1 Chapter 6 Wealth Creation And Destruction McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Learning Objectives What is wealth? What creates wealth? How is wealth destroyed? What is consumers’ surplus? What is producers’ surplus? When is total surplus to society maximized? What is deadweight loss? How do government set prices, taxes and subsidies create deadweight loss? How do innovations affect a market economy? 6-2

3 What Is Wealth? The value of a good is the most its owner would pay for it. An individual’s wealth is the value of all his possessions. The total wealth of society is the sum of each individual's wealth. Money transfers have no effect on the wealth of society. 6-3

4 Wealth Creation Voluntary trade increases wealth of society since it moves goods to someone who places higher value on them. Production as well as trade can increase wealth. Trade allows the manufacturer to produce goods. A manufacturer will only sell a good for more than it costs to increase wealth and buyer will only pay an amount less than what the good is worth to her. 6-4

5 Wealth Creation The growth rate of wealth creation over the long run is the most important force shaping a society. 6-5

6 Destruction Of Wealth By Governments Rent control: It reduces trade by eliminating incentives of some sellers to sell. Minimum wage: It reduces trade by eliminating incentives of some buyers to buy. Taxes: Taxes reduce trade by eliminating incentives of some buyers as well as sellers as a tax raises consumer’s price and lowers producer’s price. Subsidies: Subsidies destroy wealth by encouraging wastage and misallocation of resources. 6-6

7 Destruction Of Wealth By Governments Forced sharing: It destroys wealth by reducing incentives for hard work. Theft: Unlike voluntary trade, theft may not move goods to someone who places higher value on them. Eminent domain = Power of a government to take private property. The society’s wealth is destroyed when politicians abuse the power of eminent domain for their own use. 6-7

8 Willingness To Pay And Demand The maximum amount consumers are willing to pay for goods determine the height of demand curves. 6-8

9 Consumer’s Surplus The difference between the most that consumers are willing to pay for a good and its price = Net benefit that consumers receive after buying a good. The greater the consumer’s surplus, the better off the consumers are. Most willing to pay Consumer’s surplus if price =$2 Abe$7$5 Ben$6$4 Calvin$5$3 Debbie$4$2 Ed$3$1 Fran$2$0 Gene$1Not bought 6-9

10 Consumer’s Surplus Total consumer’s surplus = The area between the demand curve and price. At lower price = Increase in consumer’s surplus. Old price Price Quantity New price $9 $ Additional consumers’ surplus to old consumers Consumers’ surplus to new consumers Demand Equilibrium 6-10

11 Production Cost And Supply The cost of producing goods determines the height of supply curves. 6-11

12 Producer’s Surplus The difference between the price and the cost of producing a good = Net benefit that producers receive after selling a good. The greater the producer’s surplus, the better off producers are. FactoryCost to Make Producer’s Surplus if Price =$3 A$1.00$2.00 B$1.50 C$2.00$1.00 D$3.00$0 E$3.50Not made 6-12

13 Producer’s Surplus Total producer’s surplus = The area between the supply curve and price. Market price Price Quantity Supply Equilibrium 6-13

14 Total Surplus Total surplus = Consumer’s surplus + Producer’s surplus. The free market equilibrium price maximizes the total surplus. Price Quantity Supply Demand $10 5,

15 Deadweight Loss Government set price above equilibrium: Money transfer from consumers to producers. Deadweight loss = Loss of wealth because of some lost trades. = Net loss of resources to society. $12 Quantity Price Supply Demand Government set price 5,0004,000 Consumers’ surplus Producers’ surplus Deadweight Loss 6-15

16 Deadweight Loss Government set price below equilibrium: Money transfers from producers to consumers. Deadweight loss = Loss of wealth because of some lost trades. Additional deadweight loss of government created shortage because of the opportunity cost of time for waiting. 9,0003,000 Consumers’ surplus Deadweight Loss Producers’ surplus Government set price Supply Demand $6 6-16

17 Wealth Maximizing Equilibrium YX Supply Demand To maximize the wealth of society, the goods must be produced only if the demand curve is above the supply curve. Producing too much of a good means that the resources used to make the good could be better used elsewhere. 6-17

18 Supply, Demand And Taxes Price Quantity Supply Demand $10 5,000 A tax: Increases the price consumers pay. Decreases the price producers get. Raises tax revenue for the government. Reduces quantity of the good traded. Creates deadweight loss to society. CS PS $11.10 $9.10 4,200 Tax Revenue Price consumers pay Price producers receive Deadweight Loss 6-18

19 Deadweight Loss of Tax The deadweight loss of the tax is caused by consumers no longer buying some goods that they value more than it costs to produce. By causing market to under produce, tax destroys society’s wealth. Any tax is shared by both consumers and producers regardless of on whom it is imposed. 6-19

20 Supply, Demand and Subsidies 5,8005,000 Deadweight Loss Supply Demand $7.70 $12.70 $10 Quantity Price A subsidy Decreases the price consumers pay Increases the price producers get Creates costs for the government Increases quantity of goods where supply curve is above the demand curve Creates deadweight loss to society by overproducing goods and wasting resources 6-20

21 Innovation Economic growth is driven by innovations. Innovations create wealth. Markets do an extraordinary job of promoting wealth and creating innovations. Marketplace innovations include small improvements to existing products along with major innovations in development of new products. 6-21

22 Innovation Markets ration resources to only those potential innovations that will appeal to consumers. Markets send signals to innovators allowing them to correct their errors. Innovations in production can eliminate some jobs, yet society as a whole gains wealth from these job-destroying technologies by freeing up resources. 6-22

23 Freedom and Wealth Creation Markets make magnificent coordinators of economic activities. History shows that free market economies produced vastly more wealth than centrally planned economies. Central planners can never match the wealth creating abilities of a free economy. 6-23

24 Do You Know? How can one person giving a good to another increase the total wealth of society? Voluntary trade increases the wealth of society. The person buying a good places higher value on it than the person selling it. Thus both people have net gains increasing society's wealth. What is total surplus? Total surplus is the sum total of the net benefits all consumers and all producers gain from trade and the value society gets from production and consumption of a good. 6-24

25 Do You Know? Does it matter if a sales tax must be paid by buyers or sellers? No. Any tax is shared by both consumers and producers regardless of on whom it is imposed. It reduces quantity trade creating deadweight loss. Why does the marketplace promote innovations? Innovations create wealth, improve welfare of people and promote economic growth. 6-25

26 Summary Value of a good is the most its owner would pay for it. An individual’s wealth is the value of all his possessions. Trade, production and innovation create wealth. Wealth can be destroyed by various government controls and interference. 6-26

27 Summary Consumer’s surplus = The maximum price consumer would have paid – Actual price. Producer’s surplus = The good’s price – The cost to the seller of making the good. Total surplus = Consumer’s surplus + Producer’s surplus Total surplus is maximized at the supply and demand determined equilibrium. Government set prices, taxes and subsidies create deadweight loss. Deadweight loss = Loss of wealth because of some lost trades. 6-27

28 Coming Up Why do we trade? 6-28