● Content: Chapters 6, 7, 8, 9, and 10 ● Time/Location/Date: 9:30AM10:40AM on Thursday, Nov 17 in our classroom, Broad 2160E. ● The format will be the same as Midterm 1, i.e., 25 multiple choice questions. CHAPTER 6 ● How do taxes affect market outcomes? ● How do the effects depend on whether the tax is Don't forget about the age old question of economics midterm
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imposed on buyers or sellers? Price Controls Two types of price controls: ● Define price ceiling a legal maximum on the price of a good or service ○ Ex: rent control ● Define price floor a legal minimum on the price of a good or service ○ Ex: minimum wage Price Ceilings Policy makers may respond to buyers’ complaints that prices are “too high” by enacting price controls such as a price ceiling ● Price ceilings limit the price sellers can charge for their goods to the maximum price ● Prices cannot legally go higher than the ceiling ○ Ex: when there’s a shortage Example: The market for apartmentsOver time, supply and demand are more price elastic; the curves start to flatten out: shortage gets larger Price ceilings that involve a maximum price below the market price create five important effects 1. Shortages 2. Reduction in product quality a. When we are at a low price ceiling (below equilibrium), there is no incentive to provide better quality 3. Wasteful lines and other costs of search 4. Loss of gains from trade 5. Misallocation of resources1. Shortages ● Created when prices are held below the market price ● Shortage = difference between the QD and the QS at the controlled price. ● The lower the controlled price relative to the market equilibrium price, the larger the shortage. ● Example: A shortage of vinyl in 1973 forced Capitol Records to melt down slow sellers so they could keep pressing Beatles’ albums. 2. Reduction of Product Quality ● At the controlled price, sellers have more customers than goods = surplus ○ In a free market, this would be an opportunity to profit by raising prices ○ But when prices are controlled, sellers cannot ● Sellers respond to this problem in two ways: (since price cannot be changed) ○ Reduce quality. ○ Reduce service. 3. Wasteful Lines and Other Costs of Search ● Shortages = not all buyers will be able to purchase the good ● Normally, buyers would compete with each other by offering a higher price ● Price ceiling → price not allowed to rise → buyers must compete in other ways ○ Bribes ○ Waiting in long lines ○ Black market ● Opportunity cost: if you COULD attach a price to this ○ i.e. apt (shortage, getting worse) – there’s a cost attached to this, not necessarily money ○ Shortage of gas ■ Long lines at gas stations ■ Waste of time ● Bribes ○ Some buyers may be willing to bribe sellers in order to obtain the good. ○ The highest bribe a buyer would pay is the difference between his (her) max price and the price ceiling. ○ If bribes are common, then the total price of the good is the legal price plus the bribe. ○ From market’s perspective, if someone bribes attendant, someone gets something out of it (money) ■ If you’re waiting in line, there’s frustration and other consequences – more waste, opportunity cost ■ Basically: bribes are a way for customers to deal with other losses, other than their own money ○ Bribes are inevitable ○ Who is more able to pay those bribes? Competing with others that can give higher bribes? ■ Those who can actually afford them ■ Helping those who have more money… ● Wasteful Lines○ Buyers can also compete with each other through their willingness to wait in line ○ The maximum wait time (translated into monetary terms) for a buyer is the difference between the max price and the price ceiling ○ So the total price of the good is the legal price plus the time costs ○ Surplus relative to where the price level is ○ Market’s perspective: Impose brand new price ceiling ● BASICALLY: Bribes and waits both lead to a total price that is greater than the controlled price, (but they are different.) ○ Bribes involve a simple transfer from buyers to sellers. ○ The time spent waiting in line, however, is simply lost – paying in time is much more wasteful. ● Total value of the wasted time = time cost per unit x quantity bought (below) 4. Lost Gains from Trade ● Price controls → reduce the gains from trade. ● Price ceilings set below the market price → QS less than the market Q. ● Q is below the equilibrium market Q → consumers value the good more than the cost of its production. ● This represents a gain from trade that would be exploited (if the market were free). ○ Market has a way to restore equilibrium ● Deadweight Loss: ○ Deadweight Loss is the total of lost consumer and producer surplus when all mutually profitable gains from trade are not exploited. ○ Price ceilings create a deadweight loss by forcing Qs below the market Q. ■ Buyers and sellers would both benefit from trade at a higher price, but cannot since it is illegal for price to rise.● At quantities between Qsupplied and Qmarket, the willingness to pay is greater than the cost of production. ● Although mutually profitable, these trades are illegal. If all mutually profitable trades were legal, the gains from trade would increase by the green plus blue triangles. ● The lost gains from trade represent a deadweight loss. 5. Misallocation of Resources● Price controls distort signals and eliminate incentives leading to a misallocation of resources. ● Consumers who value a good most are prevented from signaling their preference (by offering sellers a higher price.) ○ So producers have no incentive to supply the good to the “right” people first. ○ As a result, goods are misallocated. ○ If producers supply to people who give higher bribes, they aren’t necessarily the right people; they are people who can afford to do that. ● Gains from trade are maximized when goods flow to their highest valued uses. ○ (When people capitalize on what they’re best at) ● A price control prevents the highest valued uses from outbidding lower valued uses, so some goods flow to lower valued uses even though it would be more valuable if used elsewhere.Q: So why do price controls ever get passed? A: The general public may not understand the nasty sideeffects of price controls. ● Shortages may benefit the ruling elite… ● In the former USSR, the communist party elite used Blat to obtain goods. ○ Blat having connections that can be used to get favors. ● The party elite can use their connections and power to obtain goods for themselves or others. ● Without such leverage their power dissipates. Price Floors Define Price Floor A minimum price allowed by law. They’re not as common as price ceilings (but still important) Price floors have four common effects: 1. Surpluses 2. Lost gains from trade (deadweight loss) 3. Wasteful increases in quality 4. A misallocation of resources ● Price ceiling prevents prices from going up ● Price floors prevent prices from going down (minimum wage) ● If buyers want a particular good, they compete with price ● Sellers compete for customers by offering lower pricesLabor surplus = unemployment The actual number of unskilled workers with jobs equals 400. 550 want jobs, but firms are only willing to hire 400, leaving a surplus (i.e. unemployment) of 150 workers. Min wage laws do not affect highly skilled workers. ● They do affect teen workers. ● Studies: ● A 10% increase in the min wage raises teen unemployment by 1–3%. Higher quality raises costs and reduces seller profit. ● Buyers get higher quality, but would prefer a lower price. ● Price floors encourage sellers to waste resources: higher quality than buyers are willing to pay for ○ Example: I want the basic car without all these fancy features (GPS, Bluetooth stuff, etc. but in order to buy it, I need to spend so much more than I want to in order to get the car) 4. Misallocation of Resources ● Price controls misallocate resources by: ○ Allowing highcost firms to operate. ○ Preventing lowcost firms from entering the industry.○ Example: Southwest Airlines ■ Point A to Point B as cheap as possible ■ Low cost producers shouldn’t be entering the market Example: President Jimmy Carter deregulated the price floors in much of the trucking industry. Trucks carry almost all of the consumer goods that you purchase, so almost every time you purchase something, you're paying money to a trucking company. What do you think happened in the trucking industry after deregulation? A. The price of trucking services fell. B. Truckers earned less money. C. Consumers saved a lot of money. D. All of the above are correct. Example: If the U.S. government sets a price floor on milk, it will not always lead to a surplus. Why not? A. The price floor would be rarely enforced B. Because price floors most commonly lead to shortages, not surpluses. C. The market price of milk will sometimes rise above the price floor, rendering the price floor irrelevant because it says nothing about binding, otherwise prices could fluctuate D. Price floors cause supply and demand to change, which leads to changes in equilibrium price. Taxes The government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. ● The government can make buyers or sellers pay the tax. ● The tax can be a % of the good’s price, or a specific amount for each unit sold. ○ For simplicity, we analyze perunit taxes only. Commodity Taxes Define Commodity Tax A tax on goods. Some truths about commodity taxation: ● Who pays the tax does not depend on who writes the check to the government; ● Who pays the tax does depend on the relative elasticities of demand and supply; ● Commodity taxation raises revenue and creates lost gains from trade (deadweight loss) ○ When you’re taxing, it depends on the relative elasticities – depends on which side of the market is less elastic, and what happens to tax revenueWho is getting more hurt because of the tax? ● Seller loses 50 cents ● Buyers spend $1 more, so they are more hurt, even if sellers are taxed too. ● These are relative elasticities ● Once curve is affected, the shift makes the tax split between the buyer and seller based on new equilibrium ● Demand is affected (less), market outcome ● Demand curve shifts downIt LOOKS LIKE outcome looks the same as tax on seller, BUT only the MARKET OUTCOME is the same but all that matters is relative elasticities The Incidence of a Tax Define incidence of a tax how the burden of a tax is shared among market participants ● Market participants = buyers and sellers Who Pays the Tax? Depends… ● Depends on relative elasticities of supply and demand ● Less elastic side of market → pay greater share of tax (bear greater burden of tax) Elasticity and Time IncidenceWho Pays the Luxury Tax? Objectives ● Tax is designed for wealthy buyers ● If sellers aren’t selling as much, then the burden is on the sellers ○ They may start laying off some workers ● Example: 1990, Congress taxed luxury things like yachts, fur coats, expensive cars, etc. ○ Goal: Raise revenue from those who could afford these easily (wealthy people) ● For luxury taxes, the burden is heavier on the sellers Results● Did not work ● Sales went down, loss of thousands of jobs ● Government paid out in millions of dollars in unemployment benefits The Effects of Tax ● New consumer surplus = area above price + tax for customers ● Difference in price = magnitude of the tax ● Consumer surplus on the top left, not the case on the other slide Subsidies ● Define subsidy reverse tax where government gives money to consumers (or producers) ● Subsidy = Price Received by Sellers – Price Paid by Buyers ● Some truths about subsidies: ○ Who gets the subsidy does not depend on who receives the check from the government ○ Who benefits from the subsidy does depend on the relative elasticities of demand and supply ○ Subsidies must be paid for by taxpayers and they create inefficient increases in trade (deadweight loss). ● Taxes reduced consumer surplus, incurred deadweight loss, Subsidy WedgeExample: Which of the following statements are true? I. A $0.50 tax on each fishing lure sold raises the price per lure by $0.50. II. A tax on sellers is equivalent to a tax on buyers. III. A tax on buyers is analyzed by shifting the demand curve up by the amount of the tax.A. I and II B. II and III C. II only D. I, II, and II ANSWER IS C: II only ● Doesn’t matter who you tax, in terms that market outcome is the same ● Doesn’t mean magnitude of each tax is the same ● If you tax either, and you compute prices, it is the same ● If you impose tax on buyers, demand decreases Example: If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax? A. Producers, because consumers have a greater ability to change their behavior in response to the tax. B. Both parties will share the burden equally. C. Consumers, because they pay the tax out of pocket. D. The government, because the tax will cause less of the good to be produced and consumed. ANSWER IS A: Producers ● If demand of some good is more elastic (flatter) than supply and a tax is imposed on the consumption of the good, who will bear more of the burden on the tax? Example: Junk food has been criticized for being unhealthy and too cheap, enticing the poor to adopt unhealthy lifestyles. Suppose that the state of Oklahomaimposes a tax on junk food. What needs to be true for the tax to actually deter most of the people from eating junk food: Should junk food demand be elastic or should it be inelastic? A. Demand should be perfectly inelastic. B. Demand should be elastic. ANSWER IS C: Elastic ● What needs to happen to deter people from eating junk food? CHAPTER 7 Consumers, Producers, and Efficiency of Markets Welfare Economics Allocation of resources refers to: ● how much of each good is produced ● which producers produce it. ● which consumers consume it. ● Welfare economics studies how the allocation of resources affects economic wellbeing. WTP (Willingness to Pay) and the Demand CurveAs you drop price, more people would be willing to buy it ● STAIRCASE SHAPE with small size of consumers ● They become smaller with a lot more consumers, would start looking more like a smoother curve● Marginal buyer as price drops, buyers enter market and vice versa ○ We look at those buyers one at a time Consumer Surplus and the Demand Curve ● CS = WTP P ○ Consumer Surplus = WTP amount the buyer ACTUALLY pays ○ “Oh, I got to save more than I thought because I thought the iPod would be more expensive”Total CS equals the area under the demand curve above the price, from 0 to Q. CS with Lots of Buyers and a Smooth D Curve Area of triangles when there’s a lot of consumers to find CSCost value of everything a seller must give up to produce a good (i.e. opportunity cost) Cost and the Supply Curve A seller will produce and sell the good/service only if the price exceeds his or her cost. ● Hence, cost is a measure of willingness to sell. Goes backwards compared to demand curveDefine marginal seller seller who would leave market if the price were any lower Producer Surplus and the S Curve ● Define producer surplus amount a seller is paid for a good minus the seller’s cost ● PS = P cost ● Also grab area for PS (producer surplus) ● Total PS equals the area above the supply curve under the price, from 0 to Q.CS = (value to buyers) (amount paid by buyers) = buyers’ gains from participating in the market ● PS = (amount received by sellers) (cost to sellers) = sellers’ gains from participating in the market ● Total surplus = CS + PS ○ = total gains from trade in a market ○ = (value to buyers) (cost to sellers) Total surplus = (value to buyers) (cost to sellers) ● EFFICIENT allocation of resources = maximization of total surplus ○ Goods are consumed by buyers who value them most highly (they care) ○ Goods produced by LOWER COST ○ Producers ○ +/ quantity of good would not increase total surplus The Market’s Allocation of Resources ● Market economy: allocation of resources is decentralized ○ Determined by the interactions of many selfinterested buyers/sellers ● Is market’s allocation of resources desirable? Different allocation of resources makes society better off? ○ Use total surplus as a measure of society’s wellbeing → market’s allocation efficient? ● Policymakers are about equality, but we’re focusing on efficiency Efficiency Total Surplus = (value to buyers) (cost to sellers) Allocation of resources is efficient if it maximizes total surplus: ● Goods consumed by buyers who value them most highly ● Goods are produced by producers with the lowest costs ● Raising/Lowering quantity of a good would NOT increase total surplus Evaluating the Market Equilibrium In the eyes of the market, effects of taxing too much one way or the other: ● Tax too little = not enough revenue ● Tax too much = low incentive to work, consumers don’t want to buy, etc.Which Buyers Consume the Good? Buyers with WTP: ● >=$30, will buy ● <$30, will not Buyers who value goods most highly (willing to buy at higher price) are ones who will consume it. Buyers from 015 in quantity will value the good at least as much as the price, will purchase Basically: ● Buyers unable and unwilling to buy, then we would not get that good ● Buyers who are valued most are those who actually consume Which Buyers Consume the Good? Sellers with cost: ● <=$30, will produce ● >$30 will not Sellers with lowest cost produce the good Sellers of the first 15 units have cost <$30, worthwhile for them to produce the good ● Other sellers have cost >$30, not worthwhile to produce if P = $30Does Equilibrium Q Maximize Total Surplus? Can increase total surplus reducing Q True at any Q GREATER than 15 Can increase total surplus increasing Q True at any Q LESS than 15 Trial and error: test for anything above quality at 15, and then below. ● 2 PRICES: Price buyers pay, price sellers receive ○ Gap between the two prices looks like tax or subsidy… ○ Disparity – one way to increase surplus is to DECREASE QUANTITY Both scenarios suggest there is one ideal quantity = EQUILIBRIUM● Pushing for efficiency The Free Market vs Government Intervention ● What if central planner allocated resources instead of market? ● Planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy ● IMPOSSIBLE: which is why centrallyplanned economies are never very efficient Start by looking at consumers and producers ● How do we know one consumer values a good more than the other? ● Potential new uses for previous inputs ● What if resources for one thing can be used for future things? ● Take into account as much as we can – a lot of info ● But if there’s a price that buyers and sellers both agree on, we can go from there ● More viable than one entity taking over (communism) The Free Market vs Central Planning ● Market equilibrium = efficient ○ No other outcome achieves higher total surplus ○ Gov. cannot raise total surplus by changing market’s allocation of resources ○ Laissez faire (“allow them to do”) ■ Notion that government should not interfere with the market Markets are usually a good way to organize economic activity ● Assuming perfectly competitive markets Market failures occur when: ● buyer/seller has market power ability to affect market price ○ Remember laissez faire ● Transactions have side effects externalities CHAPTER 8 The Costs of Taxation Chapter 6 Review Tax: ● Drives a wedge between the price buyers pay and the price sellers receive (difference) ● Raises the price buyer pay and lowers the price sellers receive ● Reduces the quantity bought and sold Other outcomes of tax: ● Deadweight loss (DWL) ● Tax revenue The Effects of a TaxWITHOUT TAX: Consumer Surplus = CS = above equilibrium Producer Surplus = PS = below equilibrium Tax Revenue = 0, no one is taxed here No DWL Total Surplus = CS + PS = A+B+C+D+E+F WITH TAX: CS = A, above tax line PS = F, below tax line Tax Revenue = B+D (rectangular area) Total Surplus = consumer + producer = A+B+D+F ● ALL the costs of what both sides paid for Deadweight loss = Tax reduces total surplus by C + E ● No one gets C+E Remember: Total surplus WITH tax would’ve been A+B+C+D+E+FAbout the Deadweight Loss PB > PS Sellers good deal Buyers happy to pay more Tax is preventing efficient market outcome from happening ● It’s a tradeoffWhat Determines the Size of DWL ● Government should tax goods/services with SMALLEST DWL ○ Size of DWL depends on price elasticities of supply/demand ○ Can raise revenue government needs by taxing one with smallest DWLDWL and the Elasticity of Supply DWL and the Elasticity of Demand How Big Should the Government Be? ● Bigger government → more services → higher taxes → DWL ● Bigger DWL from taxation = greater argument for smaller government ● Tax on labor income = biggest source of government revenue ○ Marginal tax rate tax on the last dollar of earnings (for typical worker, is about 40%) ○ Larger tax = more services ○ Lower tax = less ● Labor supply is inelastic = DWL is small ○ Assuming most workers work fulltime regardless of wage ● Taxes will influence incentive to workThe Effect of Changing the Size of the Tax Increasing tax exponentially increases DWL growth is not linearTax revenue FALLS at a certain point. ● Responding to incentives ● If you tax 100% it’s not gonna work, and revenue will eventually be 0 If you’re the max, too much sensitivity – not good ● If there will be a small change in tax, it will push revenue either way ● It is unstable because it can teeter either way ● Behind the scenes, a greater loss of DWL CHAPTER 9 The World Price and Comparative Advantage ● Def: PW = the world price of a good, the price that prevails in world markets. ● Def: PD = domestic price without trade. If PD < PW, ● The country has a comparative advantage in the good.● Under free trade, the country exports the good. If PD > PW, ● The country does not have a comparative advantage. ● Under free trade, the country imports the good. Do the gains outweigh the losses? ● One equilibrium price for domestic price, one for world price Two prices to compare our price The Small Country Assumption ● A small economy is a price taker in world markets: Its actions have no effect on PW ● Not always true—especially for the U.S.—but simplifies the analysis without changing its lessons. ○ No seller would accept less than PW, since she could sell the good for PW in world markets. ○ No buyer would pay more than PW, since he could buy the good for PW in world markets. Example: A Country that Exports SoybeansTrade benefits soybean producers because they can sell at a higher price. Producer surplus rises by the area B + D. Trade makes domestic buyers worse off because they have to pay a higher price. Consumer surplus falls by the area B. The gains to producers are greater than the losses to consumers, so trade increases total welfare: total surplus rises by the amount D. Example: A Country that Imports Plasma TVsPD > PW, so this country will import plasma TV sets from abroad. The quantity of imports is simply the difference between the quantity demanded by domestic consumers and the quantity supplied by domestic firms at the world price. Trade benefits consumers in this case because it allows them to buy plasma TVs at lower prices, so more consumers can afford plasma TVs if imports are allowed. The gains to consumers appear on the graph as the area (B+D), which represents the increase in consumer surplus when the country allows trade. In this example, trade harms domestic producers because they now must sell their plasma TVs at a lower price. As a result, they produce a smaller quantity, earn less revenue, and likely let go of some of their workers. These losses are represented on the graph by the area B , which represents the fall in producer surplus resulting from trade. As the graph shows, the gains to consumers outweigh the losses to producers: total surplus increases by the amount D, which represents the gains from trade in plasma TV sets. Welfare Effects of TradeOther Benefits of International Trade ● Consumers enjoy increased variety of goods. ● Producers sell to a larger market, may achieve lower costs by producing on a larger scale. ● Competition from abroad may reduce market power of domestic firms, which would increase total welfare. ● Trade enhances the flow of ideas, facilitates the spread of technology around the world. Then why is there opposition to trade? REVIEW: Ten Principles from Chapter 1 → Trade can make everyone better off, but: ● The winners from trade could compensate the losers and still be better off. Yet, such compensation rarely occurs. ● The losses are often highly concentrated among a small group of people, who feel them acutely. ● The gains are often spread thinly over many people, who may not see how trade benefits them ● Hence, the losers have more incentive to organize and lobby for restrictions on trade. Trade Barriers (Tariff) Define Tariff: a tax on imports Example: Cotton shirts ● PW = $20 ● Tariff: T = $10/shirt ○ Consumers must pay $30 for an imported shirt. ○ Therefore, domestic producers can charge $30/shirt. ○ In general, the price facing domestic buyers & sellers equals (PW + T ). 1. We are using the “small country” assumption which implies that semiconductors can be imported at a constant price. That is, our demand for semiconductors is small relative to the world market so we can import all be want without affecting the world price. 2. The level of imports is determined by the difference between domestic demand and domestic production at the world price. 3. The lower the world price relative to the domestic “no trade” price the greater will be imports.1. With the tariff the world supply curve shifts up by the amount of the tariff per unit. 2. The price domestic consumers pays goes up by the amount of the tariff and domestic consumption falls. 3. The price domestic producers pay also goes up to domestic production rises. 4. Results: Imports are less and domestic prices are higher 5. Domestic producers win while domestic consumers lose. 6. The government gains tariff revenue. Example: Analysis of a Tariff on Cotton Shirts● The tariff benefits domestic producers by allowing them to sell for a higher price. Producer surplus increases by C. ● The tariff makes consumers worse off because they have to pay a higher price. Consumer surplus falls by C + D + E + F. ● The tariff generates revenue for the government equal to E. ● The losses from the tariff exceed the gains, so total welfare falls. The tariff reduces total surplus by (D + F). A tariff is a tax. Like the taxes we studied in the preceding chapter, the tariff causes a deadweight loss because it distorts incentives. Here, the tariff causes the economy to devote more resources to a good that could be produced at lower opportunity cost in other countries. This causes a deadweight loss, represented on the graph by the area D. Also, the tariff gives consumers an incentive to purchase a smaller quantity. The result is a deadweight loss (area F on graph). Example: A tariff results in a higher: I. Consumer surplus. II. Producer surplus.III. Government revenue. A. I and II only B. II and III only results in loss of consumer surplus C. I and III only D. I, II, and III Cost of Protectionism Define protectionism Policy of restraining trade through quotas, tariffs, or other regulations which burden foreign (but not domestic) producers. Example: ● Saving jobs through trade restrictions sounds good and is often politically rewarding. ● The problem is that the productive higher paying jobs that fail to be created are not always as visible as the jobs “saved”. ● This is one of the fundamental difficulties in debating trade politics. ● The gains from trade restrictions are seen and the losses are often not seen. A tariff has two effects: 1. ↑ domestic production, ↓ domestic consumption. a. More of the good is produced by the highercost domestic producers. 2. Less is consumed → lower gains from trade. We can measure value of wasted resources. Example: Costs of Perfectionism ● One final cost: lobbying ○ The loss to domestic consumers is greater than the gains to domestic producers. ● Why does congress pass tariffs? ○ Small number of producers → Benefit per producer is high. ○ Large number of consumers → Loss per consumer is low. Trade Barriers (Quotas) Define An import quota A quantitative limit on imports of a good. ● Mostly has the same effects as a tariff: ○ Raises price, reduces quantity of imports. ○ Reduces buyers’ welfare. ○ Increases sellers’ welfare. ● A tariff creates revenue for the govt. A quota creates profits for the foreign producers of the imported goods, who can sell them at higher price. ● Or, government could auction licenses to import to capture this profit as revenue. Usually it does not. Arguments Against International Trade 1. Trade reduces the number of jobs in the U.S. Jobs Argument ● Tariffs raise the price of protected goods ○ Trade destroys jobs in industries that compete with imports. ○ Consumers have less money to spend on other goods. ○ Jobs are lost in other industries—these lost jobs are hard to see. ● Economists’ Response:○ Total unemployment does not rise as imports rise, because job losses from imports are offset by job gains in export industries. ○ Even if all goods could be produced more cheaply abroad, the country need only have a comparative advantage to have a viable export industry and to gain from trade. ○ Trade creates jobs ○ The U.S. dollars we spend on other country’s good are often used to buy our goods. Jobs are created in U.S. exporting industries. 2. It’s wrong to trade with countries that use child labor Child Labor Argument ● It is wrong to trade with countries that employ child labor. ● Economists’ Response: ○ Restricting imports made by child labor may do more harm than good. ■ Children work out of necessity—what else will they do? ■ Often the alternative is worse. ○ Child labor is a poverty problem, not a trade problem. 3. We need to keep some industries for reasons of national security National Security Argument ● An industry vital to national security should be protected from foreign competition, to prevent dependence on imports that could be disrupted during wartime. ● Economists’ Response: ○ Fine, as long as we base policy on true security needs. ○ But producers may exaggerate their own importance to national security to obtain protection from foreign competition. 4. We need to keep some “key” industries because of beneficial spillovers onto other sectors Unfair Competition Argument ● Producers argue that their competitors in another country have an unfair advantage, e.g., due to government subsidies. ● Economists’ Response: ○ Great! Then we can import extracheap products subsidized by the other country’s taxpayers. ○ The gains to our consumers will exceed the losses to our producers. 5. We can increase U.S. wellbeing with strategic trade protectionism ProtectionasBargaining Chip Argument ● Example: The U.S. can threaten to limit imports of French wine unless France lifts their quotas on American beef. ● Economists’ Response: ○ Suppose France refuses. Then the U.S. must choose between two bad options: ■ Restrict imports from France, which reduces welfare in the U.S. ■ Don’t restrict imports, which reduces U.S. credibility CHAPTER 10 Externalities Review from Ten Principles of Economics in Chapter 1: ● Markets are usually a good way to organize economic activity.● In absence of market failures, the competitive market outcome is efficient, maximizes total surplus. One type of market failure is an externality. ● Define Externality The uncompensated impact of one person’s actions on the wellbeing of a bystander ● Externalities can be negative or positive, depending on whether the impact on a bystander is adverse or beneficial ● Selfinterested buyers and sellers neglect the external costs or benefits of their actions, so the market outcome is not efficient. Another principle from Chapter 1: ● Governments can sometimes improve market outcomes. ● In presence of externalities, public policy can improve efficiency. Definitions ● Define Private Cost A cost paid by the consumer or producer. ● Define External Cost A cost paid by people other than the consumer or the producer trading in the market. ● Define Social Cost The cost to everyone, the private cost plus the external cost. ● Define Social Surplus Consumer surplus + producer surplus + everyone else’s surplus. ● Define Efficient Equilibrium The price and quantity that maximize social surplus. ● Define Efficient Quantity The quantity that maximizes social surplus. Negative Externality Examples ● Air pollution from a factory. ● The neighbor’s barking dog. ● Latenight stereo blasting from the dorm room next to yours. ● Noise pollution from construction projects. ● Health risk to others from secondhand smoke. ● Talking on cell phone while driving makes the roads less safe for others. Note that maximizing consumer + producer surplus is NOT the same as maximizing TOTAL surplus when the trades impose external costs (or benefits) on bystanders. “At any Q < 20, value of additional gas exceeds social cost.” For example, at Q = 10, the value to buyers of an additional gallon equals $4, while the social cost is only $2. ● Therefo re, total surplus (society’s well being) would increase with a larger quantity of gas. “At any Q > 20, social cost of the last gallon is greater than its value.” For example, at Q = 25 (the market equilibrium) the last gallon cost $3.50 (including the external cost) but the value of it to buyers was only $2.50. ● Hence, total surplus would be higher if Q were lower. ● Only at Q = 20 is society’s welfare maximized. When external costs are significant, output is too high. ● Costs are underestimated: QEfficient < QMarket ● At the higher market level of output, costs exceed the private benefits to buyers. ● A deadweight loss emerges, reducing social surplus. When external costs are ignored, the social surplus is reduced. ● In this case, reducing output below the market quantity increases social surplus. ● To maximize social surplus, output should be reduced to the socially efficient level.○ For example, the government can tax sellers $1/gallon ○ shift the supply curve up by $1. Define Internalizing the Externality Altering incentives so that people take account of the external effects of their actions. ● In our example, the $1/gallon tax on sellers makes sellers’ costs = social costs. ● When market participants must pay social costs, market equilibrium = social optimum. ● Note: Imposing the tax on buyers would achieve the same outcome ○ market Q would equal optimal Q. Positive Externality Examples: ● Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. ● R&D creates knowledge others can use. ● People going to college raise the population’s education level, which reduces crime and improves government. In the presence of a positive externality, the social value of a good includes: ● private value – the direct value to buyers. ● external benefit – the value of the positive impact on bystanders. The socially optimal Q maximizes welfare: ● At any lower Q, the social value of additional units exceeds their cost. ● At any higher Q, the cost of the last unit exceeds its social value.When external benefits are significant, output is too low. ● Benefits are underestimated: QEfficient > QMarket . ● At the lower market level of output, total benefits exceed the private benefits to buyers. ● A deadweight loss emerges, reducing social surplus. When consumers and producers ignore external benefits, they base their decisions on private benefits only. ● In this case, increasing output above the market quantity increases social surplus. ● To maximize social surplus, output should be increased to the socially efficient level.● In our example, the $10/shot subsidy for buyers ○ shift the demand curve up by $10. Effects of Externalities: SUMMARY If it is a negative externality: ● The market quantity is larger than socially desirable. If it is a positive externality: ● The market quantity smaller than socially desirable. To remedy the problem, “internalize the externality”. ● Tax goods with negative externalities. ● Subsidize goods with positive externalities. Corrective Taxes and Subsidies Definitions: ● Define Corrective Tax A tax designed to induce private decisionmakers to take account of the social costs that arise from a negative externality ○ Also called Pigouvian taxes after Arthur Pigou (18771959). ● Define A Pigouvian Tax a tax on a good with external costs (e.g., $1/gallon tax on gasoline). ○ The ideal corrective tax = external cost. ● Define A Pigouvian Subsidy a subsidy on a good with external benefits (e.g., $10/shot subsidy for flu shots). ○ For activities with positive externalities, ideal corrective subsidy = external benefit. Other taxes and subsidies distort incentives and move economy away from the social optimum. ● Corrective taxes & subsidies: ○ Align private incentives with society’s interests ○ Make private decisionmakers take into account the external costs and benefits of their actions ○ Move economy toward a more efficient allocation of resources Corrective Taxes vs Regulations ● Different firms have different costs of pollution abatement. ● Efficient outcome: Firms with the lowest abatement costs reduce pollution the most. ● A pollution tax is efficient: ○ Firms with low abatement costs will reduce pollution to reduce their tax burden. ○ Firms with high abatement costs have greater willingness to pay tax. ● In contrast, a regulation requiring all firms to reduce pollution by a specific amount not efficient. ○ If all firms must reduce emissions by a fixed amount (or fixed percentage), then abatement is NOT concentrated among firms with the lowest abatement costs, and so the total cost of abatement will be higher. Pollution “abatement” simply means taking measures to cut pollution. Corrective taxes are better for the environment: ● The corrective tax gives firms an incentive to continue reducing pollution as long as the cost of doing so is less than the tax. ● If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. ● In contrast, firms have no incentive for further reduction beyond the level specified in a regulation. Solutions to Externality Problems ● When externalities are significant, the market equilibrium is no longer efficient. ● What can be done to resolve this problem? ○ Private Solutions ■ The Coase Theorem ○ Government Solutions ■ Taxes and Subsidies ■ Command and Control ■ Tradable Allowances Private Solutions ● In certain situations the private sector can resolve externalities. ● Solving problems requires time and effort. ● Define Transaction Costs All the costs necessary to reach an agreement. ● Types of Private Solutions: ○ Moral codes and social sanctions. ○ Charities. ○ Contracts between market participants and the affected bystanders. ● The Coase Theorem ○ If transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even when there are externalities. ○ In other words: “if private parties can costlessly bargain over the allocation of resources, they can solve the externalities problem on their own.” ○ Makes sense if the costs aren’t too expensive, wouldn’t bring more parties to make things more difficult, cuts down costs ○ Example: ■ Assume that collectively, the 1000 residents of Green Valley value swimming in Blue Lake at $100,000. ■ A nearby factory pollutes the lake water, and would have to pay $50,000 for nonpolluting equipment. ■ Describe a Coaselike private solution. ● Problems occur when factory or residents don’t want to give up more than they feel they need to ■ Solution: Each of the 1000 residents can pay $75, so the town can offer $75,000 to the factory to stop polluting Why Private Solutions Do Not Always Work● Transaction Costs: ○ Transaction costs may make it impossible to reach a mutually beneficial agreement. ○ Suppose lawyers charge $60,000 to represent the two parties and draw up a contract that is enforceable in a court. Then it will be impossible for both parties to come to a mutually beneficial agreement, and the factory will continue polluting the lake. ● Stubbornness: ○ Even if a beneficial agreement is possible, each party may hold out for a better deal. ○ Suppose the town offers $55,000 to the factory. The factory would be better off taking this offer than nothing at all, but the factory may counter with a $95,000 price. Both parties hold out in hopes that the other will cede, but neither does. The factory keeps polluting, and the residents of Green Valley continue to be denied the joy of swimming in the lake. ● Coordination Problems: ○ If the number of parties is very large, coordinating them may be costly, difficult, or impossible. ○ Getting all 1000 residents to agree to a specific offer will be difficult. Moreover, each resident has an incentive to freeride off his neighbors. Government Solutions ● Taxes and Subsidies ○ Governments often use taxes and subsidies to resolve externalities. ■ If there are negative externalities, governments impose Pigouvian taxes to reduce the market quantity. ■ If there are positive externalities, governments offer Pigouvian subsidies to increase the market quantity. ● Command and Control ○ Note: Command and control regulations do not always bring about an efficient solution… ■ Governments may not possess enough information for good policy. ■ Regulations do not provide buyers and sellers the flexibility to choose the least costly method of compliance. ○ This approach makes sense for certain problems (like smallpox) but not all. ■ Zika virus ■ Taxes and subsidies ● Tradable Allowances (MarketBased Policies) ○ The government can address external costs by establishing a market for tradable allowances. ■ The government sets a maximum quantity and rations a portion of that level to players in the market. ■ Consumers and producers individually choose the best (least costly) approach to limit their quantity. ● Example: Tradable Pollution Permits ○ Acme and US Electric (USE) run coalburning power plants. Each emits 40 tons of sulfur dioxide per month.○ Total emissions = 80 tons/month. ○ Goal: Reduce SO2 emissions 25%, to 60 tons/month ○ Cost of reducing emissions: $100/ton for Acme, $200/ton for USE ● Policy Option 1 (Regulation): ○ Every firm must cut its emissions 25% (10 tons). ○ Compute the cost to each firm and total cost of achieving goal using this policy. ■ Cost to Acme: (10 tons) x ($100/ton) = $1000 ■ Cost to USE: (10 tons) x ($200/ton) = $2000 ■ Total cost of achieving goal = $3000 ● Policy Option 2 (Tradable pollution permits): ○ Issue 60 permits, each allows one ton of SO2 emissions. Give 30 permits to each firm. ■ Establish market for trading permits. ○ Each firm may use all its permits to emit 30 tons, may emit < 30 tons and sell leftover permits, or may purchase extra permits to emit > 30 tons. ○ Compute the cost of achieving goal if Acme uses 20 permits and sells 10 to USE for $150 each. ○ Acme: ■ sells 10 permits to USE for $150 each, gets $1500 ■ uses 20 permits, emits 20 tons SO2 ■ spends $2000 to reduce emissions by 20 tons ■ net cost to Acme: $2000 − $1500 = $500 ○ USE: ■ buys 10 permits from Acme, spends $1500 ■ uses these 10 plus original 30 permits, emits 40 tons ■ spends nothing on abatement ■ net cost to USE = $1500 ○ Total cost of achieving goal = $500 + $1500 = $2000 ● Using tradable permits, the goal is achieved at lower total cost and lower cost to each firm than using regulation. ● Firms with low cost of reducing pollution do so and sell their unused permits. ● Firms with high cost of reducing pollution by permits. ● Result: Pollution reduction is concentrated among those firms with lowest costs. Corrective Taxes vs. Tradable Pollution Permits ● Like most demand curves, firms’ demand for the ability to pollute is a downwardsloping function of the “price” of polluting. ○ A corrective tax raises this price and thus reduces the quantity of pollution firms demand. ○ A tradable permits system restricts the supply of pollution rights, has the same effect as the tax. ● When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely. ● There is a close relationship between using taxes and tradable allowances to internalize externalities. ○ A tax set equal to the level of the external cost is equivalent to tradable allowances when the number of allowances is set equal to the efficient quantity. ● Buyers and sellers have much more flexibility about how to cut cost. ● There are strong incentives for buyers and sellers to reduce quantity since the allowances are tradable. Objections to the Economic Analysis of Pollution ● Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment. ● However, people face tradeoffs. The value of clean air and water must be compared to their cost. ● The marketbased approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment.