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Tax cuts and the economy during a recession

The Economy during a Recession The effects of the Great Depression revealed the weak areas with in the market system. There was little output from factories and many business’s were failing and shut down. This caused a depletion of available jobs. Around this era, the government played only a small role in the intervention of the downturn. There were few government assistance programs to help the people living in poverty. Many government programs today such as, unemployment compensation, welfare benefits and social security are inspired from the Depression era.
One the government issues a tax cut, it reduces government revenues, which create budget deficits. These tax cuts are a source of government spending that depend on the public needs and priorities.
Our economy went into a recession due to the decline in real GDP. The Obama administration passed legislation in the fall of 2008 to enact an $800 billion fiscal stimulus to be spread out of the course of two and a half years. Many economists believe this policy will not pull our economy out of a recession. Classical Economists believe that unregulated markets are self-stabilizing. They believe government intervention is more harmful than it is beneficial. Classical economists believed that our economy was either at or leading toward full employment. Keynesian economists are more in favor of government intervention to help balance out the market system. They dismiss the idea that the economy is self regulating and will by it self, return to full employment. The Obama administration favors the ideas of John Maynard Keynes.
Fiscal Policy The government will use fiscal policy when the economy is not operating at full production and full employment. Fiscal policy helps to stabilize the economy and increase the level of aggregate demand. During the times of a recession, consumers will decrease their spending and increase their saving. Also, unemployment rises causing more and more people to rely on government transfer payments such as unemployment compensation. One way to increase the consumer purchasing power is to lower taxes in order for the private sector to have an increase in money, to be spent on goods and services.
Fiscal policy can level out business cycle fluctuations by expansionary public spending or tax cuts in recessions or contractionary policy in expansions (Weil).
This plan directs government spending and taxes to keep actual GDP close to the potential full employment GDP. The government collects taxes in order to finance expenditures on a number of public goods and services, which can cause a reduction in output.
Discretionary fiscal policy is the purposeful change of expenditures and tax collections by the government to encourage full employment, price stability, and economic growth.
The government uses Expansionary Fiscal policy to shift the AD curve rightward in order to expand real output. The expansionary fiscal policy increases government spending or tax cuts to push the economy out of a recession. It is a increase in government expenditures and or a decrease in taxes that causes the government’s budget deficit to increase or it’s budget surplus to decrease. Usually an expansionary fiscal policy will be needed when the economy is experiencing a recession(McConnell). An increase in unemployment accompanies a negative GDP gap because fewer workers are needed to produce the reduced output. When this happens, the economy is suffering a recession and cyclical unemployment. A sufficient increase in government spending will shift an economy’s aggregate demand curve to the right, ceteris paribus. Investment has a multiplier effect on production. When investment changes, there is an equal primary change in national amount produced. The multiplier represented as 1/(1/MPC) is any change in spending (C, I, or G) will set off a chain reaction leading to a multiplied change in GDP. On the other hand, the government can reduce taxes to shift the aggregate demand curve rightward. According to McConnell and Brue “Suppose the government cuts personal income taxes by $6.67 billion, which increases disposable income by the same amount. Consumption will rise by $5 billion (= MPC of .75 x $6.67 billion), and saving will go up by $1.67 billion (= MPS of .25 x $6.67 billion).”
The AD curve eventually shifts rightward by four times the $5 billion initial increase in consumption produced by the tax cut( McConnell). Real GDP rises by $20 billion, from $490 billion to $510 billion, implying a multiplier of 4. Employment will increase. The multiplier works upward or downward. A tax reduction increases saving, rather than consumption. The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a specific shift in the Aggregate demand curve. In order to stop the progression of demand-pull inflation, the government will use a contractionary fiscal policy. This policy entails reductions in government spending, tax increases, or a combination of both and will cause the aggregate demand curve to shift to the left. When the economy faces demand-pull inflation, fiscal policy should move toward a government budget surplus-tax revenues in excess of government spending. A reduction in government spending shifts the AD curve leftward to control demand-pull inflation. The government can use tax increases to reduce consumption spending.
If the economy has a MPC of .75, the government must raise taxes by $6.67 billion to reduce consumption by $5 billion. The $6.67 billion tax reduces saving by $1.67 billion ( = the MPS of .25 x $6.67 billion). This $1.67 billion reduction is not a reduction in spending.The $6.67 billion tax increase also reduces consumption spending by $5 billion (= the MPC of .75 x $6.67 billion). After the multiplier process is complete, the aggregate demand curve will have shifted leftward by $20 billion at each price level (= multiplier of 4 x $5 billion) and the demand-pull inflation will have been controlled. Leftward shifts of the aggregate demand curve are associated with downshifts of the aggregate expenditures schedule.
Automatic Stabilizers Automatic stabilizers are programs such as unemployment insurance benefits and taxes that are already on the books to help alleviate recessions and hold down the rate of inflation. Over the course of the business cycle, government tax revenues automatically change in order to stabilize the economy. Transfer payments perform in the opposite way from tax revenues. Unemployment compensation payments, welfare payments, and subsidies to farmers all decrease during economic expansion and increase during economic contraction.
Tax revenues T vary directly with GDP, and government spending G is assumed to be independent of GDP. As GDP falls during a recession, deficits occur automatically and help improve the recession. As GDP rises during expansion, surpluses occur automatically and help counteract possible inflation. There are a number of problems that pertain with applying fiscal policy such as, time lags, political problems, expectations, and state and local finances (Geoff
Riley). One issue in particular is the crowding -out effect which is an increase in government public expenditure that has the effect of. The crowding-out effect increases real national income and output, thus increasing the demand for additional capital. This causes the equilibrium rate of interest to rise and reduces or crowds out the amount of private investment.
Conclusion The main factors effecting consumer confidence are expectations of future income and employment, current interest rates, trends in unemployment, anticipated changes in government taxation and changes in household wealth. The economy will experience peaks and troughs. Economist’s can look at the history of recessions to evaluate what must be done to help keep the market balanced. The classical economist believed that the market system would be able to fix its self. The Keynesian Economists believe however, the government would need to step in to help boot the current economic downturn. The Obama stimulus package and government tax cuts help to enhance the economy in the long run.

Olipology and price fixing in the music industry

What is Oligopoly? An oligopoly arises out of a market which is dominated by a small number of sellers, also known as oligopolists. The oligopolists dominate a substantial portion of the market and are known to be mutually dependent. The mutual dependency is determined by the ability of one seller to influence the decision of the others in the market (Begg and Ward 2009).
Bhagwati (1970) clarifies that traditional oligopoly theory was derived the assumption – each firm maximizes profits and each firm concerns with the repercussions of its action on the rivals. The latter assumption distinguishes oligopoly from competitive theories. Perfectly competitive structure assumes ‘a cut in price enables higher sales and raise in prices decline sales’, whereas an oligopolistic firm is conscious of the impact of its decisions on the economic behaviour of the rivals (Bhagwati 1970).
Each firm also believes that a price raise will not be followed by rivals but a price cut would be. This is represented in the “Kinked Demand curve” developed by Sweezy (Riley 2006).
Source: Adapted from (2010)
Common examples of oligopolistic industries are oil, banking, retail (grocery, clothing), music etc.
Main economic features of an oligopoly: An oligopoly is characterised by factors such as barriers to entry, product differentiation, interdependent decision making, competition and collusion etc.
Barriers to entry:
Stigler (1965), defines barriers to entry as “a cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry”. Barriers may arise out of natural causes such as factors outside the control of an entrant or by strategic causes created by incumbents.
Natural barriers:
A primary barrier to entry is economies of scale. In the long run, Minimum Efficient Scale (MES) is the point of efficiency where a firm produces the required level of output to meet the demand, at an average cost. As shown in the diagram below, it takes a larger plant to attain MES at a certain cost and a smaller plant will not be able to produce at MES. The costs of production will rise (Begg and Ward 2009).
Source: Begg and Ward (2009)
Strategic barriers:
Branding may prevent new entrants when the MES is low enough to attract new players. When an incumbent spends more on product branding and advertising, its long run production costs are higher, thus the MES is shifted towards greater quantities of output. This in turn affects new entrants (Begg and Ward 2009).
Sunk costs also deter entry/exit and the market appears not contestable. Sunk costs are huge costs invested into the business, which cannot be regained on exit (Begg and Ward 2009), such as on brand development or huge equipments which are scrapped on exit. An entrant may ignore the pre-entry price and profit levels with barriers to entry, but will infer the post-entry equilibrium price and profit levels. Salop (1979) states that the incumbent may deter the equally efficient entrant by displaying sunk costs, which make his own exit uneconomical.
Therefore, if expected profits are negative, the entrant is deterred and the no-entry profits accrue to the incumbent.
Key economic theories of price fixing: The oligopolist will aim at fixing a price which promises maximum profits or covers expected costs and resulting in sustainability in the long run (Rothschild 1947). Therefore the directions that industries take in an oligopolistic situation would be to either compete or collude with other firms.
Fierce competition reduces industry profits. Firms use strategies such as lowering prices or increased advertisements to grab market share. This is a loss to the firms and a gain to consumers.
A Cartel occurs when firms get into a formal collusive agreement to share profits and hold significant market shares and therefore set the prices at the profit maximization level (Sloman et al 2010). Cartels are formed for the mutual benefit of members. The industry profits are maximized and consumers are at loss. This is because the cartel may result in higher prices or monopoly markets.
For instance, Nokyo is a Japanese agricultural cartel, controlling the rice trade. Nokyo’s umbrella dominance included Zenno, the business arm controlling significant percentages over fertilizers, agrichemicals, and rural petroleum, feed and farm markets.
For instance, in selling 60kgs of semi-controlled rice for ¥21000, deductions will comprise of handling charge of 2.0 percent at the local Nokyo branch, handling fee of 0.6 percent charged by the Keizairen [Nokyo’s prefectural association], and Zenno’s handling fee of 0.4% all borne by the farmer and included in the consumer’s price. The cartel is permitted and supervised by the Government (Bullock 1997).
Non-price competition occurs when the cartel players try alternative ways of competing against one another such as product differentiation, where the firm tries to maximize profits with a unique product or zone based monopolies where each firm covers different regions to maximize sales.
Tacit collusion occurs where there is a market leader and other firms in the oligopoly follow the leader’s pricing statements. The market leader is an established firm with greater influences over prices.
Game Theory is a decision-making process where one player’s choice must affect the interests of other players. The payoff is the accrued result on the choice made (Begg and Ward 2009).
In the table below, the game would be advertising dilemma for Sony and EMI. The decision is a choice between advertising heavily and moderately and the pay offs are listed.
The dominant strategy is to choose the decision which results in best possible outcome, whereby EMI would choose cell B and Sony would choose cell C.
Nash equilibrium is the choice of optimal decision when the opponent’s behaviour is known or is trusted. Here EMI would chose to moderate if it knew Sony would moderately advertise and therefore pick cell D and there is no incentive to move from this position.
Maximin is picking the least bad among the worst decisions when the opponent behaviour is favourable, in which case, EMI and Sony choses A. Maximax is picking the best possible outcome when opponent is not favourable, which is B for EMI and C for Sony.
It is apparent in this case that the dominant strategy is also Maximax. Therefore, the dominant strategy is the best strategy for the firm.
Oligopoly in the Music Industry Let us consider the music industry. The music industry is an oligopoly, with the “Big Four” accounting for 71.7% of the world market share for retail music consumption.
By applying the N-firm concentration ratio, which is a measure of the total market share attributed to the N largest firms, the music industry is thus an oligopoly with 4 firms holding market share between 50%-80%, and therefore, medium level of concentration (AmosWEB 2010).
What are the barriers to entry in the music industry?
Cost barriers: Natural Barrier
Caves (Lewis et al 2005) stated that risk is high where 10% of products account for 90% of turnover and nobody knows the reasons for success.
Therefore, when record companies buy major artists, they bear the financial risk with 90% of the artists that are not successful. Success of artists has a direct impact over the revenues generated and it is seen that 20% of the revenues are re-invested in Artists and Repertoire (A