72

The tax burden should be spread as fairly as possible among the various taxpayers. If a tax system is generally perceived to be equitable, taxpayers might be quite willing to pay high taxes
Two principles can be used to answer these questions: the ability to pay principle and the benefit principle. As its name implies, the ability to pay principle means that people should pay according to their ability

Question 73

Horizontal vs Vertical Equity

Answer 73

Horizontal equity requires that people in the same position
(ie two taxpayers who have the same income) should be taxed equally. Vertical equity requires that people in different positions should be taxed differently

Question 74

Benefit principle

Answer 74

According to the benefit principle, the recipients of the benefits generated by a particular government expenditure should pay for the goods or services concerned. In this case taxation can therefore be viewed as a charge or levy that has to be paid for goods and services provided by government – the more you receive, the more you have to pay

Question 75

Administrative policy

Answer 75

In addition to the tax payments that they have to make, taxpayers have to keep records and complete tax returns or pay accountants to do it for them. These costs are called
compliance costs.
Government also has to employ people to write tax laws, design tax forms, collect taxes and assess tax returns. These costs are called administration costs A good tax (or tax system) is one that
keeps the compliance and administration costs as low as possible. Taxes must therefore be simple. Complicated taxes entail high compliance and administration costs and also present taxpayers with a variety of tax loopholes. The practice of exploiting these loopholes is called tax avoidance. This is quite legal but it lowers the government’s tax revenue

Question 76

Different types of taxes

Answer 76

DIRECT AND INDIRECT TAXES
GENERAL TAXES AND SELECTIVE TAXES
PROGRESSIVE, PROPORTIONAL AND REGRESSIVE TAXES

Question 77

Direct and indirect taxes

Answer 77

Direct taxes (also called taxes on income and wealth) are levied on persons, more specifically the income or wealth of individuals and organization’s such as companies. They include personal income tax, company tax and estate duty.

Indirect taxes (also called taxes on goods and services or taxes on products and production) are levied on transactions (eg the purchase of goods and services) and are usually paid by those who consume the goods and services in question. Examples include VAT, customs duties and excise duties

Question 78

General and Selective taxes

Answer 78

VAT is a general tax since it is levied on most goods and services. Excise duties are selective taxes which are levied on specific goods only(sintax, fuel and few luxury goods)

Question 79

Progressive, Proportional and regressive tax

Answer 79

Progressive tax-Applied in SA, the higher your income the higher the tax rate/percentage of income tax you must pay
Proportional tax-Equal rate for all levels of income
Regressive tax-. Takes a larger percentage of the income of low income individuals and groups than of those with higher incomes. Indirect taxes (eg VAT) are often regress

Question 80

Personal income

Answer 80

Personal income tax is levied on individuals’ taxable income. Taxable income is the legal tax base and is obtained by deducting personal and other allowances from an individual’s total income

Question 81

Capital gains tax

Answer 81

Capital gains tax (CGT), is not a separate tax, that is, gains resulting from the sale of assets such as shares and fixed
property. CGT was introduced primarily to protect the integrity of the personal income tax base and to ensure
horizontal equity.

Question 82

Company tax

Answer 82

Companies are separate legal entities and are taxed independently from their shareholders and other individuals
The company tax rate is thus an example of a proportional tax
rate. Recall that in the case of a proportional tax the average tax rate is equal to the marginal tax rate. The contribution of company tax depends significantly, of course, on general economic conditions. The better the performance of the
economy, the higher the company profits and therefore the greater the contribution of company tax

Question 83

Value added tax

Answer 83

VAT is based on the concept of value added that we introduced originally in our discussion of the production method of calculating GDP .VAT is an important and effective source of revenue for government but it is a regressive tax. Most goods and services are taxed at the same standard rate. However, since low-income consumers spend a greater proportion of
their income on goods which carry VAT than high-income consumers (who save part of their income), the ratio
between tax paid and income is greater for low-income households than for high-income households. In other
words, the tax burden increases as income decreases (or falls as income rises)

Question 84

Tax incidence: who really pays the taxes?

Answer 84

This is sometimes called the flypaper theory of taxation – the burden of any tax sticks where the government puts it. Governments also act as if they determine the actual tax burden
In technical terms we say that government can determine the statutory or legal incidence of the different taxes. But governments cannot determine who will ultimately bear the burden of the taxes.
In technical terms we say that the effective incidence can be quite different from the statutory incidence. The effective incidence or burden of a tax cannot be established by determining who actually hands over the money to the government

Question 85

How do they try to avoid paying taxes

Answer 85

Shifting the statutory tax burden from individuals to
companies simply changes the group of individuals in the economy that bears the burden of the tax. The government
cannot shift the tax from an individual to some other entity in the economy – such a shift is simply impossible
Companies will always try to shift the burden of the tax (away from their shareholders and employees) to their consumers by increasing the prices of the goods and services which they produce.The extent to which they can do this is, however, limited
by the structure of the relevant market and the features of the demand and supply of the goods concerned