Economics September Lecture 8 Chapter 6

Economics 10 1 2017 September Lecture 8 Chapter 6
Government Actions in the Market 2017 Economics 101 CCC

Sources of Market Failure
In competitive markets, underproduction or overproduction arise when there are Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly High transactions costs

Price controls Price controls are government- mandated legal minimum or maximum prices set for specified goods, usually implemented as a means of direct economic intervention to manage the affordability of certain goods. Governments most commonly implement price controls on staples, essential items such as food or energy products.

Price controls

Agricultural Subsidy agricultural subsidy is a governmental subsidy paid to farmers and agribusinesses to supplement their income, manage the supply of agricultural commodities, and influence the cost and supply of such commodities.

Tax Sin tax is an excise tax specifically levied on certain goods deemed harmful to society, for example alcohol and tobacco, candies, drugs, soft drinks, fast foods, coffee, sugar, gambling

Production quota Production quota is a goal for the production of a good. It is typically set by a government or an organization, and can be applied to an individual worker, firm, industry or country. Quotas can be set high to encourage production, or can be used to restrict production to support a certain price level.

Supply Management or Price Control
Another name for Production quota Supply management is a catch-all term for policies that control the price of milk, cheese, eggs, chicken, and turkey in Canada via a quota based system that limits entry to the industry and defines specific regulations r: production process.

Terms defined

Terms - Costs Firm define (Private Costs)
Total cost of producing goods Marginal Cost of producing goods decide whether to produce and sell in market basis their costs – sometimes called marginal private costs goal: profit maximization MC is the Supply Curve

Terms – Costs: A baker example – firms marginal cost
Firm define their MC - Supply Curve

Terms This graph shows marginal cost on the y-axis, but the supply curve has price on the y-axis. It makes sense that the investor in the bakery example would only be willing to make more bread if the price was equal to or greater than the marginal cost to make that bread. Thus by simply substituting price for marginal cost we can get an idea of what the bakery would supply at a given market price. If market price $1.33/loaf, 430 loaves. If market price $2.00/loaf 600 loaves. That is how a supply curve is constructed. The above curve represents only a single firm, but you could also replicate that curve for several firms and then add them together to get an industry supply curve.

Terms - Costs External Cost
Total cost of production is a cost that is not borne by the firm but borne by other people outside the transaction Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer. Referred to as negative externality In this case – what is the negative externality ?

Terms - Costs Negative Externality or Negative External cost
Occurs when the individual or firm making a decision does not have to pay the full cost of the production/activity. producers don't take responsibility for external costs that exist--these are passed on to society. Which curve does this affect? And how? A cost will influence supply curve

Terms - Costs Social cost of production
Total cost incurred by the entire society—by the firm and by everyone else on whom the cost falls. Marginal social cost (MSC) sum of marginal private cost and marginal external cost. MSC = MC + Marginal external cost

Terms - Costs All three costs need to be considered in the assessment of government actions and efficiency MSC MEC MPC

Terms - Costs Which curve does this affect? And how?
A cost will influence supply curve MSC MEC MPC

Terms - Benefits Consumers define Private Benefits of consumption
Total Benefit Marginal Benefit decide whether to consume and purchase in market basis comparison of that marginal benefit to the market price goal: maximization of happiness ( utility)

Terms - Benefits Linking MB and Demand Curve Marginal Benefit
Value of one more unit of a good or service expressed as the maximum price that people are willing and able to pay for another unit of the good. Therefore, the demand curve is the marginal benefit curve. When an individual pays less than his or her marginal benefit for a unit of a good, he or she is gaining a surplus. When price is higher what happens?

Terms - Benefits External Benefits
Total external benefit of consumption is a benefit that is enjoyed by a third-party as a result of an economic transaction. Marginal external benefit is the benefit of consuming one more unit of a good or service that falls on people outside transaction Referred to as positive externality positive externalities should be encouraged. In this case – what is the positive externality ?

Terms - Benefit Social benefit of consumption
Total benefit incurred by the entire society—by the individual consumer and by everyone else on whom receives the benefit. Marginal social benefit (MSB) sum of marginal private benefit and marginal external benefit. MSB = MB + Marginal external benefit

Terms - Benefit All three benefit need to be considered in the assessment of government actions and efficiency MSB MEB MPB

Terms - Benefit Which curve does this affect? And how?
A benefit will influence demand curve MSB MEB MPB

Terms - Externalities Externalities (External Cost) (External Benefits) costs and benefits that are not experienced directly by producers and consumers of goods. “spill over” onto third parties. Negative Externality Positive Externality Results in misallocation of resources – too much or too little produced & inefficiency!

Terms - Externalities External cost example
Drivers consider private marginal cost when calculating MC Drive if MC = MB External cost of driving – pollution to air If forced to pay for the health damage of car exhaust what happens? MC will increase by the amount of the external cost. forced to equate marginal private and external (social) cost with marginal benefit.

Terms - Externalities External benefit Example Immunizations
If you get a vaccinations for a certain disease, it less likely that you will contract the disease. – private benefit. External benefit - less likely that other vulnerable people will get the disease, because they probably will not catch it from you.

Terms – Market Assessment
Market failure Conditions that occur when resources are inefficiently allocated and so too much or too little product is produced. Deadweight Loss: Loss of economic surplus ( efficiency) that can occur when equilibrium for a good or service is not achieved or is not achievable. Measure by ?? Efficiency

Terms - Elasticity of Demand

Rent Ceiling & Housing Market
Textbook pages

A Housing Market with a Rent Ceiling
price ceiling or price cap regulation that makes it illegal to charge a price higher than a specified level. Ex: rent ceiling in housing market Why do you think it is regulated? Set above the equilibrium rent - no effect Set below equilibrium rent - creates A housing shortage Increased search activity A black market

1. Housing Shortage Figure 6.1 shows the effects of a rent ceiling that is set below the equilibrium rent. The equilibrium rent is $1,000 a month. A rent ceiling is set at $800 a month. So the equilibrium rent is in the illegal region. 900

1. Housing Shortage SHORTAGE! Is that what was wanted? 900

2. Black Market illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. Illegal arrangements are made between renters and landlords at rents above the rent ceiling

2. Black Market Because the legal price cannot eliminate the shortage, other mechanisms operate: With the shortage, someone is willing to pay up to $1,200 a month. A black market 900

3. Increased Search Activity Because the legal price cannot eliminate the shortage, other mechanisms operate: The time spent looking for someone with whom to do business is called search activity. costly because opportunity cost of housing equals its rent (regulated) plus the opportunity cost of the search activity (unregulated).

So we see that price control set below equilibrium rent - creates A housing shortage Increased search activity A black market What about Efficiency?

Assessing Efficiency: Rent ceiling decreases the quantity of housing supplied to less than the efficient quantity. Deadweight loss arises. Producer surplus shrinks. Consumer surplus shrinks. 1,100 900

Are Rent Ceilings Fair? According to the fair-rules view, a rent ceiling is unfair because it blocks voluntary exchange. According to the fair-results view, a rent ceiling is unfair because it does not generally benefit the poor

Alternatives A lottery gives scarce housing to the lucky. A first-come, first served gives scarce housing to those who have the greatest foresight and get their names on the list first. Discrimination gives scarce housing to friends, family members, or those of the selected race or sex.

Example: A Housing Market with a Rent Ceiling
Assessing Efficiency: Can you compute values ? PS CS ES DWL Why do we need these? S D Consumer surplus Producer surplus

D Consumer surplus Producer surplus STEP 1: BEFORE CEILING For the supply and demand curves shown, the equilibrium P $14/bbl, equilibrium Q 3000 bbl/day. Calc PS & CS and the ES

STEP 2: SET THE CEILING (government does this!) Set a price of 10$ .. Q supplied goes to 1000 bbl/day Q demanded is 5000 Too bad consumers don’t get that! Recalc PS & CS and the ES Quantity (1000’s of bbl/day) Price ($/bbl) Producer surplus 1 2 3 4 5 8 10 12 14 16 18 20 S D Consumer surplus Lost economic surplus called deadweight loss = $8000 Price ceiling

Quantity (1000’s of bbl/day) Price ($/bbl) Producer surplus 1 2 3 4 5 8 10 12 14 16 18 20 S D Consumer surplus Lost economic surplus called deadweight loss Price ceiling What is the DWL or loss of efficiency due to rent control? Be sure you understand the PS , CS , and DWL (triangles and rectangles) gains? losses? Economic surplus loss!

Labour Market and Minimum Wage
Textbook pages

A Labour Market with a Minimum Wage
Price floor regulation that makes it illegal to trade at a price lower than a specified level. Ex: wage in labour market Set below the equilibrium wage rate - no effect Set above the equilibrium wage rate surplus of labour & unemployment

Set above the equilibrium wage rate The equilibrium wage rate is $9 an hour. The minimum wage rate is set at $10 an hour. So the equilibrium wage rate is in the illegal region.

Set above the equilibrium wage rate Demanders of labour are the firms Suppliers of labour are the labourers Q labour supplied > Q labour demanded unemployment is created. With 20 million hours demanded, some workers are willing to supply the last hour demanded for $8.

So we see that Set above the equilibrium wage rate surplus of labour & unemployment What about Efficiency? Is Minimum Wage Inefficient? leads to an inefficient outcome. Q labour supplied > Q labour demanded

Assessing Efficiency: deadweight loss arises. potential loss from increased job search decreases both workers’ surplus and firms’ surplus. full loss is the sum of the red and grey areas.

Is the Minimum Wage Fair? A minimum wage rate in Canada is set by the provincial governments. In 2014, the minimum wage rate ranged from a low of $ an hour in Alberta to a high of $11.00 an hour in Nunavut. Most economists believe that minimum wage laws increase the unemployment rate of low-skilled younger workers.

Taxes Textbook pages

Taxes Everything you earn and most things you buy are taxed.
Who really pays these taxes? Remember there Tax revenue

Taxes Tax Incidence (Who Pays)
division of the burden of a tax between buyers and sellers. When an item is taxed, its price might rise by the full amount of the tax, by a lesser amount, or not at all. 3 scenarios: If the price rises by the full amount of the tax, buyers pay the tax. If the price rise by a lesser amount than the tax, buyers and sellers share the burden of the tax. If the price doesn’t rise at all, sellers pay the tax. Tax incidence doesn’t depend on tax law!

Review Tax Incidence using tax on cigarettes in Ontario example
On February 1, 2006, Ontario raised the tax on the sales of cigarettes to $3.09 a pack of 25. What are the effects of this tax?

Taxes on Sellers Before Tax Equilibrium P = $6 Q= 350 Add tax
Tax is the same as an increase costs for the producer (shift intercept of supply curve by $3) except they have to collect the tax and give it to the government

Taxes on Sellers Impose Tax
Take intercept of curve S + tax to get new supply curve. Intercept shift from P = 2 + … to P = 5 Result.. shift left of the supply curve –won’t produce as much Q at each P because the cost increases..

Taxes on Sellers With the tax get a new P = 8$ Q = 325
How does this affect sellers? Price they collect is $8 and then they pay govt the $3 tax and net out $5 a pack. How does this affect buyers? Price is the $8

Taxes on Sellers Who pays tax of 3$? Before Tax: Equilibrium P = $6 Q= 350 With tax Equilibrium P = 8$ Q = 325 How does this affect sellers? Before tax they got $6 /pack After tax they now collect is $8 pay govt the $3 tax and are left with $5 a pack. receive $1 less How does this affect buyers? Price used to pay was $6 and now they pay $8 pay $2 a pack more

Taxes on Buyers Before Tax Equilibrium P = $6 Q= 350
Impose tax on buyers $3 a pack Demand curve intercept changes and new demand curve

Taxes on Buyers With the tax get a new P = 8$ Q = 325 Sellers receive:
$5 a pack and the quantity decreases. Buyers pay: $8 a pack.

Taxes on Buyers Who pays tax? buyers pay $2 a pack more
sellers receive $1 a pack less. Tax incidence ( who pays tax) is the same regardless of whether the law says sellers pay or buyers pay.

Tax Incidence and Elasticity of Demand
Tax incidence ( who pays tax) is the same regardless of whether the law says sellers pay or buyers pay. So what makes the effect change? The division of the tax between buyers and sellers depends on the elasticities of demand and supply.

Perfectly Elastic demand Huge response in Q for P change Ex: Pink Pens Tax this product and seller pays all

Perfectly Elastic Demand tax is imposed on this good sellers pay the entire tax.

Perfectly Inelastic demand No response in Q for P change Consumers do not switch to substitutes even when price increases dramatically Ex: Insulin Tax this product and buyer pays all

Inelastic Demand Curve When a tax is imposed on this good, buyers pay the entire tax Tax of 20 cents imposed

Tax Incidence and Elasticity of Supply
Perfectly inelastic supply: Sellers pay the entire tax. Perfectly elastic supply: Buyers pay the entire tax. The more elastic the supply, the larger is the buyers’ share of the tax.

Perfectly Inelastic Supply The supply of this good is perfectly inelastic—the supply curve is vertical. tax is imposed on this good sellers pay the entire tax.

Perfectly Elastic Supply supply of this good is perfectly elastic—the supply curve is horizontal. tax is imposed on this good, buyers pay the entire tax.

Taxes in Practice Taxes usually are levied on goods and services with an inelastic demand or an inelastic supply. Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most the tax on them. Labour has a low elasticity of supply, so the seller—the worker—pays most of the income tax and most of the social security tax. Can you draw these on a curve? And assess the reasons /logic of each of these?

Are Taxes Efficient? How can we measure?
Except in the extreme cases of perfectly inelastic demand or perfectly inelastic supply when the quantity remains the same, imposing a tax creates inefficiency. Review the economic effect: - Total Economic Surplus (CS, PS, DWL) - Change In Total Output

Example: The Market for Potatoes Before Tax: Economic Surplus, PS and CS
total surplus in the potato market equals the area of the blue triangle. $9 million/month. Producer surplus (4.5) plus consumer surplus (4.5) = economic surplus = 9$

Example: Adding Tax Shifts Supply Curve
Tax can be seen as the same as an increase costs for the producer Result.. So a shift left of the supply curve –won’t produce as much Q for each P as cost increases.. Note: they don’t get to keep the tax they collect it and give it to the gov’t 3.50 2.50 2.5 S + tax S D

Example: After tax, prices paid/received and quantity supplied/demanded
3.50 2.50 2.5 S + tax S D Lost Surplus Also called deadweight loss Result from tax … shift SC and decrease Q to 2.5 Producer: Using SC with Q=2.5 producer receives P = 2.5 Or 3.5 and give the tax to govt. Consumer: Using DC with Q = 2.5 consumer pays P = 3.5 SO.. THE TAX INCREASE OF 1$ WAS PLACED ON SUPPLIERS BUT SHARED ½ AND ½

Example: After Tax, Economic Surplus, PS and CS
A $1/kilogram tax on potatoes would cause an upward shift in the supply curve by $1. Total surplus would shrink to the area of the pale blue triangle, $6.25 million/month. At the new Q and P what is the economic surplus? PS= ½ X 2.5 X 2.5= 3.13 plus CS = ½ X 2.5 X 2.5= 3.13 6.25 total surplus in the potato market equals the area of the blue triangle. $6.25 million/month. 3.50 S + tax S D 2.50 2.5 1 2 3 4 5 6 Quantity (millions of kg/month) Price ($/kg)

So what is the Effect of a $1/ Pound Tax on Potatoes
With tax - At the new Q and P what is the economic surplus?6.25 Without tax - - At the new Q and P what is the economic surplus? 9.00 Net difference= 2.75 million WOW! But what is missing? Tax revenue gained – 1$ for 2.5 million Q ( just like the cost of the government to buy the wheat needs to be accounted for) Therefore the tax really results in a gain of 2.5 million in taxes loss of economic surplus of 2.75 million netting a reduction of economic surplus or deadweight loss of million.

Who bears the burden of the tax?
Government collects the tax times Q Tax was collected entirely from potato sellers that was why their SC increased Burden fell on buyers and sellers equally 50cent higher paid by consumer 50 cent lower received by producer Note: need not be equally always..

Taxes and Fairness Economists propose two conflicting principles of fairness to apply to a tax system: The benefits principle The ability-to-pay principle

Taxes and Fairness The Benefits Principle
The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government. This arrangement is fair because it means that those who benefit most pay the most taxes.

Taxes and Fairness The Ability-to-Pay Principle
The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden of the tax. A rich person can more easily bear the burden than a poor person can. So the ability-to-pay principle can reinforce the benefits principle to justify high rates of income tax on high incomes.

Production quota and subsidies
Textbook pages

Production Quotas and Subsidies
Intervention in markets for farm products takes two main forms: production quota upper limit to the quantity of a good that may be produced during a specified period. subsidy payment made by the government to a producer. Why are these done?

Production quotas set below the equilibrium quantity results: Decrease in supply Rise in price Decrease in MC Inefficient underproduction Incentive to cheat and overproduce

Production Subsidies and Quotas
Production quotas set below the equilibrium quantity results: no quota, the price is $3 a tonne and 16 million tonnes a year are produced. with quota of 14 million tonnes a year, quantity decreases to 14 million tonnes a year. The market price rises to $5 a tonne and marginal cost falls to $2 a tonne.

Subsidies result: Increase in supply Fall in price and increase in quantity produced Increase in MC Inefficient underproduction Payment to farmers

Subsidies result: No subsidy, the price is $40 a tonne and 40 million tonnes a year are produced. With subsidy of $20 a tonne, marginal cost minus subsidy falls by $20 a tonne and the new supply curve is S – subsidy.

Subsidies result: market price falls to $30 a tonne and farmers increase the quantity to 60 million tonnes a year. farmers’ marginal cost increases to $50 a tonne. farmers receive more on each tonne produced—the price of $30 a tonne plus the subsidy of $20 a tonne, which is $50 a tonne. Is that why we do this policy?

So why do we do these? Efficient? Fair?

Illegal Goods Textbook pages

Markets for Illegal Goods
The Canadian government prohibits trade of some goods, such as illegal drugs. Yet, markets exist for illegal goods and services. How does the market for an illegal good work? To see how the market for an illegal good works, we begin by looking at a free market and see the changes that occur when the good is made illegal.

A Free Market for a Drug Figure 6.13 shows the market for a drug such as marijuana. Market equilibrium is at point E. The price is PC and the quantity is QC.

Penalties on Sellers If the penalty on the seller is the amount HK, then the quantity supplied at a market price of PC is QP. Supply of the drug decreases to S + CBL. The new equilibrium is at point F. The price rises and the quantity decreases.

Penalties on Buyers If the penalty on the buyer is the amount JH, the quantity demanded at a market price of PC is QP. Demand for the drug decreases to D – CBL. The new equilibrium is at point G. The market price falls and the quantity decreases.

But the opportunity cost of buying this illegal good rises above PC because the buyer pays the market price plus the cost of breaking the law.

Penalties on Both Sellers and Buyers With both sellers and buyers penalized for trading in the illegal drug, both the demand for the drug and the supply of the drug decrease.

The new equilibrium is at point H. The quantity decreases to QP. The market price is PC. The buyer pays PB and the seller receives PS.

Legalizing and Taxing Drugs An illegal good can be legalized and taxed. A high enough tax rate would decrease consumption to the level that occurs when trade is illegal. Arguments that extend beyond economics surround this choice. Such as ??

questions Define and give examples of externalities (+/-)
How does an externality affect the MB and MC curves? What does efficiency mean to a society? Consumers? Producer? Define efficiency. Why does market failure occur? Show on a graph? What is a private costs? Social cost? What is socially optimal Q? How is dead weight loss measured? How is efficiency defined and measured and shown on a graph?

questions Why is a rent cap regulated? What are the effects on the market? What is a black market? Is a rent cap efficient ? fair? Why is min wage so controversial? Fairness? Efficiency? Would you rather work at a lower wage or not work at all? How does the graph and the min wage application show this scenario? Why does min wage create and inefficient allocation of labour resources?

questions How does elasticity of demand affect tax incidence? Is elasticity of supply and tax incidence any different? Why is tax inefficient? When would tax be efficient? Alcohol, tobacco, and gasoline often have tax on them. Why ? What are the principles of fairness applied to tax? Explain What are the effects of subsidies and quotas? Why are subsidies and quotas inefficient? Unfair? Does voluntary production quota work?

questions How does imposing a penalty on selling or buying influence market for illegal drugs? Efficiencies? Qd? Qs? Can you defend a case for legalizing drugs using economics? What are the downsides to legalizing drugs? Economics? Other concerns?

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Economics September Lecture 8 Chapter 6

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