Transcript Chapter 6

Chapter 6
Wealth Creation
And Destruction
1
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
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What is wealth?
What creates wealth?
How is wealth destroyed?
What is consumers’ surplus?
What is producers’ surplus?
When is total surplus to society maximized?
What is deadweight loss?
How do government set prices, taxes and
subsidies create deadweight loss?
• How do innovations affect a market economy?
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What Is Wealth?
• The value of a good is the most its owner
would pay for it.
• An individual’s wealth is the value of all his
possessions.
• The total wealth of society is the sum of
each individual's wealth.
• Money transfers have no effect on the
wealth of society.
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Wealth Creation
• Voluntary trade increases wealth of society
since it moves goods to someone who
places higher value on them.
• Production as well as trade can increase
wealth.
• Trade allows the manufacturer to produce
goods. A manufacturer will only sell a good
for more than it costs to increase wealth
and buyer will only pay an amount less
than what the good is worth to her.
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Wealth Creation
• The growth rate of wealth creation over
the long run is the most important force
shaping a society.
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Destruction Of Wealth By Governments
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Rent control:
It reduces trade by eliminating incentives of some sellers
to sell.
Minimum wage:
It reduces trade by eliminating incentives of some
buyers to buy.
Taxes:
Taxes reduce trade by eliminating incentives of some
buyers as well as sellers as a tax raises consumer’s
price and lowers producer’s price.
Subsidies:
Subsidies destroy wealth by encouraging wastage and
misallocation of resources.
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Destruction Of Wealth By Governments
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Forced sharing:
It destroys wealth by reducing incentives for hard work.
Theft:
Unlike voluntary trade, theft may not move goods to
someone who places higher value on them.
Eminent domain
= Power of a government to take private property.
The society’s wealth is destroyed when politicians
abuse the power of eminent domain for their own use.
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• The maximum
amount consumers
are willing to pay for
goods determine the
height of demand
curves.
Price of Hats
Willingness To Pay And Demand
$10
$9
$8
$7
$6
$5
$4
$3
$2
$1
$0
0
1
2
3
4
5
6
7
8
9
Quantity Demanded of Hats
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Consumer’s Surplus
• The difference between
the most that consumers
are willing to pay for a
good and its price
= Net benefit that
consumers receive after
buying a good.
• The greater the
consumer’s surplus, the
better off the consumers
are.
Most
Consumer’s
willing to surplus if
pay
price =$2
Abe
$7
$5
Ben
$6
$4
Calvin
$5
$3
Debbie
$4
$2
Ed
$3
$1
Fran
$2
$0
Gene
$1
Not bought
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Consumer’s Surplus
• Total consumer’s
surplus
= The area between the
demand curve and
price.
Price
Additional
consumers’
surplus to old
consumers
Consumers’
surplus to new
consumers
Equilibrium
Old price
$9
• At lower price
= Increase in
consumer’s surplus.
New price
$7
Demand
100
130
Quantity
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Production Cost And Supply
$3.50
$3.00
Price of Hats
• The cost of producing
goods determines the
height of supply
curves.
$2.50
$2.00
$1.50
$1.00
$0.50
$0.00
0
1
2
3
4
5
Quantity Supplied of Hats
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Producer’s Surplus
• The difference between
Factory
the price and the cost of
producing a good
= Net benefit that producers
A
receive after selling a
B
good.
C
Cost to Producer’s
Make
Surplus if
Price =$3
• The greater the
producer’s surplus, the
better off producers are.
$1.00
$2.00
$1.50
$1.50
$2.00
$1.00
D
$3.00
$0
E
$3.50
Not made
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Producer’s Surplus
• Total producer’s
surplus
= The area between the
supply curve and
price.
Price
Equilibrium
Supply
Market price
Quantity
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Total Surplus
• Total surplus
= Consumer’s surplus
+ Producer’s surplus.
• The free market
equilibrium price
maximizes the total
surplus.
Price
Supply
$10
Demand
5,000
Quantity
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Deadweight Loss
Government set price
above equilibrium:
• Money transfer from
consumers to producers.
Price
Consumers’
surplus
Supply
Deadweight
Loss
Government
set price
$12
• Deadweight loss
= Loss of wealth because of
some lost trades.
= Net loss of resources to
society.
Demand
5,000
4,000
Producers’
surplus
Quantity
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Deadweight Loss
Government set price below
equilibrium:
• Money transfers from
producers to consumers.
Consumers’
surplus
Deadweight
Loss
• Deadweight loss
= Loss of wealth because of
some lost trades.
• Additional deadweight loss of
government created shortage
because of the opportunity
cost of time for waiting.
Supply
Producers’
surplus
Government
set price
$6
Demand
3,000
9,000
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Wealth Maximizing Equilibrium
• To maximize the wealth of
society, the goods must
be produced only if the
demand curve is above
the supply curve.
• Producing too much of a
good means that the
resources used to make
the good could be better
used elsewhere.
Supply
Demand
X
Y
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Supply, Demand And Taxes
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A tax:
Increases the price
consumers pay.
Decreases the price
producers get.
Raises tax revenue
for the government.
Reduces quantity of
the good traded.
Creates deadweight
loss to society.
Price
consumers
pay
Price
Deadweight
Loss
Supply
CS
$11.10
$10
Tax
Revenue
$9.10
PS
Price
producers
receive
4,200 5,000
Demand
Quantity
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Deadweight Loss of Tax
• The deadweight loss of the tax is caused by
consumers no longer buying some goods that
they value more than it costs to produce.
• By causing market to under produce, tax
destroys society’s wealth.
• Any tax is shared by both consumers and
producers regardless of on whom it is imposed.
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Supply, Demand and Subsidies
A subsidy
• Decreases the price
consumers pay
• Increases the price producers
get
• Creates costs for the
government
• Increases quantity of goods
where supply curve is above
the demand curve
• Creates deadweight loss to
society by overproducing
goods and wasting resources
Price
Supply
Deadweight
Loss
$12.70
$10
$7.70
Demand
5,000
5,800
Quantity
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Innovation
• Economic growth is driven by innovations.
Innovations create wealth.
• Markets do an extraordinary job of
promoting wealth and creating
innovations.
• Marketplace innovations include small
improvements to existing products along
with major innovations in development of
new products.
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Innovation
• Markets ration resources to only those
potential innovations that will appeal to
consumers.
• Markets send signals to innovators
allowing them to correct their errors.
• Innovations in production can eliminate
some jobs, yet society as a whole gains
wealth from these job-destroying
technologies by freeing up resources.
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Freedom and Wealth Creation
• Markets make magnificent coordinators of
economic activities.
• History shows that free market economies
produced vastly more wealth than centrally
planned economies.
• Central planners can never match the
wealth creating abilities of a free economy.
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Do You Know?
• How can one person giving a good to another increase
the total wealth of society?
Voluntary trade increases the wealth of society. The
person buying a good places higher value on it than the
person selling it. Thus both people have net gains
increasing society's wealth.
• What is total surplus?
Total surplus is the sum total of the net benefits all
consumers and all producers gain from trade and the
value society gets from production and consumption of a
good.
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Do You Know?
• Does it matter if a sales tax must be paid by buyers or
sellers?
No. Any tax is shared by both consumers and producers
regardless of on whom it is imposed. It reduces quantity
trade creating deadweight loss.
• Why does the marketplace promote innovations?
Innovations create wealth, improve welfare of people
and promote economic growth.
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Summary
• Value of a good is the most its owner
would pay for it.
• An individual’s wealth is the value of all his
possessions.
• Trade, production and innovation create
wealth.
• Wealth can be destroyed by various
government controls and interference.
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Summary
• Consumer’s surplus = The maximum price consumer
would have paid – Actual price.
• Producer’s surplus = The good’s price – The cost to the
seller of making the good.
• Total surplus = Consumer’s surplus + Producer’s surplus
• Total surplus is maximized at the supply and demand
determined equilibrium.
• Government set prices, taxes and subsidies create
deadweight loss.
• Deadweight loss = Loss of wealth because of some lost
trades.
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Coming Up
Why do we trade?
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