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ECON 1000
David Stamos

Welfare economics: asses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity. 1. Efficiency: How well the economies resources are used and allocated. 2. Equity: how society’s goods and rewards are/ should be, distributed among its different members and how the associate costs should be assigned. Consumer and producer surplus Consumer surplus: Distance between market price and individual valuation (relates to the demand side of the market) Supplier surplus: excess of market price over the reservation price of the supplier. (relates to the supply side of the market) The suppliers and demanders are willing to participate in this market because they earn this surplus. Computing total surplus The sum of each participant’s surplus in defines the total surplus in the market. Consumer surplus is the difference between the demand curve and the equilibrium price (forming a triangle) Computed as half the base X perpendicular height. CS = (demand value – price) = ½ X base X perpendicular height CS = ½ X 500 X 5 = 1250 Efficient market outcomes Efficient market: Maximizes the sum of producer and consumer surpluses. The market mechanism, in which suppliers and demanders freely trade, leaves no scope for additional trades that would improve the well-being of participants. Taxation and efficiency Tax wedge: tax wedge is placed between the price consumers must pay and the price that the supplier receives. The price received by the supplier is lower than that paid by the buyer by the amount of the tax wedge. Two burdens associated with tax 1. Revenue burden: the amount of tax revenue paid by the market participants and received by the government. 2. Excess burden (dead weight loss): component of the economic surplus that is not transferred to the government in the form of tax revenue. It is the component of consumer and producer surpluses forming a net loss to the whole economy. Distortions: Impact of taxes and other influences that result in an efficient use of the economy’s recourses. Elasticity’s revisited Elasticity is important in determining the size of the dead weight loss. Triangle ABC forms the area of deadweight loss. A wage tax When income tax is imposed, the net wage falls. Less labour is supplied because the net wage is lower. The government now generates tax revenue. A larger reduction in labour supply is generally accompanied by a bigger excess burden. Market failures Negative externalities Externality: impact individuals who are not participants in the market in question. The effects of the externalities may not be captured in the market price. Markets characterized by externalities are not efficient. An externality creates a divergence between private costs/ benefits and social costs/ benefits. This is represented on a graph by the difference between the cost to the supplier and the full cost of society. As output increases the external cost per unit rises, because the difference between the two supply curves increases with output. Corrective tax: Seek to direct the market towards a more efficient output. A corrective tax is imposed on the production of the good that causes the externality; with the appropriate increase in the price, consumers will
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