Mac Econ Chap 4 – Mixed Capitalism


Chapter 4:


The purpose of this topic is to show why capitalism must be termed as mixed rather than pure because of the presence in all countries of a large government. The role of the government is tied to the legality of social framework, the redistribution of income, the need to reallocate resources, and the stabilization of the economy.

A government must exist to assure that no individual or firm takes advantage of others. Thus, property must be protected, contracts must be enforced, and in general all markets must perform the way they should. To this end, the government provides a court and judicial system.

The responsibility of the Food and Drug Administration (i.e. to verify that the ingredients of a product are shown on the label) is an example of how the government provides a legal environment. Another example is the verification of weights and measures.

The government must attempt to maintain as much competition as possible in all markets. This is done by preventing monopolies or controlling them where necessary.

In 1945, the Aluminum Company of America (ALCOA) was judged to be a monopoly. Indeed, since 1893, it was virtually the only company producing aluminum in the United States, and therefore, it could charge any price it wanted.

The government must be present to alleviate the hardship of those who have insufficient income because the free market economy tends to reward only those with marketable skills.

Unemployment benefits, food stamps and welfare programs, are all examples of how the government helps those whose income is insufficient in the United States.

Costs of production not borne by the firm but passed on to society (e.g. pollution), are known as spillover or external costs, or negative externalities. The government must reallocate resources away from areas where spillover costs exist and toward areas where spillover benefits are large (e.g. health and education).

A firm which pollutes water is imposing costs on society in the health problems it may cause for some, and in the clean-up that will be necessary; these are spillover costs. A spillover benefit exists when a firm operates its own clinic: healthier employees represent a benefit for the entire society since they are less likely to need health care from the government.

Public or collective goods are goods which are consumed collectively by all, which consumption cannot be divided among individuals, and from which no one can be excluded. An example of a public good is that of a lighthouse benefiting all ships. Public goods have large spillover benefits but must be paid by all.

Public goods are enjoyed by all. Streets, parks, bridges are available for everyone to use. Less noticeable may be national defense or the local police force, both of which provide safety. To some extent, income redistribution, such as a welfare program, is also a public good since it relieves individuals from the responsibility of having to care for afflicted persons.

The government must take responsibility for avoiding periods of economic inefficiency which occur when excessive unemployment or inflation exist.

In the United States, the Employment Act of 1946 was specifically intended to make the government responsible for taking the necessary actions to prevent periods of excessive unemployment.

Capitalism is characterized by a market economy relying on the use of capital and a set of ideological premises. The use of capital for mass production and division of labor is found to be essential. The market economy relies on the price system to express the consumer sovereignty which dictates to businesses what they should produce as if guided by an invisible hand.

The United States and all the other Western countries are relying on a system where capital, i.e. means of production, are freely owned by private individuals. This is one of the major differences with State ownership in socialist countries.

Capitalism is based on the principles of private property, freedom of choice, reliance on self-interest, competition, and a free market economy, with limited interference from the government.

Among the tenets of capitalism, competition in a market economy means that there exists a large number of buyers and sellers in each market so that none have the power to significantly affect the market price. This also requires that entry and exit to/from any market is free.

Small retail operations, such as restaurants or food stores, are in competition with each other. A major advantage of many firms offering similar products is that prices are freely set by demand and supply, rather than by one powerful seller.

Pure capitalism requires freely operating competitive markets. These markets allow the excess production of firms to be exchanged. In addition, the markets permit the pricing mechanism to reflect the value of items being traded.

In a market economy the price of any item, such as a VCR, is set by demand and supply. If the VCR is in great demand, the price will be high and a large number will be produced. In a planned economy, the quantity to be produced is determined by bureaucrats.

Greater productive efficiency is achieved through specialization of resources in their most productive use. Division of labor allows more intensive use of skills and greater output with the use of capital. This mass production results in excess production beyond the immediate needs of the producers: such excess production must be traded. Such trading requires a market economy and the use of money.

Assembly lines, such as the one used to produce the Ford model T show how production can be increased and the cost can be reduced if it can be subdivided into simple tasks which require a minimum of skills for that task alone.

The circular flows model represents how goods and services are purchased by households from firms in the product markets, and how resources of households are acquired by firms in the resource markets. Money flows (payments and income) move in opposite direction of the product and resource flows.

A circular flow of money can be observed even at the level of a household where the income earned is used to go to the store and buy a variety of goods. These purchases create, in turn, income for those who produce the goods.

Consumers express their preferences with their dollar votes for the products they like best. Producers find it profitable to produce precisely these products.

What consumers want most, firms will be eager to provide. This can be seen in all lines of products: from toys to computers. It can especially be observed in the fashion industry where production of trendy clothing is favored.

A freely operating market economy is necessary for the price system to adequately reflect the preferences of consumers and the value they see in various products. The price system allows maximum consumption for the least price, but it does not prevent market failures.

Adam Smith described pure capitalism as a society where individuals make isolated decisions based on selfish motives (profits) to buy, sell and produce various products, but these decisions turn out to be precisely what society wanted as if the isolated decisions were guided by some invisible hand.

Ten years ago, VCR’s used to be very expensive: over one thousand dollars. Since then, the features and the variety of VCR’s have considerably increased. At the same time, the prices have decreased by one half. This situation appears to have been created to benefit the consumers, but it was really created by the producers competing to gain market share and profits. Now DVD players are in demand.

The private sector consists of the households and the business communities. Households are analyzed in terms of how they obtain their income and how they spend it. The businesses are compared in their various forms of business organization.

All firms and households are part of this sector of the economy.

The functional distribution of income shows the breakdown of the various sources of income by type of resource ownership. Empirical data shows that the combination of salaries and proprietor’s income (that is human resource ownership) combine for over 80% of total income. Profits, rent and interest account for the remaining 20%.

The functional distribution of income is very similar for most countries of the world: over 3/4 of income is derived from work.

The personal distribution of income shows what proportion of households receives what share of total income. Empirical data shows that the upper 20% of the population receives over 40% of income, while the lower 20% receives less than 5%. This verifies that large income inequalities exist.

The inequality shown by the personal distribution of income is in part attributable to the large proportion of non-employment income earned by the wealthiest segment of the population.

Income is used for consumption, savings and taxes. Consumption is further subdivided among durable goods (lasting more than one year), nondurable goods (lasting less that one year) and services.

Income disposition shows what people do with their income. For instance, the savings rate, or proportion of income devoted to saving shows the attitude of the population toward thrift and consumption. Compared to other nations, the United States is more of a consumption oriented society.

There are three forms of business organization: sole proprietorship, partnership and corporation. Sole ownership or proprietorship is by far the most common, but corporations control most assets and sales.

The legal form of a firm is usually indicative of the actual form of business organization, but not always. For example, a few small businesses are incorporated, but owned by only one shareholder actually.

The sole proprietorship is by far the most common form of business in the United States. The lack of funds and unlimited liability of the owner are major limitations.

Most small farms and retail operations are in the form of sole ownership or proprietorship.

Partnership forms of business are most common where combinations of skills are essential (such as for lawyers and doctors).

Many partnerships are found in highly specialized professions such as lawyers, architects, C.P.A.’s, securities dealers and doctors.

Corporation have the major advantage of protecting the liability for owners (i.e. shareholders), which is limited to the funds contributed. This facilitates capital formation. Corporations control over 75% of assets and sales in the United States (although they represent less than 20% of the business population).

All the major firms in the United States are corporations. Some, such as AT&T, have millions of owners, i.e. shareholders, directly, or indirectly through pension and retirement plans. Such firms have easier access to new funds from investors than small and not so well-known firms do.

The public sector is the government which can be studied in terms of its the expenditures and revenues, and the principles which guide the analysis of its taxes.

The public sector is the government. But, in closer analysis, it may be observed that it includes a large number and a great variety of administrations from the Federal Government responsible for national defense to the town hall of a small rural village.

The expenditures of the Federal government are primarily devoted to income maintenance (such as Social Security and Welfare), also known as transfer payments. The second category is national defense. The largest portion of expenditures of State and municipal governments goes to education and health.

All payments made by any form of government is what government expenditure means. Some of these payments are for the purchases of items such as pens or tanks. Some are for the performance of services such as those of a policeman. A large proportion of government expenditure consists of payments to retired persons or persons in need of assistance.

The revenues of the Federal government come primarily from personal income taxes. That of State and municipal governments from real estate and sales taxes.

The Internal Revenue Service (or I.R.S.) is the branch of the American government responsible for the collection of federal taxes. State and local governments have treasurer’s offices for that purpose.

Income taxes, the largest proportion of tax revenues, are voluntary and thus must be perceived to be by and large as equitable. Otherwise, tax avoidance and tax evasion may limit tax revenues. Tax avoidance is seeking legal means of reducing taxes. Tax evasion is illegal.

The Internal Revenue Code provides for a variety of methods to delay or avoid taxes in a perfectly legal manner. One example is the use of individual retirement accounts to build a nest egg for retirement, which is not taxable until withdrawn.

One principle of taxation proposes that taxes paid should correspond to the benefit derived by the taxpayer from the public goods provided by the government. An example of such principle is evident in the Federal excise gasoline tax used to finance highways, and the real property taxes used to finance schools. The principle is inapplicable for income redistribution taxes.

Many expenditures at the town or municipal level are correlated to collections which reflect the benefit received principle. For instance, one community may have higher real estate taxes because its citizens want well maintained roads, or a well equipped school system.

The “ability to pay” principle of taxation rests on the fact that the sacrifice from the last dollar is small for high income individuals but large for low income individuals. Thus, the principle leads to a recommendation of progressivity of tax rates for all taxes.

The principle of ability to pay is obvious in income taxes: the higher the income the higher the rate one has to pay. The principle used to be even more noticeable in the U.S. prior to the Tax Reform Act of 1986: the rate of taxes assessed on higher income was much higher (50%) than what it has been since then (33%).

Progressivity means that a higher tax rate is assessed on higher income. A proportional tax rate would be the same for all income levels, and a regressive tax would have higher tax rate for lower income. Empirical data shows that income taxes are very close to being proportional in the United States.

The Personal Income Tax in the United States used to be much more progressive than what it is today. The rate on the highest income bracket was at one time 70%, while the rate on the lowest income bracket was 14%. However, various deductions and exemptions available to high income individuals were reducing their effective tax rate.

The tax incidence shows who really bears the burden of a tax. Because taxes can be shifted from one person to another, tax schemes which appear to be progressive may be regressive in reality. This is the case for property taxes, which are technically paid by the landlord, but charged to the tenant as part of the rent.

It is sometimes argued that the Corporate Income Tax incidence falls on consumers and not on corporations because the corporations, although liable for the tax, are able to increase the price of their products.




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