MIDTERM #2 STUDY GUIDE
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.
Willingness to Pay (WTP)
∙ A buyer’s willingness to pay for a good
∙ Maximum amount the buyer will pay for that good
∙ How much the buyer values the good
If price of iPod is $200, Anthony and Flea will buy it while Chad and John won’t. Qd = 2 when P = $200 We also discuss several other topics like What happens to people with ocd?
Consumer Surplus (CS) = WTP Price of a good (P)
∙ extra benefits received by consumers above the price they must pay ∙ the amount by which WTP is greater than the price consumers actually pay ∙ the area between the demand curve and the price line up to the quantity transacted ∙ the area of the triangle in a smooth demand curve.
∙ CS is measured in $
CS (Consumer Surplus) Example
Price of iPod = $260 and Flea’s CS = $300 $260 = $40
Total CS = $40 If you want to learn more check out Who made up the einsatzgruppen and order police?
Other’s don’t receive CS because they don’t buy the iPod at this price
Higher Price Reduces Consumer Surplus
Cost: Value of everything a seller must give up to produce a good
Producer Surplus (PS) = Price of a good (P) –cost
∙ Amount a seller is paid for a good minus the seller’s cost of producing it ∙ Price received minus WTS
∙ Extra benefits received by producers relative to the price they receive ∙ Amount by which the price producers receive exceeds producer’s WTS ∙ The area between the price line and the supply curve
∙ PS is also measured in $
PS (Producer Surplus) Example
P = $25: PS = P – cost
Jack = 25 – 10 = 15: Janet = 25 – 20 = 5: Christ = 0
Total PS = 15 + 5 = $20
Total PS equals the area above supply curve underprice from 0 – QWe also discuss several other topics like What are the examples of thermodynamics?
We also discuss several other topics like What is an example of an unintentional tort?
Lower Price Reduces PS
Total surplus (TS) or social surplus (SS) = CS + PS
∙ Consumer surplus = Value to buyers –Amount paid by buyers (P)
∙ Buyers’ gains from participating in the market
∙ Producer surplus = Amount received by sellers (P) –Cost to sellers ∙ Sellers’ gains from participating in the market We also discuss several other topics like What does a replicated chromosome consist of?
∙ Total surplus = CS + PS = Value to buyers – Cost to sellers
∙ TS is the measure of society’s wellbeing
Efficient level of output: the level of output at which TS is maximized = equilibrium level of output in the market If you want to learn more check out What is the concept of realism?
Deadweight Loss (DWL):
the reduction in TS
in a market due to a
distortion in that market.
∆ TS = ∆CS +
∆ PS + ∆ Government Revenue
Determinants of DWL I
Elasticity affects the size of the
∙ Price elasticities of supply
∙ More inelastic supply curve,
smaller DWL of a tax.
∙ More elastic supply curve,
larger DWL of a tax
∙ Price elasticities of demand
∙ More inelastic demand
curve, smaller DWL of a tax.
∙ More elastic demand curve,
larger DWL of a tax
When supply is inelastic, it’s harder for firms to leave the market when the tax reduces Ps. When supply is inelastic, the tax reduces Q only a little.
When supply is elastic, it’s easier for firms to leave the market when the tax reduces Ps. When supply is elastic, the tax reduces Q a lot.
When demand is inelastic, it’s harder for consumers to leave the market when the tax raises to Pb.
When demand is more elastic, it is easier for buyers to leave the market when the tax increases Pb.
∙ When tax increases, DWL increases even more rapidly than the size of the tax. ∙ Tax revenue increases initially, then decreases.
∙ Higher tax reduces size of market
DWL = a/2 * T^2
The Laffer Curve shows the relationship between size of tax and tax revenue.
∙ Only domestic buyers and domestic sellers exist in the market.
∙ Equilibrium price and quantity are determined in the domestic market.
∙ Total benefits to the economy include consumer surplus for domestic buyers and
producer surplus for domestic producers.
PW= the world price of a good, the price that prevails in the world market.
P*= domestic price without trade.
P* < Pw
Type of Trade
Tariff: Tax on goods produced abroad and sold domestically.
∙ Domestic producers often argue that they need protection from imports.
∙ Tariff on imports raises the domestic price above the world price by the amount of the tariff
Import quota: a limit on the quantity of imported goods.
Externality: The uncompensated impact of one’s actions on the wellbeing of a bystander in the market.
Negative externality: Impact on the bystander is adverse/harmful.
∙ Ex. 1: The candy factory produces pollution such as CO2, resulting in greenhouse effects. The factory does not consider the harm that its pollution causes to all of society. There is a cost that goes beyond the cost of candy production, so the cost of candy production to society is much higher than the cost to an individual firm
∙ Ex. 2: Health risk to others from secondhand smoke.
∙ Ex. 3: Talking on a cell phone while driving makes roads less safe for others. ∙ Ex. 4: A neighbor’s barking dog.
Positive externality: Impact on the bystander is beneficial.
∙ Ex. 1: Planting trees, which absorb CO2, reduces greenhouse effects. Thus, the cost of planting trees to society is actually lower than the cost to an individual firm planting trees to sell them.
∙ Ex. 2: Research and development creates knowledge others can use.
∙ Ex. 3: People going to college raises the population’s education level, which reduces crime and improves government.
∙ Ex. 4: Being vaccinated against contagious diseases protects not only you, but also people around you.
Externality with production: Seller/producer of a good is incurring externality problem to society
Externality with consumption: Buyer/consumer of a good is incurring externality problem to society
Internalizing the externality: Altering incentives so that people consider the external effects of their actions.
Commandandcontrol policies: Environmental Protection Agency (EPA) develops and enforces regulations directly
∙ Limits on quantity of pollution emitted
∙ Requirements that firms adopt a particular technology to reduce emissions
Marketbased policies: Provide incentives so that private decision makers will choose to solve the problem on their own
∙ Corrective taxes and subsidies
∙ Tradable pollution permits
The Coase Theorem: If private parties can bargain without cost over the allocation of resources (called transaction costs, ex: litigation fees), they can solve the problem of externalities on their own.
∙ Whatever the initial distribution of rights, interested parties can reach a bargain, in which everyone is better off and the outcome is efficient.
∙ Result: The party who puts higher value on the good gets to keep
Excludability: Property of a good whereby a person can be prevented from using it
∙ Excludable: fish tacos, wireless internet access.
∙ Not excludable: radio signals, national defense.
Rivalry in consumption: Property of a good whereby one person’s use diminishes other people’s use.
∙ Rival: fish tacos.
∙ Not rival: an MP3 file of Beyoncé’s latest single.
Private Goods: Goods that are excludable and rival in consumption.
Ex: Candy, ice cream, clothing.
Club Goods: Goods that are excludable but not rival.
Ex: cable TV, uncongested toll roads.
Public Goods: Goods that are neither excludable nor rival in consumption. Ex: national defense, lighthouse, tornado siren, roads, bridges.
Free rider: A person who receives the benefit of a good but avoids paying for it. Common Resource: Goods that are rival but not excludable.
Ex: Fish in the ocean, clean environment, congested nontoll road.
Regulate use of the resource.
Ex: limits on hunting & fishing seasons, on size and quantity of animals
Impose a corrective tax to internalize the externality.
Ex: Hunting & fishing license, entrance fee for congested national park.
Auction permits allowing use of the resource.
Ex: Spectrum auctions (selling the license to transmit signals over specific bands of the electromagnetic spectrum) by the U.S. Federal Communications Commission (FCC).
Budget deficit: an excess of g’vt. spending over g’vt. Receipts
G’vt. Expenditure > G’vt. Revenue
Budget surplus: an excess of g’vt. receipts over g’vt. spending
G’vt. Expenditure < G’vt. Revenue
What are the costs of taxes to taxpayers?
1)Tax payment itself
2)Deadweight losses (DWL)
3)Administrative burdens of complying with the complex tax laws
Average tax rate: total taxes paid divided by total income
Assess the sacrifice a taxpayer makes because it measures the fraction of income paid in taxes.
Marginal tax rate: the extra taxes paid on an additional dollar of income
Measures the incentive effects of taxes on work effort, saving, etc. (the more you work, the greater the tax rate).
Lumpsum taxes: the same amount of tax for every person
Tax with a zero marginal tax rate
Ex.: Suppose lumpsum tax = $4,000
∙ Another goal of tax policy.
∙ Concerns whether the tax burden is distributed fairly among the population. ∙ Agreeing on what is “fair” is much harder than agreeing on what is “efficient.” ∙ Yet, there are several principles people apply to evaluate the equity
of a tax system.
Benefits principle: the idea that people should pay taxes based on the benefits they receive from g’vt. Services
Abilitytopay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden.
Vertical equity: the idea that taxpayers with a greater ability to pay taxes should pay a larger amount (hence, average tax rate is relevant for this).
∙ This says that rich people should pay more than poor people.
∙ Most people think that this is fair, but debates are on how much more. Proportional tax system: a system in which highincome and lowincome taxpayers pay the same fraction of income in taxes.
Progressive tax system: a system in which highincome taxpayers pay a larger fraction of their income in taxes than lowincome taxpayers do.
Regressive tax system: a system in which highincome taxpayers pay a
smaller fraction of their income in taxes than lowincome taxpayers do
Horizontal equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount. This says that “similar” taxpayers should pay
a similar amount.