American Government Micro-Economics

2 What is the economic problem? Providing for people’s wants and needs in a world of scarcity * Return to previous slide while in slide show mode

3 What is meant by scarcity? The condition in which wants are forever greater than the available supply of time, goods, and resources

4 What does scarcity force us to do? It forces us to make choices

5 What are resources? The basic categories of inputs used to produce goods and services

6 What are the three categories of resources? Land Labor Capital

7 What is a land resource? A shorthand expression for any natural resource provided by nature

8 What is labor? The mental and physical capacity of workers to produce goods and services

9 What is entrepreneurship? The creative ability of individuals to seek profits by combining resources to produce innovative products.

10 What is capital? The physical plants, machinery, and equipment used to produce other goods

11 Land Labor Capital Entrepreneurship organizes resources to produce goods and services Entrepreneurship organizes resources to produce goods and services

12 What is economics? The study of how society chooses to allocate its scarce resources to the production of goods and services in order to satisfy unlimited wants

13 What is macroeconomics? The branch of economics that studies decision- making for the economy as a whole

14 What is microeconomics? The branch of economics that studies decision- making by a single individual, household, firm, industry, or level of government

What are the three fundamental economic questions? What to produce? How to produce? For whom to produce?

What is opportunity cost? The best alternative sacrificed for a chosen alternative

What opportunity cost am I experiencing now? The most money that you could be making if you were somewhere else instead of studying these slides

Can opportunity cost be something other than money? That most desired activity that you are presently giving up is considered an opportunity cost Yes!

What is a production possibilities curve? A curve that shows the maximum combinations of two outputs that an economy can produce, given its available resources and technology

What is technology? The body of knowledge and skills applied to how goods are produced

What assumptions underlie the productions possibilities model? Fixed resources Fully employed resources Technology unchanged

What is the conclusion of the production possibilities curve? Scarcity limits an economy to points on or below its production possibilities curve

What is the law of increasing opportunity costs? The principle that the opportunity cost increases as production of one output expands

What is economic growth? The ability of an economy to produce greater levels of output, an outward shift of its production possibilities curve

What makes possible economic growth? Research and development of new technologies Increase production in excess of worn out capital

What happens when a country does not invest in new technology? Everything else being equal, the country will not grow

What is investment? The accumulation of capital, such as factories, machines, and inventories, that is used to produce goods and services

What is the opportunity cost of investment? The consumer goods that could have been purchased with the money spent for plants and other capital

What does an increase in investments make possible in the future? Economic growth and more goods and services

What conclusion can we make about investments? A nation can accelerate growth by increasing production of capital goods in excess of the capital being worn out

Why do countries trade? International trade allows a country to consume a combination of goods and services that exceeds its production possibilities curve

B´ (with trade) B (without trade) U.S. A C PPC Steel (tons per day) U.S. Production and Consumption Grain (tons per year)

Japan F E´ (with trade) PP C E (without trade) Steel (tons per day) Japanese Production and Consumption Grain (tons per year) D

Why should countries specialize and trade? Total world output increases, and therefore, the potential for greater total world consumption also increases

If countries should specialize, in what should they specialize? They should produce those goods and services in which they have a comparative advantage

What is comparative advantage? The ability of a country to produce a good at a lower opportunity cost than another country

What is Absolute Advantage? When one country produces a good or service using fewer resources.

What is the law of demand? The principle that there is an inverse relationship between the price of a good and the quantity buyers are willing to purchase in a defined time period, ceteris paribus

What does “ceteris paribus” mean? All else remains the same

What is a demand curve? Depicts the relationship between price and quantity demanded

$20 $15 $10 $ A B C D Individual’s Demand Curve for Compact Discs Demand Curve P Q

Why do demand curves have a negative slope? At a higher price consumers will buy fewer units, and at a lower price they will buy more units

What is a demand schedule? Shows the specific quantity of a good or service that people are willing and able to buy at different prices

What is market demand? The summation of the individual demand schedules

IMPORTANT - KNOW THE DIFFERENCE BETWEEN A CHANGE IN THE QUANTITY DEMANDED AND A CHANGE IN DEMAND

When price changes, what happens? The curve does not shift - there is a change in the quantity demanded

Decrease in Price Increase in Quantity Demanded

$20 $15 $10 $ P Q Fred’s Demand Curve D1D1

$20 $15 $10 $ P Q Mary’s Demand Curve D2D2

$20 $15 $10 $ P Q Market Demand Curve D3D3 12

$ = 1 $ $ $ $ Price Fred Mary Total Demanded Market Demand Schedule for Compact Discs

$20 $15 $10 $ A B A change in price causes a change in the quantity demanded D P Q 50

When something changes other than price, what happens? The whole curve shifts,there is a change in demand

$20 $15 $10 $ D1D1 D2D2 P 50 A When the ceteris paribus assumption is relaxed, the whole curve can shift Q B

Change in nonprice determinant Increase in demand

What can cause a shift in a demand curve? Tastes and preferences Number of buyers in the market Income Expectations of consumers Prices of related goods

Price increases Upward movement along the demand curve Decrease in quantity demanded

Price decreases Downward movement along the demand curve Increase in quantity demanded

Nonprice determinant Leftward or rightward shift in the demand curve Decrease or increase in demand

What is a normal good? Any good for which there is a direct relationship between changes in income and its demand curve

What is an inferior good? Any good for which there is an inverse relationship between changes in income and its demand curve

What are substitute goods? Goods that compete with one another for consumer purchases

What happens when the price increases for a good that has a substitute? The demand curve for the substitute good increases

What happens when the price decreases for a good that has a substitute? The demand curve for the substitute good decreases

What does a direct relationship between price and quantity mean? The two move in the same direction

What are complementary goods? Goods that are jointly consumed with another good

What happens when the price increases for a good that has a complement? The demand curve for the substitute good decreases

What happens when the price decreases for a good that has a complement? The demand curve for the substitute good increases

What does an inverse relationship between price & quantity mean? It means that the two move in opposite directions

What is the law of supply? The principle that there is a direct relationship between the price of a good and the quantity sellers are willing to offer for sale in a defined time period, ceteris paribus

Why do supply curves have a positive slope? Only at a higher price will it be profitable for sellers to incur the higher opportunity cost associated with supplying a larger quantity

$20 $15 $10 $ A B C Supply Curve A company’s Supply Curve for Compact Discs P Q

A $20 40 B C 6 20 Point Price Quantity An Individual Seller’s Supply for Compact Discs

$25 $20 $15 $10 10 P Q 1520 Super Sound Supply Curve S1S1 25

$25 $20 $15 $10 20 P Q 2530 High Vibes Supply Curve S2S2 35

What is a market? Any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged

What is market supply? The horizontal summation of all the quantities supplied at various prices that might prevail in the market

$25 $20 $15 $10 40 P Q 4555 Market Supply Curve 60 S total

$ = 60 $ $ $ $ Price Super Sound High Vibes Total Market Supply Schedule for Compact Discs

IMPORTANT - KNOW THE DIFFERENCE BETWEEN A CHANGE IN THE QUANTITY SUPPLIED AND A CHANGE IN SUPPLY

When price changes, what happens? The curve does not shift - there is a change in the quantity supplied

$20 $15 $10 $ A B C Supply Curve A change in price causes a change in the quantity supplied P Q

Increase in Price Increase in Quantity Supplied

When something changes other than price, what happens? The whole curve shifts - there is a change in supply

$20 $15 $10 $ S1S1 S2S2 When the ceteris paribus assumption is relaxed, the whole curve can shift P Q

Change in nonprice determinant Increase in supply

What can cause a shift in a supply curve? 1. Number of sellers in the market 2. Technology 3. Resource prices 4. Taxes and subsidies 5. Expectations of producers 6. Prices of other goods the firm could produce

$120 $90 $60 $30 1,0002,0003,0004,000 D S The Supply & Demand for Tennis Shoes P Q Surplus Shortage

What is an equilibrium? A market condition that occurs at any price for which the quantity demanded and the quantity supplied are equal

What is the price system? A mechanism that uses the forces of supply and demand to create an equilibrium through rising and falling prices

What can cause a shift in a demand curve? Tastes and preferences Related good prices # Buyers in the market Income Expectations of consumers

$1200 $600 $ D1D1 The Effects of Shift in Demand on Market Equilibrium D2D2 Shortage $900 S P Q

$40 $30 $ D2D2 S D1D1 Surplus $20 The Effects of Shift in Demand on Market Equilibrium

Increase in Demand Increase in Equilibrium Price Increase in Quantity Supplied

Decrease in Demand Decrease in Equilibrium Price Decrease in Quantity Supplied

What can cause a shift in a supply curve? Resource prices Other Goods the company can make (prices) Technology Taxes and subsidies Expectations of producers Number of sellers in the market

$4 $ D Surplus $3 $2 S1S1 The Effects of Shift in Supply on Market Equilibrium S2S2

$800 $ D Shortage $600 S1S1 S2S2 $400 The Effects of Shift in Supply on Market Equilibrium

Increase in Supply Decrease in Equilibrium Price Increase in Quantity Demanded

Decrease in Supply Increase in Equilibrium Price Decrease in Quantity Demanded

Can the laws of demand and supply be repealed? In some markets, the objective of politicians is to prevent prices from reaching the equilibrium price

What are the two types of price controls? Price ceilings Price floors

What is a price ceiling? A legally established maximum price a seller can charge

$800 $600 $400 $ D S Rent Control Results in a Shortage of Rental Units Shortage Rent ceiling P Q

Rent Ceiling Quantity Demanded exceeds the quantity supplied Shortage

What is the purpose of price ceilings on rent? So needy people will pay lower rent than the equilibrium rent

Why may rent controls be counterproductive? Shortages Illegal markets Less maintenance Discrimination

What are other examples of price ceilings? Wage and price controls Usury laws

What is a price floor? A legally established minimum price a seller can be paid

WmWm WeWe QDQD QEQE QSQS D S A Minimum Wage Results in a Surplus of Labor Unemployment Minimum wage

Unemployment

What are examples of price floors? Minimum wage law Agricultural price supports

Why do we have price ceilings and floors? Because of failures in the free market

What is market failure? A situation in which the price system creates a problem for society or fails to achieve society’s goals

Who was Adam Smith? The father of modern economics who wrote The Wealth of Nations, published in 1776

What did Adam Smith say about competition? There must be competition for markets to function properly

What happens when competition is lacking? Market failure results

$2000 $ Rigging the Personal Computer Market D $1500 S1S1 S2S2 $ $ Inefficient equilibrium Efficient equilibrium

What is an example of another market failure? Externalities

What is an externality? A cost or benefit imposed on people other than the consumers and producers of a good or service

What is a negative externality? An externality that is detrimental to third parties

What is an example of a negative externality? Pollution

P2P2 Q1Q1 External Cost of Pollution P1P1 S1S1 S2S2 Q2Q2 Includes external costs of pollution Excludes external costs of pollution D

What is a positive externality? An externality that is beneficial to third parties

What is an example of a positive externality? Vaccinations

$10 Q1Q1 Q2Q2 D1D1 S External Benefits of AIDS Vaccinations D2D2 P1P1 Excludes Vaccination benefits Includes Vaccination benefits P2P2

External costs Inefficient equilibrium

External benefits Inefficient equilibrium

What is another example of a positive externality? Public goods

What is a public good? A good that, once produced, has two properties: (1) users collectively consume benefits (2) no one can be excluded

What are examples of public goods? National defense Public education Roads

What is another example of market failure? Income inequality

8.1 TAXES ON BUYERS AND SELLERS Tax Incidence –Tax incidence –The division of the burden of a tax between the buyer and the seller. –When a good is taxed, it has two prices: A price that includes the tax A price that excludes the tax –Buyers respond to the price that includes the tax. –Sellers respond to the price that excludes the tax.

8.1 TAXES ON BUYERS AND SELLERS –The tax is like a wedge between the two prices. – Suppose that the government puts a $10 tax on MP3 players. –How does the price that buyers pay change? –How does the price sellers receive change? –How is the burden of a tax shared between the buyer and the seller?

8.1 TAXES ON BUYERS AND SELLERS 1. With no tax, the price is $100 and 5,000 players a week are bought. 2. A $10 tax on buyers of MP3 players shifts the demand curve to D – tax. Figure 8.1(a) shows what happens when the government taxes buyers of the MP3 players.

8.1 TAXES ON BUYERS AND SELLERS 3. The price paid by buyers rises to $105—an increase of $5 a player. 4. The price received by sellers falls to $95—a decrease of $5 a player. 5. The quantity decreases to 2,000 players a week. 6. The government’s tax revenue is $20,000 a week.

8.1 TAXES ON BUYERS AND SELLERS 1. With no tax, the price is $100 and 5,000 players a week are bought. 2. A $10 tax on sellers of MP3 players shifts the supply curve to S + tax. Figure 8.1(b) shows what happens when the government taxes sellers of the MP3 players.

8.1 TAXES ON BUYERS AND SELLERS 3. The price paid by buyers rises to $105—an increase of $5 a player. 4. The price received by sellers falls to $95—a decrease of $5 a player. 5. The quantity decreases to 2,000 players a week. 6. The government’s tax revenue is $20,000 a week.

–A tax places a wedge between the buyers’ price (marginal benefit) and the sellers’ price (marginal cost). –The equilibrium quantity is less than the efficient quantity and a deadweight loss arises.  Taxes and Efficiency 8.1 TAXES ON BUYERS AND SELLERS

In Figure 8.2(a), the market is efficient with marginal benefit equal to marginal cost. Figure 8.2 shows the inefficiency of taxes. 8.1 TAXES ON BUYERS AND SELLERS Total surplus—the sum of 2. Consumer surplus and 3. Producer surplus—is maximized.

A $10 tax shifts the supply curve to S + tax. 3. Consumer surplus and 4. Producer surplus shrink. Figure 8.2(b) shows how taxes create inefficiency. 5. The government collects its tax revenue. 6. A deadweight loss arises. 1. Marginal benefit exceeds 2. Marginal cost. 8.1 TAXES ON BUYERS AND SELLERS

The loss of consumer surplus and producer surplus is the burden of the tax. 8.1 TAXES ON BUYERS AND SELLERS The burden of the tax equals the tax revenue plus the deadweight loss.

–Excess burden –The deadweight loss from a tax— the amount by which the burden of a tax exceeds the tax revenue received by the government. 8.1 TAXES ON BUYERS AND SELLERS –The excess burden is $15,000. –(3,000  $10  2)

Incidence, Inefficiency, and Elasticity –The incidence of a tax and its excess burden depend on the elasticites of demand and supply: For a given elasticity of supply, the buyer pays a larger share of the tax the more inelastic is the demand for the good. For a given elasticity of demand, the seller pays a larger share of the tax the more inelastic is the supply of the good. 8.1 TAXES ON BUYERS AND SELLERS

Tax Incidence and Elasticity of Demand –Perfectly Inelastic Demand: Buyer Pays and Efficient –Perfectly Elastic Demand: Seller Pays and Inefficient –Figures 8.3(a) and 8.3(b) illustrate these two extreme cases.

8.1 TAXES ON BUYERS AND SELLERS –Figure 8.3(a) shows tax incidence in a market with perfectly inelastic demand—the market for insulin. A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax. Marginal benefit equals marginal cost, so the outcome is efficient.

8.1 TAXES ON BUYERS AND SELLERS –Figure 8.3(b) shows tax incidence in a market with perfectly elastic demand—the market for pink pens. A tax of 10¢ a pink pen lowers the price received by the seller by 10¢, and the seller pays all the tax. A deadweight loss arises, so the outcome is inefficient.

8.1 TAXES ON BUYERS AND SELLERS Tax Incidence, Inefficiency, and Elasticity of Supply –Perfectly Inelastic Supply: Seller Pays and Efficient –Perfectly Elastic Supply: Buyer Pays and Inefficient –Figures 8.4(a) and 8.4(b) illustrate these two extreme cases.

8.1 TAXES ON BUYERS AND SELLERS –Figure 8.4(a) shows tax incidence in a market with perfectly inelastic supply—the market for spring water. A tax of 5¢ a bottle does not change the price paid by the buyer but lowers the price received by the seller by 5¢. Marginal benefit equals marginal cost, so the outcome is efficient. The seller pays the entire tax.

8.1 TAXES ON BUYERS AND SELLERS –Figure 8.4(b) shows tax incidence in a market with perfectly elastic supply—the market for sand. A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax. A deadweight loss arises, so the outcome is inefficient.

8.2 INCOME TAX AND SOCIAL SECURITY TAX –In 2004, the personal income tax raised: More than $1 trillion for the federal government About $300 billion for state and local governments –The amount of income tax that a person pays depends on her or his taxable income and on the tax rates. –Taxable income –Total income minus a personal exemption and a standard deduction (or other allowable deductions).  The Personal Income Tax

– 8.2 INCOME TAX AND SOCIAL SECURITY TAX –Marginal tax rate –The percentage of an additional dollar of income that is paid in tax. –Average tax rate –The percentage of income that is paid in tax.

–A tax can be progressive, proportional, or regressive. –Progressive tax –A tax whose average rate increases as income increases. –Proportional tax –A tax whose average rate is constant at all income levels. –Regressive tax –A tax whose average rate decreases as income increases. THE TAX SYSTEM 8.2 INCOME AND SOCIAL SECURITY TAX

8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.5 shows U.S. tax rates in Marginal tax rate increases with income. 2. Average tax rate increases with income The personal income tax is a progressive tax.

–Tax on Labor Income –Firms can substitute machines for labor, so the demand for labor is elastic. –Most people must work for their income, so the supply of labor is inelastic. –With elastic demand and inelastic supply, the worker bears the greater burden of the income tax. 8.2 INCOME TAX AND SOCIAL SECURITY TAX  The Effects of the Income Tax

8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.6 shows the effects of a tax on labor income. 4. A deadweight loss arises. With a 20% income tax: 2. The employer pays some of the tax. 3. The worker pays most of the tax. 1. The supply of labor decreases, the wage rate rises, and the after-tax wage rate falls.

–Taxes on Capital Income –Taxing the income from capital works like taxing the income from labor. –One crucial difference: capital is internationally mobile and so the supply of capital is highly elastic—perhaps perfectly elastic. 8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.7 shows the effect of a tax on capital income. 1. The supply of capital is perfectly elastic. 2. With a 40 percent tax on capital income, the interest rate rises. 3. The firm pays the entire tax. 4. A large deadweight loss arises.

–Taxes on Income from Land and Unique Resources –Works in the same way as taxing the income from other sources except for one crucial difference. –The supply of land is highly inelastic. –The tax on land income is fully borne by the landowners and the quantity of land is unaffected by the tax. –With no change in the quantity of land, the tax on land income creates no deadweight loss or excess burden and is efficient. 8.2 INCOME TAX AND SOCIAL SECURITY TAX

Figure 8.8(a) shows a tax on income from land. 1. Supply is perfectly inelastic. 2. With a 40 percent tax, the supply of land is unchanged and the market rent is unchanged. 3. The landowner pays the entire tax. No deadweight loss arises—the tax is efficient.

8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.7 (b) shows a high tax rate on Barbara Walter’s income. 1. Supply is perfectly inelastic. 2. With a 40 percent tax, the supply curve is unchanged and the market price is unchanged. 3. Barbara Walters pays the entire tax. No deadweight loss arises and the tax is efficient.

8.2 INCOME TAX AND SOCIAL SECURITY TAX The Social Security Tax The Social Security tax law says that the tax is to be shared equally by workers and employers. But the principles that determine the incidence of other taxes you’ve studied in this chapter also apply to the Social Security tax. We look at two extreme Social Security taxes: one on workers only and one on employers only.

8.2 INCOME TAX AND SOCIAL SECURITY TAX –With no taxes, the wage rate is $6.00 an hour and 4,000 people are employed. 1. A 20 percent Social Security tax on workers shifts the supply curve to LS + tax. –A Social Security Tax on Workers

8.2 INCOME TAX AND SOCIAL SECURITY TAX –2. The wage rate paid by employers rises to $6.25 an hour—an increase of 25 cents an hour. 3. The number of people employed decreases to 3, Workers receive $5 an hour—a decrease of $1 an hour.

8.2 INCOME TAX AND SOCIAL SECURITY TAX –5. The government collects tax revenue shown by the purple rectangle. Workers pay most of the tax because the supply of labor is more inelastic than the demand for labor.

8.2 INCOME AND SOCIAL SECURITY TAX –A Social Security Tax on Employers Payroll tax A tax on employers based on the wages they pay their workers. Figure 7.4 on the next slide shows the effects of a payroll tax.

8.2 INCOME TAX AND SOCIAL SECURITY TAX With no tax, the wage rate is $6.00 an hour and 4,000 people are employed. 1. A tax on employers of $1.25 an hour shifts the demand curve to LD – tax. –A Social Security Tax on Employers

8.2 INCOME TAX AND SOCIAL SECURITY TAX 2. The wage rate falls to $5.00 an hour—a decrease of $1.00 an hour. 3. The number of workers employed decreases to 3,000.

8.2 INCOME TAX AND SOCIAL SECURITY TAX 4. Employers’ total cost of labor rises to $6.25 an hour—the $5.00 wage rate plus the $1.25 payroll tax. 5. The government collects tax revenue shown by the purple rectangle.

–Whenever political leaders debate tax issues, it is fairness, not efficiency, that looms above all other considerations. –There are two conflicting principles of fairness of taxes: The benefits principle The ability-to-pay principle 8.3 FAIRNESS AND THE BIG TRADEOFF

The Benefits Principle –Benefits principle –The proposition that people should pay taxes equal to the benefits they receive from public goods and services. –This arrangement is fair because it means that those who benefit most pay the most. –But to implement it, we would need an objective way of measuring each person’s marginal benefit from public goods and services. 8.3 FAIRNESS AND THE BIG TRADEOFF

The Ability-to-Pay Principle –Ability-to-pay principle –The proposition that people should pay taxes according to how easily they can bear the burden. –A rich person can more easily bear the burden of providing public goods than a poor person can, so the rich should pay higher taxes than the poor. –This principle compares people according to Horizontal equity Vertical equity 8.3 FAIRNESS AND THE BIG TRADEOFF

Horizontal equity The requirement that taxpayers with the same ability to pay the same taxes. Vertical equity The requirement that taxpayers with a greater ability to pay bear a greater share of the taxes. 8.3 FAIRNESS AND THE BIG TRADEOFF

The Marriage Tax Problem In the U.S. tax code, a married couple is considered a single taxpayer. This arrangement means that if they each earn the same income as before a marriage, the married couple might pay more tax than they did before marriage. 8.3 FAIRNESS AND THE BIG TRADEOFF

The Big Tradeoff –Questions about the fairness of taxes conflict with efficiency questions and create the big tradeoff. –Taxes on capital incomes create the greatest deadweight loss—are the most inefficient. –But most of the capital is owned by a small number of rich people, so (most people believe) taxes on capital are the fairest. –Our tax system is an evolving attempt to juggle to two goals of efficiency and fairness. 8.3 FAIRNESS AND THE BIG TRADEOFF

Taxes in YOUR Life The Tax Foundation has calculated “Tax Freedom Day”— the day by when the average U.S. citizen has worked long enough to pay a year’s tax bill. In 2004, Tax Freedom Day was 17 April— 107 days: 38 days to pay personal income taxes 30 days to pay Social Security taxes 16 days to sales and excise taxes 11 days to pay property taxes 9 days to pay corporate income taxes 3 days to pay all other taxes Work out your own “Tax Freedom Day.”