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Complete Study Guide for Exam 2 (got 94%)

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University of Miami
ECO 211

Ch. 7: Welfare Economics: studies how the allocation of resources affects economic wellbeing (of all participants in the economy/market) Consumer Surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it – measures the benefit buyers receive from participating in a market – area below the demand curve and above the price – WTP - p • Willingness to Pay: the maximum amount that a buyer will pay for a good o If p is greater than the willingness to pay, consumer will not buy the good • Example: mint condition Elvis Presley guitar Buyer Price John 100 Paul 80 George 70 Ringo 50 o Winning bid would go to John for $80.01 and John gains around a $20 CS o If there are multiple guitars we can use their WTP to create a demand curve o Marginal Buyer: the buyer who would leave the market first if the price were any higher (Ringo) – p affects the WTP of the marginal buyer, if p decreases, CS increases Price Buyers QD > 100 none 0 > 80 J 1 > 70 J, P 2 > 50 J, P, G 3 < 50 J, P, G, R 4 o If p = 50 there are 4 buyers, o CS = (100-50) + (80-50) + (70-50) + (50-50) = 100 o A =  in CS due to existing buyers paying  P o B =  in CS due to marginal buyers now in the market o In a market with many buyers, steps from each buyer are so small that they form a smooth, straight curve Producer Surplus: the amount a seller is paid for a good minus the seller’s cost of providing it – measures the benefit sellers receive from participating in a market – area below the price and above the demand – P – cost • Cost: the value of everything a seller must give up to produce a good o Economic cost or opportunity cost – a measure of willingness to sell – if p is less than the cost, the seller will not sell the good • Example: Painting a house Seller Cost Mary 900 Frida 800 Georgia 600 Grandma 500 o Winning bid would go to Grandma for $599 and she gains around a $100 PS o If there are multiple house we can use their cost to create a supply curve o Marginal Seller: the seller who would leave the market first if the price were any lower (Mary) - p reflects the cost to the marginal seller, if p increase, PS increases Price Sellers Q S > 900 M, F, G, GR 4 > 800 F, G, GR 3 > 600 G, GR 2 > 500 GR 1 < 500 none 0 o If p = 700 there are 2 sellers, o PS = (700-600) + (700-500) = 300 o If p increases, PS increases – p = 850, there are 3 sellers o PS = (850-600) + (850-500) + (850-800) = 650 o The Q seller receives no additional surplus – marginal seller o C =  in PS for sellers that were already in the mkt. selling at P o D =  in PS for new sellers who have entered the market Equilibrium and Market Efficiency: o The Benevolent Social Planner: market has a social planner allocating all goods and services and his objective is to maximize total welfare (benefit) o His methodology: o Graphs all sellers costs = S o Graphs all buyers WTP = D o Allocates the 1 cookie so that the guy with the lowest cost sells to the guy with the highest WTP o The gain in surplus will be the value to buyer – cost to seller th o At the Q cookie the seller’s cost is equal to the buyer’s value – additional surplus = 0 o Any cookie about the Q surplus will be lost and seller’s cost for next cookie is greater than the value of the buyer o This area represents the largest possible surplus in this market Efficiency: if an allocation of resources maximizes total surplus received by society o If an allocation is not efficient, some potential gains from trade among buyers/sellers are not being realized o An allocation is inefficient if a good is not being produced by the sellers with the lowest cost Equality: the property of distributing economic prosperity uniformly among society (whether the various buyers/sellers in the market have a similar level of economic well- being) – sharing pieces of the pie TS = CS + PS (value to buyers – cost to sellers) o The free market allocation is efficient because o It is maximized o The seller with the lowest cost sells to the buyers who value it the most o Everyone who is willing to sell it does and everyone who is willing to buy it does o Free markets allocate the supply of goods to the buyers who value them most highly (WTP) o Free markets allocate the demand of goods to the sellers who can produce them at the lowest cost o Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus o Market outcome makes the sum of CS and PS as large as it can be, equilibrium outcome is an efficient allocation of resources – laissez faire This is why markets are usually a good way of organizing economic activity – surplus is maximized (assuming there is no market power: the ability to influence prices and externalities: cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers – both can cause market failure) Ch. 6 (Taxes): o Assume the government levies a flat tax on the market o Government requires wither the buyer or seller to pay a certain dollar amount for every good purchased or sold Tax on Buyers: government imposes a flat tax, t, for every good purchased by buyers, the tax changes the price p = price buyer pays o P = P + t the tax  price by t - - - Q  Tax Lowers demand by t – demand shifts the amount t left (vertically down) Equilibrium Effect: McDoubles – the government imposes a tax of 7c 1. Demand shifts down by 7c 2. Causes the price to fall 3. The buyer pays $1.07 for the McDouble o Market effects on the tax: 1. Buyers pay more 2. Sellers receive less 3. Less is bought and sold Tax Incidence: buyers and sellers share the burden of the tax o Buyers pay 4c o Sellers pay 3c o 7c total tax Tax on Sellers: government requires the firm to pay t for every good sold, increases the firm’s costs by t - - - S Tax Increases supply by t – supply shifts the amount t right (vertically up) Equilibrium Effects: The 7c tax is now imposed on sellers 1. Supply curve shifts up by t 2. Causes prices to rise 3. Buyer pays higher price – $1.07 E B o P = P – t More effects on tax on sellers 1. Buyers pay more 2. Seller receives less 3. Less is bought and sold Tax Incidence: buyers and sellers share the burden of the tax • Buyers pay $1.04 • Sellers pay $1.03 o It doesn’t matter who pays the tax! The incidence will remain the same Can Congress distribute the burden of the tax? • FICA taxes were designed so that firms and workers would pay equal shares of the tax – payroll tax: tax on the wages that firms pay their workers • 50% imposed on workers • 50% impo
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