If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency. V. In addition to efficiency, the social planner might also care about equality – that is, whether various buyers and sellers in the market have a similar level of economic well-being. B. Evaluating the Market Equilibrium I. Total Area be; en the supply and demand curves up to the point of equilibrium represents the total surplus in the market at equilibrium. Ii. Is equilibrium allocation of resources efficient? 1 .
Recall that those buyers who value the good more than the price choose to buy the good; buyers who value it less than the price do not 2. Similarly, those sellers whose costs are less than the price choose to produce and sell the good; sellers whose costs are greater than the price do not 3. These observations lead to two insights about market outcomes: a. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. . Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost. C.
Free markets produce the quantity of goods that maximize the sum of consumer and producer surplus 4. These observations reveal that: a. Given the quantity produced and sold in market equilibrium, the social planner cannot increase well-being by changing the allocation of consumption among buyers or the allocation of production among sellers b. The social planner cannot raise well-being by increasing or decreasing quantity Of the good. 5. These three insights tell us that the market outcome sakes the sum of consumer and producer surplus as large as it can be. In other words, the equilibrium outcome is an efficient allocation of resources a.
This policy of leaving the market alone is known as laissez fairer, a French term meaning “ allow them to do. ” b. The task of knowing the value of a particular good to every potential consumer and the cost of every producer for every market in the economy is impossible, which is why centrally planned economies never work well. 4. Conclusion: Market Efficiency and Market Failure a. To conclude that markets are efficient, we made several assumptions. When these assumptions do not hold, our conclusion that the market equilibrium is efficient may no longer be true I. First, we assumed that markets are perfectly competitive.
In the world, some market may be able to be influenced by a single buyer or seller 1. The ability to influence prices is called market power 2. Market power can cause markets to be inefficient by preventing equilibrium ii. Second, we assumed that the outcome in a market matters only to buyers and sellers in that market. 1. In the world, decisions of buyers and sellers sometimes affect people who are not participants in the market at all. A. Ex: pollution b. Side effects, called externalities, cause welfare in a market to depend on more than just the value to the buyers and the cost to the sellers. . When these side effects are not considered, the equilibrium can be inefficient from the standpoint of society as a whole b. Market power and externalities are examples of a general phenomenon called market failure – the inability of some unregulated markets to allocate resources efficiently. I. When markets fail, public policy can potentially remedy the situation Chapter 8: Application: The Cost of Taxation 1 . The Deadweight Loss of Taxation a. Recall: I. The outcome is the same whether a tax on a good is levied on buyers or sellers of the good. 1 .
When a tax is levied on buyers, the demand curve shifts downward by the size of the tax 2. When a tax is levied on sellers, the supply curve shifts upward by the amount of the tax ii. The key result of a tax is that it places a wedge between the price buyers pay and the price sellers receive. 1 . Because of this tax wedge, the quantity sold falls below the level that would be sold without the tax. 2. In other words, a tax on a good causes the size of a market to shrink iii. How A Tax Affects Market Participants 1. Recall a. He benefit received by buyers is measured by consumer surplus b. He benefit received by sellers is measure by producer surplus 2. In the case of a tax, a third party, the government is included. A. If T is the size of the tax and Q is the quantity Of the good sold, then the government gets a total tax revenue of T x Q. B. We use the government’s tax revenue (T x Q), to measure the public benefit from the tax, because the revenue is spent on the public (in the form of services such as roads, police, education). 3. Welfare Without a Tax a. Total Surplus: the area between the supply and demand curve up to the equilibrium point. . Total Surplus: consumer surplus + producer surplus 4. Welfare With a Tax a. With a tax wedge, consumer and producer surplus decreases b. Thus total surplus with the tax decreases and includes consumer surplus + producer surplus + tax revenue 5. Changes in Welfare a. The effects of a tax can be seen by comparing welfare before and after the tax is enacted b. Whereas pretax welfare included total surplus, the post-tax welfare include the consumer surplus (which is now lower), the producer surplus (also now lower), and the government tax revenue. I. He area between the supply and demand curves up to the equilibrium quantity minus he area of the tax wedge ii. The losses to buyers and sellers from a tax exceed the revenue raised by the government. 1 . In other words, the fall in total surplus exceeds the tax revenue 2. On the graph, the area of the tax wedge (fall in surplus) exceed the area of tax revenue (Q x T). C. TO understand why taxes impose deadweight losses (fall in total surplus that result from a market distortion, such as a tax), recall that people respond to incentives. I. With a tax, less incentive to buy and less incentive to produce ii.
This causes the market to shrink below its optimum size and resources are allocated inefficiently iv. Deadweight Losses and the Gains from Trade 1 . Taxes cause deadweight loss because they prevent buyers and sellers from realizing some of the gains from trade a. Gains from trade = the difference between buyers’ value and sellers’ costs b. When these are less than the tax, sellers leave the market. 2. Determinants of the Deadweight Loss a. The price elasticity of supply and demand (which measure how much the SQ and Q respond to changes in the price) determine whether the deadweight loss is large or small b.
Elasticity of Supply Affect on Size of Deadweight Loss I. Inelastic Supply – SQ responds only slightly to changes in price 1. Deadweight loss, the area of the triangle between the supply and demand curves is relatively lower than that on an elastic supply curve 2. Inelastic Supply = Less Deadweight Loss (smaller tax wedge size) ii. Elastic Supply – SQ responds substantially to changes in price 1 . Deadweight loss, the area of the triangle between the supply and demand curves is relatively higher than that on an inelastic supply curve 2.
Elastic Supply = higher deadweight loss (larger tax wedge size) c. Elasticity of Demand Affect on Size of Deadweight Loss I. Inelastic Demand – Q responds only slightly to a change in price 1 revues is relatively smaller than that on an elastic demand curve 2. Inelastic Demand = Smaller Deadweight Loss (smaller tax wedge size) ii. Elastic Demand ; Q responds substantially to a change in price 1 . Deadweight Loss, the area of the triangle between the supply and demand curves is relatively larger than that on an inelastic demand curve 2.
Elastic Demand = Larger Deadweight Loss (larger tax wedge size) d. The lesson from this is clear: I. A tax has a deadweight loss because it induces buyers and sellers to change their behavior 1. Buyers consume less 2. Sellers produce less ii. These changes shrink the size of the market ii. The elasticity of supply and demand measure how much sellers and buyers respond to the changes in the price and therefore determine how much the tax distorts the market outcome e. The greater the elasticity of supply and demand, the greater the deadweight loss of a tax. . Deadweight Loss and Tax Revenue as Taxes Vary a. The Deadweight Loss and Tax Revenue Change as the Size of the Tax Changes I. The deadweight loss (reduction in total surplus from a tax) grows larger and larger as a the size of a tax rises ii. Deadweight loss grows more rapidly than the size of the tax because it is the area of the triangle. 1. The area of a triangle depends of the square Of it size 2. Therefore if a tax is doubled, the base and height of the triangle double and the deadweight loss increases by a factor of 4. Iii.
As the size of a tax increases, tax revenue grows until a certain point, where a large tax drastically reduces the size of a market to the point where tax revenue falls. B. In summation: I. Deadweight loss grows exponentially with tax size ii. Tax revenue first rises with tax size but as the tax get larger, the market shrinks so much that tax revenue starts to fall Chapter 9: Application: International Trade 1 . The Determinants of Trade a. Equilibrium without Trade: I. When an economy cannot trade in world markets, the price adjusts to balance domestic supply and demand ii.
Important to remember that total surplus measure both the benefit received by domestic producers and consumers participating in this market b. The World Price and Comparative Advantage I. The first step in trade for a country is to determine whether it will be an importer or exporter of a good; will it end up buying or selling that good. 1. Based on the world price: the prevailing price in the world markets for that good 2. If the world price of a good is higher than the domestic price, then a entry will export the good if trade is permitted 3.
Conversely, if the world price of a good is lower than the domestic price, then the country will import that good ii. In essence, comparing world price and domestic price of a good before trade indicates whether a county has a comparative advantage in producing that good. 1. If domestic price is low, cost of producing that good is low, suggesting a comparative advantage relative to the rest of the world 2. If domestic price is high, cost of producing that good is high, suggesting that foreign countries have comparative advantage 2. The Winner and Losers from Trade . The Gains and Losses of an Exporting Country I.
An exporting countries domestic price before trade would be below the world price ii. Once trade is allowed, the domestic price rises to equal the world price, as no seller would accept less than the world price, and no buyer would pay more. Iii. After the domestic price has risen to the world price, domestic SQ differs from domestic Q. 1 . Higher price lowers the Q, but sellers want to sell more at that price, raising SQ 2. Thus there is a surplus that can be exported. Iv. The market remains in equilibrium because the rest of the world is also now a part of it v.
Who is Better and Worse Off? 1. Domestic producers are better off because they can now sell the good at a higher price 2. Domestic consumers are worse off because they have to pay a higher price 3. To measure these gains and losses, we look at changes in the consumer and producer surplus a. After trade, consumer surplus is reduced in area to the area between the demand curve and the world price b. After trade, producer surplus is increased to the area between the supply and the world price vi. These welfare calculations show who wins and loses in an exporting country 1 .
Sellers benefit (increases producer surplus) 2. Buyer are worse off ( decrease in consumer surplus) 3. HOWEVER the gains of sellers exceed the losses of buyers and the total surplus of the country increases b. The Gains and Losses of an Importing Country I. An importing country domestic price before is above the world price ii- Once trade is allowed, the domestic price must equal the world price. Iii. After the domestic price has lowered to the world price, domestic SQ is less than domestic Q and the domestic SQ is bought from other countries, thus making the country an importer iv.
Who is Better or Worse Off? 1 . When trade forces domestic price to fall, domestic consumers are better if as they pay a lower price for that good 2. When trade forces domestic price to fall, domestic producers are worse off as they have to sell at a lower price 3. To measure these gains and losses, we look at changes in the consumer and producer surplus a. After trade, consumer surplus is increased to the area between the demand curve and the world price b. After trade, producer surplus is decreased to the area between the supply curve and world price v.
These welfare calculations show who wins and who loses from trade in an importing country 1 . Domestic consumer/buyers benefit because consumer surplus is increased 2. Domestic producers/sellers are worse off because producer surplus is reduced 3. The gains of buyers exceed the losses of sellers and total surplus is increased. Trade raises the economic well-being of a nation in the sense that the gains of the winners exceed the losses of the losers c. The Effects of a Tariff I. A Tariff – a tax on imported goods 1 . As a tax on an imported good, a tariff is only the concern of an importing country. . If a country is an exporter, a tariff has no effect on it ii. A tariff raises the price of imported textiles above the world price by the amount of the tariff. 1 . Domestic suppliers can then sell their good for more (the world price + the tariff) 2. Thus the price of a good – both imported and domestic rises by the amount of the tariff and is, therefore, closer to the price that would prevail without trade. Iii. The change in price affects the behavior of domestic buyers and sellers. 1 . Because the price of the good is higher (due to tariff), domestic Q is reduced 2.
Because the price of the good is higher (due to tariff) and domestic sellers can raise their price, domestic SQ raises. 3. Thus, the tariff reduces the quantity of imports and moves the domestic rake closer to its equilibrium without trade. Iv. Gains and losses from a tariff 1 . Because the tariff raises domestic price, domestic sellers are better off and domestic buyers are worse off 2. Government revenue increases also 3. Refer to figure below for how surplus uses change: 4. After a tariff, we find that total surplus in the market decreased by the area D+F.
This fall in total surplus is called deadweight loss of the tariff a. A tariff causes deadweight loss because it is a type of tax b. It distorts incentives and makes the allocation of resources less efficient d. Other Benefits of International Trade I. The case for free trade can be made even stronger because there are several other economic benefits of trade beyond those emphasized in the standard analysis: 1 . Increased variety of goods. Goods produced in different countries are not exactly the same. Free trade gives consumers in all countries greater variety from which to choose. 2.
Lower costs through economies of scale. Some goods can be produced at low cost only if they are produced in large quantities – a phenomenon called economies of scale. A firm in a small country cannot take full advantage Of economies Of scale if it an sell only in a small domestic market. Free trade gives firms access to larger world markets and allows them to realize economies of scale fully. 3. Increased competition. A company shielded from foreign competitors is more likely to have market power, which in turn gives it the ability to raise prices above competitive levels. This is a type of market failure.
Opening up trade fosters competition and gives the invisible hand a better chance to work its magic. 4. Enhanced flow of ideas. The transfer of technological advances around the world is often thought to be linked to the trading of the goods that embody those advances. The best way for a poor agricultural nation to learn about the computer revolution, for instance, is to buy some computers from abroad rather than trying to make them domestically. 3. The Arguments for Restricting Trade a. The Jobs Arguments I. Opponents of free trade often argue that trade with other countries destroys domestic jobs. . If a good is imported, the quantity produced domestically falls 2. As a result some workers in this particular industry for this good would lose their job ii. Yet free trade creates jobs at the same time that it destroys them 1 . With trade, a country can specialize where they have a imperative advantage 2. While some jobs may be lost in one industry, jobs in another may grow b. The National Security Argument I. When an industry is threatened with competition from other countries, opponents of free trade often argue that the industry is vital for national security. 1 .
For Example: foreign dependency on steel could affect national security if war were to break out, as the domestic industry would not be able to produce the need quantity ii. However, one should be wary of this argument when it is made by representatives of industry as companies have incentive to exaggerate c. The Infant-Industry Argument I. New industries sometimes argue for temporary trade restrictions to help them get started. Ii. After a period of protection, the argument goes, these industries will mature and be able to compete with foreign firms iii. Economists are skeptical because: 1. Picking winners” is extremely difficult 2. Sometime the “ temporary’ policy is hard to remove because of political circumstances d. The Unfair-Competition Argument I. A common argument is that free trade is desirable only if all countries play by the same rules. Ii. If firms in different countries are subject to different saws and regulations, then it is unfair (the argument goes) to expect the firms to compete in the international marketplace. E. The Protection-as-a- Bargaining-Chip Argument I. Another argument for trade restrictions concerns the strategy of bargaining.
Many policymakers claim to support free trade but, at the same time, argue that trade restrictions can be useful when we bargain with our trading partners. Ii. This is done, for example, with threats of tariffs on the importer iii. If the threat works, it reduces its own economic welfare; if it does not work, it could lose prestige in international affairs Chapter 10: Externalities 1 . Markets sometimes fail to allocate resources efficiently a. Externalities arise when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives any compensation for that effect I.
If the impact on the bystander is adverse, it is a negative externalities ii. If is it beneficial, it is called a positive externalities b. In the presence of externalities, society interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market to include the well-being of bystanders who are affected indirectly. . Market equilibrium is not efficient when there are externalities ii. This is because the equilibrium fails to maximize the total benefit to society as a whole c. Examples: I. Exhaust from automobiles is a negative externalities.
Federal gob. Tries to solve this problem by setting emission standards and taxing gasoline. Ii. Restored historic buildings are a positive externalities because people who walk or ride by them can enjoy the beauty and the sense of history that these buildings provide. Iii. Barking dogs are a negative externalities d. In each of these cases, a decision maker fails to take account of the external effects of his or her behavior. The gob. Responds by trying to influence this behavior to protect the interests of bystanders. 2. Externalities and Market Inefficiency a.
Welfare Economics: A Recap I. In the absence of government intervention, the price of a good adjusts to balance the supply and demand for that good (market equilibrium). Ii. In this way, the market allocates resources in a way that maximizes the sum of producer and consumer surplus. B. Negative Externalities I. Suppose production of a good emits a pollution 1 . Because this pollution creates a health risk for society, it is a negative externally ii. Because of the externalities, the cost to society of producing this good is larger than the cost to the producers 1 .
The social cost includes the private costs of the good producers plus the costs to the bystanders affected by the pollution 2. The social cost curve is above the supply curve because it takes into account the external costs imposed on society by production of the good 3. The difference between the social cost curve and supply curve represents the cost of the pollution emitted iii. The optimum quantity of good to produce from the standpoint of society is where the demand curve crosses he social cost curve 1. The optimum point quantity, SUBOPTIMAL, is less than the market equilibrium quantity. . This inefficiency occurs because the market equilibrium reflects only the private costs Of production. Iv. This optimum quantity outcome can be achieved through a tax on the good production 1 . Such a tax would shift the supply curve for the good upward by the size of the tax 2. If the tax accurately reflected the external cost of pollutants, the new supply curve would coincide with the social cost curve v. The use of such a tax is called internalizing the externalities – or altering incentives so that people take account of the external affects of their actions. C. Positive Externalities I.
Although some activities impose a cost on bystanders, others yield benefits. Ii. For example, consider education 1 . Beyond private benefits, education also yields positive externalities a. Such as more education population, more educated voters b. Which means better government for everyone c. Lower crime rates d. Technological advances lead to higher productivity and wages for everyone 2. Because the social value is greater than the private value, the social value curve lies above the demand curve iii. The social value curve: 1 . The optimal quantity is found where the social value curve and supply curve intersect. . Hence, the socially optimal quantity is greater than the quantity determined by the private market iv. Once again, the government can correct this market failure by inducing market participants to internalize the externalities 1 . The response is the exact opposite of negative externalities: a subsidy (rather than a tax) 2. To move the market equilibrium closer to the social optimum, a positive externalities requires a subsidy. 3. Public Policies toward Externalities a. In practice, both public policymakers and private individuals respond to externalities in various ways.