Transcript Micro Unit V Notes

McConnell and Brue Chapters 4, 28, 29, and 32
 What role does government play in a market economy?
 What are some responsibilities/functions of federal government?
 State government?
 Local government?
Enforce laws and contracts.
2. Maintain competition.
3. Redistribute income. Provide an economic safety net.
1.
4. Provide public goods:
 Nonexclusion: individuals cannot be excluded from the benefits of a good or
service, regardless of whether or not they have paid for it.
 Shared consumption: when one person’s use or consumption of a good or
service does not reduce its usefulness to others.
5. Correct market failures:
 Provide market information.
 Correct negative externalities.
 Subsidize goods with positive externalities.
 Externality: the uncompensated impact of one person’s actions on the
well-being of a bystander
 Free goods provide a special challenge for economic analysis.
 Most goods in our economy are allocated in markets…
 When goods are available free of charge, the market forces that normally
allocate resources in our economy are absent.
 When a good does not have a price attached to it, private markets cannot
ensure that the good is produced and consumed in the proper amounts.
 In such cases, government policy can potentially remedy the market
failure that results, and raise economic well-being.
 When thinking about the various goods in the economy, it is useful to
group them according to two characteristics:
 Is the good excludable?
 Is the good rival?
• Excludability
– Excludability refers to the property of a good whereby a person can be
prevented from using it.
• The seller controls who can receive benefits from the product.
• Rivalry
– Rivalry refers to the property of a good whereby one person’s use diminishes
other people’s use.
• When one buys or consumes the product, it is not available for someone else.
 Four Types of Goods
 Private Goods
 Public Goods
 Common Resources
 Natural Monopolies
• Private Goods
– Are both excludable and rival.
• Public Goods
– Are neither excludable nor rival.
• Common Resources
– Are rival but not excludable.
• Natural Monopolies
– Are excludable but not rival.
Rival?
Yes
Yes
No
Private Goods
Natural Monopolies
• Ice-cream cones
• Clothing
• Congested toll roads
• Fire protection
• Cable TV
• Uncongested toll roads
Common Resources
Public Goods
• Fish in the ocean
• The environment
• Congested nontoll roads
• Tornado siren
• National defense
• Uncongested nontoll roads
Excludable?
No
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 A free-rider is a person who receives the benefit of a good but avoids
paying for it.
 Since people cannot be excluded from enjoying the benefits of a public
good, individuals may withhold paying for the good hoping that others
will pay for it.
 The free-rider problem prevents private markets from supplying public
goods.
 Solving the Free-Rider Problem
 The government can decide to provide the public good if the total benefits
exceed the costs.
 The government can make everyone better off by providing the public good
and paying for it with tax revenue.
 National Defense
 Basic Research
 Fighting Poverty
 Cost-benefit analysis refers to a study that compares the costs and
benefits to society of providing a public good.
 In order to decide whether to provide a public good or not, the total
benefits of all those who use the good must be compared to the costs of
providing and maintaining the public good.
 A cost-benefit analysis would be used to estimate the total costs and
benefits of the project to society as a whole.
 It is difficult to do because of the absence of prices needed to estimate social
benefits and resource costs.
 The value of life, the consumer’s time, and aesthetics are difficult to assess.
 Common resources, like public goods, are not excludable. They are
available free of charge to anyone who wishes to use them.
 Common resources are rival goods because one person’s use of the
common resource reduces other people’s use.
 The Tragedy of the Commons is a parable that illustrates why common
resources get used more than is desirable from the standpoint of society as
a whole.
 Common resources tend to be used excessively when individuals are not
charged for their usage.
 This is similar to a negative externality.
 Clean air and water
 Congested roads
 Fish, whales, and other wildlife
 Will the market protect me?
Private
Ownership and
the Profit
Motive!
 Recall: Adam Smith’s “invisible hand” of the marketplace leads self-
interested buyers and sellers in a market to maximize the total benefit
that society can derive from a market.
But market failures can still happen.
• An externality refers to the uncompensated impact of one person’s
actions on the well-being of a bystander.
• Externalities cause markets to be inefficient, and thus fail to maximize
total surplus.
• An externality arises...
. . . when a person engages in an activity that influences the well-being of a
bystander and yet neither pays nor receives any compensation for that effect.
 When the impact on the bystander is adverse, the externality is called a
negative externality.
 Negative externalities lead markets to produce a larger quantity than is
socially desirable.
 When the impact on the bystander is beneficial, the externality is called a
positive externality.
 Positive externalities lead markets to produce a smaller quantity than is
socially desirable.
 Negative Externalities
 Automobile exhaust
 Cigarette smoking
 Barking dogs (loud pets)
 Loud stereos in an apartment building
 Positive Externalities
 Immunizations
 Restored historic buildings
 Research into new technologies
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
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 The Market for Aluminum
 The quantity produced and consumed in the market equilibrium is efficient
in the sense that it maximizes the sum of producer and consumer surplus.
 If the aluminum factories emit pollution (a negative externality), then the
cost to society of producing aluminum is larger than the cost to aluminum
producers.
 The Market for Aluminum
 For each unit of aluminum produced, the social cost includes the private
costs of the producers plus the cost to those bystanders adversely affected by
the pollution.
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
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 The intersection of the demand curve and the social-cost curve
determines the optimal output level.
 The socially optimal output level is less than the market equilibrium quantity.
 Internalizing an externality involves altering incentives so that people
take account of the external effects of their actions.
 Achieving the Socially Optimal Output
 The government can internalize an externality by imposing a tax on the
producer to reduce the equilibrium quantity to the socially desirable quantity.
 When an externality benefits the bystanders, a positive externality exists.
 The social value of the good exceeds the private value.
 A technology spillover is a type of positive externality that exists when a
firm’s innovation or design not only benefits the firm, but enters society’s
pool of technological knowledge and benefits society as a whole.
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
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 The intersection of the supply curve and the social-value curve determines
the optimal output level.
 The optimal output level is more than the equilibrium quantity.
 The market produces a smaller quantity than is socially desirable.
 The social value of the good exceeds the private value of the good.
• Internalizing Externalities: Subsidies
– Used as the primary method for attempting to internalize positive
externalities.
• Industrial Policy
– Government intervention in the economy that aims to promote technology-
enhancing industries
• Patent laws are a form of technology policy that give the individual (or firm) with
patent protection a property right over its invention.
• The patent is then said to internalize the externality.
 Government action is not always needed to solve the problem of
externalities.
 Moral codes and social sanctions
 Charitable organizations
 Integrating different types of businesses
 Contracting between parties
• The Coase Theorem is a proposition that if private parties can bargain
without cost over the allocation of resources, they can solve the problem
of externalities on their own.
– 3 Conditions
• Property ownership is clearly defined
• The number of people involved is small
• Bargaining costs (transaction costs) are negligible
• Transactions Costs
– Transaction costs are the costs that parties incur in the process of agreeing
to and following through on a bargain.
 Sometimes the private solution approach fails because transaction costs
can be so high that private agreement is not possible.
 When externalities are significant and private solutions are not found,
government may attempt to solve the problem through . . .
 command-and-control policies.
 market-based policies.
 Command-and-Control Policies
 Usually take the form of regulations:
 Forbid certain behaviors.
 Require certain behaviors.
 Examples:
 Requirements that all students be immunized.
 Stipulations on pollution emission levels set by the Environmental Protection Agency
(EPA).
 Market-Based Policies
 Government uses taxes and subsidies to align private incentives with social
efficiency.
 Pigovian taxes are taxes enacted to correct the effects of a negative
externality.
 Examples of Regulation versus Pigovian Tax
 If the EPA decides it wants to reduce the amount of pollution coming from a
specific plant. The EPA could…
 tell the firm to reduce its pollution by a specific amount (i.e. regulation).
 levy a tax of a given amount for each unit of pollution the firm emits (i.e.
Pigovian tax).
 Market-Based Policies
 Tradable pollution permits allow the voluntary transfer of the right to
pollute from one firm to another.
 A market for these permits will eventually develop.
 A firm that can reduce pollution at a low cost may prefer to sell its permit to a
firm that can reduce pollution only at a high cost.
 Governments levy taxes to raise revenue for public projects.
 Taxes discourage market activity.
 When a good is taxed, the
quantity sold is smaller.
 Buyers and sellers share
the tax burden.
 Tax incidence is the manner in which the burden of a tax is shared
among participants in a market.
 The economic burden of a tax is independent of the legal burden.
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax ($0.50)
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Equilibrium
with tax
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
tax
S2
Equilibrium
with tax
S1
Tax ($0.50)
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90
100
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
So, how is the burden of the tax divided?
 The burden of a tax falls more
heavily on the side of the
market that is less elastic.
 How do taxes affect the economic well-being of market participants?
 It does not matter whether a tax on a good is levied on buyers or sellers
of the good . . . the price
paid by buyers rises, and
the price received by
sellers falls.
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
 A tax places a wedge between the price buyers pay and the price sellers
receive.
 Because of this tax wedge, the quantity sold falls below the level that
would be sold without a tax.
 The size of the market for that good shrinks.
• Tax Revenue
– T = the size of the tax
– Q = the quantity of the good sold
T  Q = the government’s tax revenue
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
Copyright © 2004 South-Western
 Changes in Welfare
 A deadweight loss is the fall in total surplus that results from a market
distortion, such as a tax.
 The change in total welfare includes:
 The change in consumer surplus,
 The change in producer surplus, and
 The change in tax revenue.
 The losses to buyers and sellers exceed the revenue raised by the government.
 This fall in total surplus is called the deadweight loss.
• What determines whether the deadweight loss from a tax is large or small?
– The magnitude of the deadweight loss depends on how much the quantity
supplied and quantity demanded respond to changes in the price.
– That, in turn, depends on the price elasticities of supply and demand.
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
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(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
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(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
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(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
 The greater the elasticities of demand and supply:
 the larger will be the decline in equilibrium quantity and,
 the greater the deadweight loss of a tax.
• The Deadweight Loss Debate
– Some economists argue that labor taxes are highly distorting and believe that
labor supply is more elastic.
– Some examples of workers who may respond more to incentives:
• Workers who can adjust the number of hours they work
• Families with second earners
• Elderly who can choose when to retire
• Workers in the underground economy (i.e., those engaging in illegal activity)
Wage
Labor supply
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Labor demand
0
Quantity
of Labor
Copyright©2003 Southwestern/Thomson Learning
 With each increase in the tax rate, the deadweight loss of the tax rises
even more rapidly than the size of the tax.
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
Copyright © 2004 South-Western
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
 As the size of a tax increases, its deadweight loss quickly gets larger.
 By contrast, tax revenue first rises with the size of a tax, but then, as the
tax gets larger, the market shrinks so much that tax revenue starts to fall.
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size
Copyright © 2004 South-Western
(b) Revenue (the Laffer curve)
Tax
Revenue
0
Tax Size
Copyright © 2004 South-Western
 The Laffer curve depicts the relationship between tax rates and tax
revenue.
 Supply-side economics refers to the views of Reagan and Laffer who
proposed that a tax cut would induce more people to work and thereby
have the potential to increase tax revenues.
100
80
60
40
20
0
1789
Taxes paid in Ben
Franklin’s time
accounted for 5
percent of the
average
American’s
income.
100
80
Today, taxes
account for up
to a third of
the average
American’s
income.
60
40
20
0
1789
Today
Revenue as
Percent of 35
GDP
Total government
30
25
State and local
20
15
Federal
10
5
0
1902
1913
1922 1927 1932
1940
1950
1960
1970
1980
1990
Copyright © 2004 South-Western
2000
• The U.S. federal government collects about two-thirds of the taxes in our
economy.
– The largest source of revenue for the federal government is the individual
income tax.
• The marginal tax rate is the tax rate applied to each additional dollar of income.
• Higher-income families pay a larger percentage of their income in taxes.
 Other taxes
 Payroll Taxes: tax on the wages that a firm pays its workers.
 Social Insurance Taxes: taxes on wages that is earmarked to pay for Social Security
and Medicare.
 Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic
beverages.
 Federal Government Spending
 Government spending includes transfer payments and the purchase of public
goods and services.
 Transfer payments are government payments not made in exchange for a good or a
service.
 Transfer payments are the largest of the government’s expenditures.
 Federal Government Spending
 Expense Category:
 Social Security
 National Defense
 Income Security
 Net Interest
 Medicare
 Health
 Other
 State and local governments collect about 40 percent of taxes paid.
 Receipts
 Sales Taxes
 Property Taxes
 Individual Income Taxes
 Corporate Income Taxes
 Federal government
 Other
Taxes
$
 Spending
 Education
 Public Welfare
 Highways
 Other
 Policymakers have two objectives in designing a tax system...


Efficiency
Equity
 One tax system is more efficient than another if it raises the same amount
of revenue at a smaller cost to taxpayers.
 An efficient tax system is one that imposes small deadweight losses and
small administrative burdens.
 The Cost of Taxes to Taxpayers
 The tax payment itself
 Deadweight losses
 Administrative burdens
 Complying with tax laws creates additional deadweight losses.
 Taxpayers lose additional time and money documenting, computing, and
avoiding taxes over and above the actual taxes they pay.
 The administrative burden of any tax system is part of the inefficiency it
creates.
 The average tax rate is total taxes paid divided by total income.
 The marginal tax rate is the extra taxes paid on an additional dollar of
income.
 A lump-sum tax is a tax that is the same amount for every person,
regardless of earnings or any actions that the person might take.
 How should the burden of taxes be divided among the population?
 How do we evaluate whether a tax system is fair?
 The benefits principle is the idea that people should pay taxes based on
the benefits they receive from government services.
 An example is a gasoline tax:
 Tax revenues from a gasoline tax are used to finance our highway system.
 People who drive the most also pay the most toward maintaining roads.
 The ability-to-pay principle is the idea that taxes should be levied on a
person according to how well that person can shoulder the burden.
 The ability-to-pay principle leads to two corollary notions of equity.
 Vertical equity
 Horizontal equity
 Vertical equity is the idea that taxpayers with a greater ability to pay
taxes should pay larger amounts.
 For example, people with higher incomes should pay more than people with
lower incomes.
• Vertical Equity and Alternative Tax Systems
– A proportional tax is one for which high-income and low-income taxpayers
pay the same fraction of income.
– A regressive tax is one for which high-income taxpayers pay a smaller
fraction of their income than do low-income taxpayers.
– A progressive tax is one for which high-income taxpayers pay a larger
fraction of their income than do low-income taxpayers.
 Horizontal Equity
 Horizontal equity is the idea that taxpayers with similar abilities to pay taxes
should pay the same amounts.
 For example, two families with the same number of dependents and the same
income living in different parts of the country should pay the same federal
taxes.
Copyright©2004 South-Western
 The difficulty in formulating tax policy is balancing the often conflicting
goals of efficiency and equity.
 The study of who bears the burden of taxes is central to evaluating tax
equity.
 This study is called tax incidence.
 If the goal is equality, we must be able to measure income inequality
 Two tools
 Lorenz Curve
 Gini Coefficient
 Lorenz Curve
 shows the degree of
inequality that exists in the
distributions of two
variables, and is often used
to illustrate the extent that
income or wealth are
distributed unequally in a
particular society.
Gini Coefficient =
area between Lorenz curve and diagonal___
total area below the diagonal
=
A / A+B
• Gini Coefficient
– Closer to zero means less inequality
– Closer to one means more inequality
• How do we get closer to zero?
– More progressive tax system?
• Estate and gift taxes
• Graduated income tax
– More redistribution of income?
• Social programs
• Medicare and Medicaid
• Welfare and unemployment assistance
• Asymmetric Information
– Unequal Knowledge
• Adverse Selection
– When info known by the first party to a contract or agreement is not known by the second
party, causing the second party to incur major losses
• Moral Hazard
– Tendency for one party in a contract or agreement to alter behavior in ways that could be
costly to the other party
• Principal-Agent Problem
– Interests of the principal does not align with interests of the agent