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Chapter 6-13

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McMaster University
Hannah Holmes

CHAPTER SIX Controls on Prices  Price ceiling: a legal maximum on the price at which a good can be sold  Price floor: a legal minimum on the price at which a good can be sold How Price Ceilings Affect Market Outcomes  Not binding: if price ceiling is above equilibrium price, will not have effect on price or quantity sold because can still set price to what everyone is happy with  Binding constraint: if price ceiling is below equilibrium price, quantity demanded will exceed quantity supplied and there will be a shortage  Some buyers will get to buy at lower price, some will not get to buy at all  Causes long lines to develop and sellers to create personal biases about who they want to sell their goods to How Price Floors Affect Market Outcomes  Not binding: if price floor is below equilibrium price, has not effect on market forces or equilibrium  Binding constraint: if price floor is above equilibrium price, quantity supplied exceeds quantity demanded causing a surplus  Consumers create personal biases due to racial or family ties, etc. Evaluating Price Controls  Policymakers obscure signals that normally guide allocation of resources by setting price ceilings/floors  Prices balance supply and demand and coordinate economic activity  Price controls often aimed at helping the poor (ex. Rent control and minimum wage)  Price controls can hurt whom government is trying to help (ex. Landlords don’t take good care of buildings and make houses hard to find)  Rent and wage subsidies are better than price controls because will not shift supply/demand but require higher taxes Taxes  Tax incidence: the manner in which the burden of a tax is shared among participants in a market How Taxes on Buyers Affect Market Outcomes  Local government passes law requiring buyers to pay $0.50 extra for each good purchased  (1) Tax shifts demand curve, supply curve is not affected because buyers are paying extra not sellers  (2) Demand curve shifts to left because buyers demand smaller quantity at every price (market price would have to be $0.50 lower for demand not to change)  (3) Equilibrium price falls and equilibrium quantity falls  Buyers pay more for a good and sellers receive less so effects both of them How Taxes on Sellers Affect Market Outcomes  Government passes law requiring sellers to send $0.50 to government for every good sold  (1) Tax shifts supply curve, demand cure is not affected because buyers are not paying the tax  (2) Supply curve shifts left because tax reduces quantity supplied at every price since suppliers have to pay more (market price has to be $0.50 higher to compensate for tax)  (3) Equilibrium price rises and equilibrium quantity falls  Tax burden has the same effect on equilibrium no matter who is paying the money to the government  Only difference is who actually pays the government in the end  With any tax, both buyers and sellers share the burden Elasticity and Tax Incidence  Elastic Supply & Inelastic Demand: o Sellers very responsive to change in price but buyers are not o Tax causes price paid by buyers to rise substantially but price received by sellers does not fall much o Buyers bear most of the burden  Inelastic Supply & Elastic Demand: o Sellers not very responsive to changes in price but buyers are very responsive o Tax causes price received by sellers to fall substantially but price paid by buyers does not rise much o Sellers bear most of burden  Tax burden falls more heavily on side of market that is less elastic  Elasticity measures willingness of buyers or sellers to leave market when conditions become unfavorable  Side of market with fewer alternatives cannot easily leave market and must bear more of burden CHAPTER SEVEN Consumer Surplus Willingness to Pay  Welfare economics: study of how the allocation of resources affects economic well-being  Willingness to pay: maximum amount that a buyer will pay for a good  Consumer surplus: buyer’s willingness to pay minus amount the buyer actually pays  Measures benefit to buyers participating in market Using the Demand Curve to Measure Consumer Surplus  Consumer surplus closely related to demand curve for a product  At any price, demand curve shows willingness to pay of marginal buyer  Marginal buyer: buyer who would leave market first if price was any higher  Can use demand curve to calculate consumer surplus  Area below demand curve and above price measure consumer surplus in a market How a Lower Price Raises Consumer Surplus  Consumer surplus increases when price falls  Increase is made up of two parts: o (1) Buyers who were already buying the good at the higher price o Increase their consumer surplus because reduces amount they pay o (2) New buyers that enter market because of lower price o Consumer surplus of newcomers is also included What Does Consumer Surplus Measure?  Consumer surplus is good measure of economic well-being if policymakers want to respect preferences of buyers  Usually consumers are best judge of how much benefit they receive from goods they buy  Sometimes policymakers choose not to care about customer surplus because do not respect preferences of buyers (ex. Low price of heroin seems good to consumer but is not really) Producer Surplus Cost and the Willingness to Sell  Cost: value of everything a seller must give up to produce a good  Cost measures willingness to sell (will not be willing to sell if cost is more than what they will profit)  Producer surplus: amount a seller is paid for a good minus the seller’s cost Using the Supply Curve to Measure Producer Surplus  Producer surplus closely related to supply curve  At any quantity, price given by supply curve shows cost of the marginal seller  Marginal seller: seller who would leave the market first if the price was any lower  Use supply curve to calculate producer surplus  Producer surplus = area below price and above supply curve How a Higher Price Raises Producer Surplus  Producer surplus increases when price increases  Increase made up of two parts: o (1) Sellers who were already selling the good at the lower price o Better off now because get more for what they sell o (2) New sellers willing to produce good at higher price enter market o Result is increase in quantity supplied  Use consumer surplus to measure well-being of buyers Market Efficiency The Benevolent Social Planner  Measure societies economic well-being by using total surplus  Consumer surplus = Value to buyers – Amount paid by buyers  Producer surplus = Amount received by sellers – Cost to sellers  Total surplus = Value to buyers – Cost to sellers  Efficiency: if allocation of resources maximizes total surplus  Inefficiency: o If good is not being produced by sellers with lowest cost (increase total surplus by moving production from high-cost producer to low- cost producer) o If good is not being consumed by buyers who value it most (increase total surplus by moving consumption of good from low valuing customer to high valuing customer)  Equity: the fairness of the distribution of well-being among various buyers and sellers Evaluating the Market Equilibrium  Total surplus = total area between supply and demand curves up to point of equilibrium (on graph)  Market outcomes 1. Free markets allocate supply of goods to buyers who value them most 2. Free markets allocate demand for goods to sellers who can produce them at lowest cost 3. Free markets produce quantity of goods that maximizes sum of consumer and producer surplus  Any quantity below equilibrium: value to marginal buyer exceeds cost to marginal seller  Any quantity above equilibrium: value to marginal buyer is less than cost to marginal seller  Equilibrium outcome is an efficient allocation of resources (“laissez faire”)  Invisible hand creates economic efficiency Conclusion: Market Efficiency and Market Failure  Two assumptions made: 1. Markets are perfectly competitive o Market power can cause markets to be inefficient because it keeps price and quantity away from equilibrium of supply and demand o Market power: single buyer or seller controls market prices 2. The outcome in a market matters only to the buyers and sellers in that market o Decisions of buyers and sellers may affect people who are not participants in the market o Externalities cause welfare in market to depend on more than just value to buyers and cost to sellers o Can be inefficient if buyers/sellers do not take side effects into account  Market failure: inability of unregulated markets to allocate resources efficiently CHAPTER EIGHT The Deadweight Loss of Taxation How a Tax Affects Market Participants  Benefit by buyers measured by consumer surplus  Benefit by sellers measured by producer surplus  Government’s tax revenue = size of the tax (T) x quantity of the good sold (Q)  Use tax revenue to analyze how tax affects economic well-being  Represented by rectangle between supply and demand curves  Height is the size of the tax (T), width is quantity of the good (Q)  Welfare without a Tax: o Total surplus is area between supply and demand curves up to equilibrium quantity o Same as in previous chapter  Welfare with a Tax: o Consumer surplus equals only area below demand curve and above buyer’s price o Producer surplus only equals area above supply curve and below sellers price o Tax revenue makes up for the areas that are now cut out of the original total surplus amount  Changes in Welfare: o Tax causes consumer surplus and producer surplus to fall o Tax revenue rises o Makes buyers and sellers worse off and government better off o Losses to buyers and sellers from a tax exceed revenue raised by government o Deadweight loss: fall in total surplus that results from a market distortion (like a tax) o Taxes cause markets to allocate resources inefficiently because distorts incentives Deadweight Losses and the Gains from Trade  Both people in a trade are better off before the tax is levied  After tax, there is no price that will leave both of them better off  Tax makes both people worse off because they lose the amount of surplus  Government will also collect no revenue if the trade is cancelled because the people do not want to pay more  Source of deadweight losses: taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade  Gains from trade are less than the tax so the trades to not get made  Deadweight loss is surplus lost because tax discourages trades  Triangle between supply and demand curves after Q bec2use quantity sold falls when no trade exists The Determinants of the Deadweight Loss  Price elasticity’s of supply and demand determines if deadweight loss is larger or small  Elasticity of supply: o (Assume demand curve and size of tax are constant) o Inelastic supply curve: quantity supplied responds only slightly to changes in price o Elastic supply curve: quantity supplied responds substantially to changes in price o Deadweight loss is larger when supply curve is more elastic  Elasticity of demand: o (Assume supply curve and size of tax are constant) o Inelastic demand curve: deadweight loss is small o Elastic demand curve: deadweight loss is larger  Tax has deadweight loss because it induces buyers and sellers to change their behavior  Tax raises price paid by buyers so they consume less  Tax lowers price received by sellers so they produce less  Elasticity measures how much sellers/buyers respond to changes in price so determine how tax distorts market income  The greater the elasticity of supply and demand, the greater the deadweight loss of a tax Deadweight Loss and Tax Revenue as Taxes Vary  Taxes do not usually stay the same for a long period of time  Deadweight loss will rise even more rapidly than the size of the tax  Area of the triangle depends on the square of its size  Doubling the size of a tax will double the base and height so deadweight loss will rise by a factor of four  Tripling the size of a tax will triple base and height so deadweight loss rises by a factor of nine  As size of tax increases, deadweight loss gets larger  As size of tax increases, tax revenue increases at first then gets smaller when tax gets too big Conclusion  Taxes imposed on buyers and sellers by government causes society to lose some of the benefits of market efficiency  Taxes are costly to market participants: transfer resources from participants to the market and alter incentives and distort market outcomes CHAPTER NINE The Determinants Of Trade The World Price and Comparative Advantage  World price: price of a good that prevails in the world market for that good  If world price is higher that domestic price, country becomes exporter  If world price is lower that domestic price, country would become importer  Domestic price reflects opportunity cost of good  Domestic price is low: cost of producing good is low, country has comparative advantage compared to rest of world  Domestic price is high: cost of producing good is high, foreign countries have comparative advantage The Winners And Losers From Trade The Gain and Losses of an Exporting Country  Domestic price rises to equal world price  Domestic quantity supplied differs from domestic quantity demanded  If domestic Qs > domestic Qd country will become an exporter  Demand curve for world is perfectly elastic  Can sell as much of good as it wants at the world price  Domestic consumers are worse off cause have to pay world price  Consumer surplus decreases  Producer surplus increases  Exporting leads to two conclusions: 3. Domestic producers of good are better off and domestic consumers of good are worse off 4. Trade raises economic well-being because gains of producer exceed losses of consumers The Gains and Losses of an Importing Country  Domestic price lowers to equal world price  Domestic consumers are better off (have to pay less)  Domestic producers are worse off (have to lower selling price)  Consumer surplus rises, producer surplus falls  Importing leads to two conclusions: 1. Domestic consumers are better off, domestic producers are worse off 2. Trade raises economic well-being because gains of consumers exceed losses of producers The Effects of a Tariff  Tariff: tax on goods produced abroad and sold domestically  Only matters if country wants to become an importer  Tariff raises price of domestic and imported goods  Reduces quantity of imports  Domestic sellers are better off and domestic buyers are worse off  Consumer surplus decrease  Producer surplus increases  Government revenue increase  Total surplus in market falls (there is a DWL)  DWL = overproduction + under consumption Other Benefits of International Trade  Increased variety of goods  Lower costs through economies of scale: o Goods can be produced at low cost if produced in large quantities o Small countries cannot do this o Free trade gives firms access to larger world markets  Increased competition: o Free trade can prevent companies from having market power o Forces competition between countries  Enhanced flow of ideas: o Technological advances in one country can be traded to another country The Arguments For Restricting Trade The Jobs Argument  Causes people in imported industry to lose jobs  Cause people in exported industry to gain jobs  More workers move to industry where country has comparative advantage The National-Security Argument  May want to protect key industries when there are concerns about national security  Ex. Exporting steel during a war may cause country to not be able to produce enough weapons to defend itself The Infant-Industry Argument  New industries are protected from trade to help them get started  Hard to decide which industries need protecting and which do not  Owners of new industries should be wiling to incur temporary losses to eventually earn profits in the long run The Unfair-Competition Argument  Free trade only desirable if all countrie
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