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Assessment Task 2: Individual Written Assignment (Microeconomic Analysis Report) Marks: 40 Word Limit: 1500 words Due Date: Friday of Week 9 (7 May 2021, 23:59 hrs Melbourne time)

The Task:  Using the models and theories of either (1) the market or (2) market failure, perform a microeconomic analysis of one appropriate economic issue or phenomenon of your choice. Clearly explain your chosen question, method and conclusionS.

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1

Prices and Markets ECON1020 Semester 2 2020

Professor Robert Hoffmann

possible new bits

5

1. Business Economics 2. Market Demand 3. Price Determination

The Market Prices and Markets: Block 1

6

1.1. Economics 1.2. Economic Method 1.3. The Economy 1.4. Economic Systems

The Market Prices and Markets: Block 1

Lecture 1 Business Economics

1.1.1. Economics: Definition of Economics

Lionel Robbins

Economics is the study of the economy. It

• studies how agents choose to allocate limited resources (rationality) • studies these issues using the scientific method (equilibrium and empiricism) • studies how these choices affect the welfare of society (efficiency)

Definition: Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses (Lionel Robbins).

Definitions: Microeconomics is the branch of economics that studies resource allocation by individual economic agents, markets, firms and government and the impact on efficiency. Macroeconomics is the branch of economics that studies the performance of the economy as a whole at the national, regional and global levels resulting from the interactions between markets, firms and government.

Definitions: Positive economics describes what economic agents actually do. Normative economics recommends what economic agents and society should do.

Macroeconomics 1 ECON 1016

Prices and Markets ECON 1025

em piri

cal Behavioural Business Minor

the ore

tica l

Phenomenon • identification • observation • measurement

Model • definitions • assumptions • variables

Analysis • ceteris paribus • equilibrium • efficiency

Theory • explanations • predictions • policy advice

Test • hypotheses • measurement • statistical analysis

(econometrics)

Price Qd Qs

1 97 23

2 87 33

3 81 43

4 74 54

5 66 66

DV = ⨍(IV1, IV2 …)

1.2.1. Economic Method: Theory and Empiricism Behavioural

Business Minor

1.2.2. Economic Method: Economic Thinking

Observation

Theory

Model

Evidence

Sep!mber 30, 1659.—I, poor miserable Robinson Crusoe, being shipwrecked during a dread#l s$rm, came on shore on %is dismal, unfortuna! island, a& %e rest of %e ship’s company being drowned, and myself almost dead. I had nei%er food, house, and in despair of any relief, saw no%ing but dea% before me—ei%er %at I should be devoured by wild beasts, murdered by savages, or starved $ dea% for want of food.

Definition: the factors of production (FOPs) are those resources used to produce: capital (man-made resources), land (natural resources) and labour (the human resource).

Robinson has resources: • pocket knife • papaya trees • skills • freshwater lake • time (a lot!) • wild goats • knowledge

The allocation of scare resources in the subsistence economy involves the following basic economic problems:

• Problem #1: What to produce? • Problem #2: How to produce?

Production = ⨍(capital, land, labour)

1.3.1. The Economy: The Subsistence Economy

Definition: Allocating limited resources involves trade offs. Opportunity cost is the best alternative that must be given up to obtain something.

Definition: Rationality means economic agents try to optimise and choose the best feasible option given their information and abilities.

Robinson develops labour (skills) I had never handled a $ol in my life; and yet, in (me, by labour, applica(on, and con)ivance, I found at last %at I wan!d no%ing but I could have made it, especia&y if I had had $ols.

Robinson acquires capital Oc$ber 1.—In %e morning I saw, $ my great surprise, %e ship was driven much nearer %e island; I might get on board, and get some necessaries out of her for my relief— I %en swam on board

Production Possibility Frontier

F oo

d (0

00 s

kc al

)

0

2

4

6

8

Shelter (sqm)

0 1 2 3 4 5 6 7 8

Robinson at first Robinson with tools Robinson with tools and new skills

Definition: the production possibility frontier (PPF) shows the various combinations of output that the economy can produce given the available factors of production.

Definition: opportunity cost is the best alternative that must be given up to obtain something.

Robinson must choose a point on the PPF depending on his tastes for the two products. Going from (4,2) to (2,3) involves a trade-off: to afford 1 extra unit of food there is an opportunity cost of 2 units of shelter which have to be given up in return.

Unattainable

Inefficient

1.3.2. The Economy: Economic Growth

2, 3

4, 2

Production Possibility Frontier

F oo

d (0

00 s

kc al

)

0

2

4

6

8

Shelter (sqm)

0 1 2 3 4 5 6 7 8

Robinson Crusoe “Man Friday” Both Definitions: Absolute advantage is the ability to

produce something with fewer inputs (or more with the same inputs). Comparative advantage is the ability to produce something at lower opportunity cost.

To produce 1 extra unit of shelter, Friday gives up 2 units of food but Robinson only gives up 1/2 unit. Robinson has comparative advantage in making shelter and specialises. Friday specialises in producing food. There is a division of labour.

The gains from trade means both are better off and together produce (8,8). But specialised individuals need to trade to get what each needs: • Problem #3: How to exchange?

4,44,4

6,6

8,80,8

8,0

Definition: the production possibility frontier (PPF) shows the various combinations of output that the economy can produce given the available factors of production.

1.3.2. The Economy: The Exchange Economy

Robinson must choose a point on the PPF depending on his preferences. Going from (4,2) to (2,2) involves a trade-off: 1 extra unit of food has an opportunity cost of 2 units of shelter which have to be given up.

2,4

2,3

4,2

1.4.1. Economic Systems: Markets v. Planning Definition: An economic system is the way which a society allocates its resources, i.e. organises production and exchange (i.e. solves economic problems #1-3).

The free market economy The command economyThe mixed economy

FOP ownership private public

Decision making

individually autonomous

centralised and hierarchical

Coordination market central planning

increasing government intervention

Inputs for production

Wages, rent & profit

Labour, land & capital

Income

Revenue

Firms

Goods & services

sold

Households

Markets for goods & services

Goods & services bought

Spending

Government Markets for the FOPs

Rest of the World

Imports Exports

T he

( cl

os ed

) ec

on om

y T

he (

op en

) ec

on om

y

1.4.2. Economic Systems: The Circular Flow

Singapore?Laos

Economics is about how to allocate one’s resources for the best result. One of the most important issues for a country is what it should produce: What do you use your workers, land and machines for?

Coffee is one of the most widely consumed beverages and therefore most important trade goods. It is widely produced in countries with equatorial climates, like Laos and Vietnam.

Should Singapore grow coffee?

Let’s use some economic thinking to get to the bottom of this. Economists look at real issues through models and theory.

Tutorial 1

Tutorial 1: Gaining from Trading These production possibilities frontiers (PPFs) show how many units of two products 1 worker can produce in one day in two countries:

1. What is Laos’ opportunity cost of producing (a) 1 unit of electronics and (b) 1 unit of coffee beans?

2. What is Singapore’s opportunity cost of producing (a) 1 unit of electronics, and (b) 1 unit of coffee beans?

3. Which if any product(s) does Laos have an absolute advantage in? Which if any products(s) does Singapore have an absolute advantage in?

4. Assume Laos produces 15 coffee and 5 electronics units, and Singapore produces 20 coffee units and 15 electronics units. That means together, they produce 35 units of coffee, and 20 of electronics. Advise the countries how together they can produce more of both. Hint: Economists use theory! Look back at your lecture notes and pick out the correct concept to help you answer.

5. Laos receives foreign aid. Show the new PPF: (a) Machinery from China that doubles Laos’ productivity in electronics but has no other use, (b) training from Vietnam for its coffee workers that raises their productivity by one third.

6. How can any country, like Laos or Singapore, produce more? Provide a general economic model rather than specific examples.

C of

fe e

B ea

ns

0

10

20

30

40

Electronics

0 5 10 15 20 25 30

C of

fe e

B ea

ns

0

10

20

30

40

Electronics

0 5 10 15 20 25 30

Singapore Laos

28

Lecture 2 Market Demand

2.1. The Market Model 2.2. The Demand Curve 2.3. Demand Elasticity 2.4. The Supply Curve

The Market Prices and Markets: Block 1

2.1. The Market Model Definition: The market is an institution where the buyers and sellers of the same good or service come together to trade.

Variables in the allocation of resources • price (p) • quantity of output (q)

Assumptions • rational agents • perfect information • zero transaction cost • flexible prices • property rights defined and enforced • perfect competitionWhile they are “unrealistic” simplifications,

together they tell us under what conditions the market will work well. They serve as a benchmark for the design and improvement of real markets.

The market model shows the relationship between two key variables, price and quantity, for both demand and supply. We analyse the model for equilibrium and efficiency.

Demand side (buyers or consumers)

Supply side (sellers or producers)

Behavioural Business

Minor

2.2.1. Demand Curve: Law of Demand

Demand schedule P QD 14 0 12 1 10 2 8 3 6 4 4 5 2 6 0 7

Demand function: P = 14 – 2QD

QD = -(P-14)/2

Demand comprises all those consumers willing and able to buy the product. How much people buy depends on many variables, we focus on price.

P ric

e (P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7

Definition: the law of demand states that as the price rises, the quantity demanded falls and vice versa (because consumers are relatively worse off and substitute into other products).

Definition: Demand shows how much consumers plan to buy at every conceivable price. Quantity demanded (QD) refers to purchasing plans at one particular price (P).

• slopes downward • steepness reflects consumer price sensitivity • position reflects the volume of demand

Q0

P

p

p’

q q’

D

2.2.2. Demand Curve: Own-Price Elasticity Definition: Elasticity measures the responsiveness of quantity to one of its determinants. We measure elasticity in the steepness (slope) of the curve concerned. There are many types of demand and supply elasticity to determinants such as price of this and related products, income etc.

Definition: own-price elasticity of demand (PED) measures the responsiveness of quantity demanded of a product to its price. It reflects the sensitivity or responsiveness of consumer purchasing plans to price.

The steepness or slope of the demand curve is a measure of own-price elasticity of demand. The flatter the demand curve, the greater is the change in consumers’ purchasing plans.

PED = % ∆ QD

% ∆ P

2.2.3. Demand Curve: Midpoint Formula

Q=2 P=10

Q=5 P=4

Q=0 P=14

P ric

e (P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7

Q=7 P=0

PED = (2 – 0) ⨉ (10 + 14) = 2 ⨉ 24 = -6 (10 – 14) (2 + 0) -4 2

PED = (2-5) ⨉ (10 + 4) = -3 ⨉ 14 = -1 (10-4) (2+5) 6 7

PED = (Q2 – Q1) ⨉ (P2 + P1) (P2 – P1) (Q2 + Q1)

PED = (7 – 5) ⨉ (0 + 4) = 2 ⨉ 4 = -0.167 (0– 4) (7 + 5) -4 12

The measured elasticity between two given points of the demand curve depends on whether we calculate the change from the higher or the lower of the two values, e.g. from P=4 to P=10 or vice versa. As a result we can use the mid-point formula which gives the same result in either case:

PED = (5 – 2) ⨉ (4 + 10) = 3 ⨉ 14 = -1 (4 – 10) (5 + 2) -6 7

The elasticity measured at different points of a linear curve differs because the percentage size of same absolute change (say a price fall of 4 either from 14 to 10 or 4 to 0) differs as we go along the axis.

∆ QD

∆ P

Example calculations:

2.3.1. Demand Elasticity: Own Price

Abs. value 0 between 0 and 1 1 >1 ∞ Classification perfectly

inelastic inelastic unit elastic elastic perfectly

elastic ∆ Q P causes ∆

QD of 0 less than

proportional proportional greater than

proportional total

P

Q

PED = % ∆ QD

% ∆ P Definition: Own-price elasticity of demand (PED) measures the responsiveness of quantity demanded of a product to its price. It reflects the sensitivity or responsiveness of consumer purchasing plans to price.

Necessity Short-term No substitutes Wide market

Luxury Long-term Substitutes Narrow market

2.3.2. Demand Elasticity: Cross Price

Definition: Cross-price elasticity of demand (CPED) measures the responsiveness of quantity demanded of a product to changes the price of another good.

Complements have negative cross-price elasticities.

Substitutes have positive cross- price elasticities.

Unrelated goods have zero cross-price elasticities.

0

0 QdP ric

e of

a no

th er

g oo

d

0 Qd

P ric

e of

a no

th er

g oo

d

0 Qd

P ric

e of

a no

th er

g oo

d

CPED = % ∆ QD

% ∆ POther

Original good (coffee) Original good (coffee) Original good (coffee)

2.3.3. Demand Elasticity: Income

Normal goods have positive income elasticities.

Inferior goods have negative income elasticities.

Necessities tend to have small income elasticities.

Luxuries tend to have large income elasticities.

Income (Y)

0 Qd

YED = % ∆ QD

% ∆ Y

0 Qd

Income (Y)

0 Qd

Income (Y)

0

0 Qd

Income (Y)

Definition: income-elasticity of demand (YED) measures the responsiveness of quantity demanded of a product to changes in consumer income.

P ric

e (P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7 8 9 10 11 12

Supply schedule

P QS

0

2 0

4 2

6 4

8 6

10 8

12 10

14 12

2.4.1. Supply Curve: Law of Supply

Supply function: P = 2 + QS

QS = P − 2

Supply comprises all those producers willing and able to produce the product. How much these firms produce depends on many variables, we focus on price.

• slopes upward • slope reflects producer price sensitivity • position reflects volume of supply

Definition: the law of supply states that as the price rises, the quantity supplied rises and vice versa (because producers substitute out of other products).

Definition: Supply shows how much producers plan to produce at every conceivable price. Quantity supplied refers to one particular price level.

2.4.2. Supply Curve: Own-Price Elasticity

Q0

P

q q’

p’ p

S

A product´s own-price elasticity depends on

• availability of close substitutes • definition of the market • availability of inputs • time horizon

Definition: Own-price elasticity of supply measures the responsiveness of quantity supplied of a product to its price. It reflects the sensitivity or responsiveness of producer purchasing plans to price.

The steepness or slope of the supply curve is a measure of own-price elasticity of supply. The flatter the supply curve, the greater is the change in firms´ producing plans.

PES = % ∆ QS

% ∆ P

Product A Product B Price of A Q

D QS QD

60 0 10.5 16.5 54 2 9 15 48 4 7.5 13.5 42 6 6 12 36 8 4.5 10.5 30 10 3 9 24 12 1.5 7.5 18 14 0 6 12 16 4.5 6 18 3 0 20 1.5

Tutorial 2 – Business Analysis of Demand You work for a market analysis firm that uses checkout data and cost information from producers to estimate the market demand and supply for different products. You have collected market data about two products one of your clients sells, product A and B. The data are shown in the table. Your manager wants you to analyse it and present findings in a report using suitable diagrams and calculations. You are meant to answer the following questions:

1. How sensitive are buyers of product A to a price change in product A from $60 to $54?

2. What is the relationship between product A and product B? 3. Interviews with customers suggest that most regard product A as a necessity. If so, how much would the quantity demanded of product A change if consumer income was to rise by 1%?

4. Your colleague claims he has good knowledge of the production process and firms selling product A and claims supply is generally own- price inelastic. Is he right?

5. Plot all the data for product A in a diagram. 6. What is the quantity of product A that you expect will be sold in this market?

50

The Market Prices and Markets: Block 1

Lecture 3 Price Determination

3.1. Market Equilibrium 3.2. Change in Demand and Supply 3.3. Comparative Statics 3.4. Market Efficiency

P QD QS Difference

14 0 12 12

12 1 10 9

10 2 8 6

8 3 6 3

6 4 4 0

4 5 2 -3

2 6 0 -6

0 7

In the competitive market, the equilibrium occurs at the price where QD = QS. This price clears the market such that no shortage nor surplus exists.

The coffee market

P ric

e (P

)

0

2

4

6

8

10

12

14

Quantity (Q)

0 1 2 3 4 5 6 7 8 9 10 11 12

Demand Supply

3.1.1. Market Equilibrium: Demand and Supply

3.1.2. Market Equilibrium: Market Clearing

Q0

P

D

S Definition: Equilibrium [from Latin aequus (equal) and lībra (level, balance) is a balance of opposing forces, i.e. a stable state of a system under prevailing conditions.

p qD qS

p qDqS

oversupply

shortage

market clearingp*

q*

At first we examine partial equilibrium in a market, i.e. ceteris paribus, prices in related markets (substitutes, complements and FOPs) are constant.

3.2.1. Change in Demand

Q0

P

Factors that change demand • price of substitutes in consumption • price of complements in consumption • consumer income • consumer tastes • changes in population

p

q’

D’

Definition: a change (rise/fall) in demand means that at every price, there is now a different (greater/smaller) quantity demanded.

q

D

q’’

D’’

risefall

3.2.2. Change in Supply

Q0

P

Factors that change supply • price of substitutes in production • price of complements in production • taxes/FOP prices • technology • firm entry/exit

p

q’

Definition: a change (rise/fall) in supply means that at every price, there is now a different (greater/smaller) quantity supplied.

risefall

S’

q

S

q’’

S’’

International Coffe prices (kg Arabica beans in 2010 real US$)

0

1

2

3

4

5

6

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

3.3.1. Comparative Statics: Co!ee Prices QUESTION Coffee is now the second most traded commodity in the world after crude oil. Not only has demand for various coffee products risen sharply in Western countries in recent years, increasingly there is also greater taste for coffee drinks in developing countries such as China and India. In addition, by-products of coffee beans have become popular such as coffee leaves which can be used to brew a tea with known health benefits. However, as a natural produce, coffee plants are subject to weather conditions. Recently major producers such as Brazil have been plagued by droughts. Using the demand-supply model, explain the likely effects of these phenomena in the coffee bean market. How can a market analyst use this information to her advantage?

3.3.2. Comparative Statics: Co!ee Demand

Coffee producing nations

Others 19%

Peru 3%

Guatemala 3%Mexico

4% India 4% Ethiopia

5% Indonesia

6% Colombia 9%

Vietnam 12%

Brazil 35%

3.3.3. Comparative Statics: Co!ee Supply

Q0

P

D

S

p1

q1

We examine the effect of a change in the prevailing conditions on the (initial) equilibrium in the market. We find the new equilibrium and compare it to the previous one.

D’

p2

q2

S’ Commodities – The Wall Street Journal India’s Taste for Coffee to Affect Bean Prices Neena Rai in London and Debi Nayak in Mumbai

“The size of the Indian economy and the rate of growth of the cafe sector, combined with rising spending power and shift in consumer preferences present a tremendous opportunity for us” says Avani Saglani Davda, chief executive of Tata Starbucks Ltd.

Barron’s -Leslie Josephs – Arabica-coffee prices have surged 72% so far this year, after Brazil’s worst drought in decades crimped output, down 8% from last year. Many parts of Brazil’s main arabica-growing areas have received half the normal amount of rainfall.

p3

q3

Coffee prices expected to rise as a result of poor harvests and growing demand Coffee bean prices top $3 a pound for first time in 34 years (Julia Kollewe, The Guardian)

3.3.4. Comparative Statics: Co!ee Price Determination

=- Consumer

value Amount

paid Consumer

surplus

Consumer surplus is the area between the demand curve and the price line.

The demand curve reflects the value consumers receive from consuming.

Definition: consumer surplus is the difference between consumers’ willingness to pay and the amount they actually pay for it is consumers’ gains from trade, i.e. the benefit of buyers from participating in the market.

We measure consumer value of consumption by their willingness to pay, i.e. the price they are willing to pay at every quantity demanded.

3.4.1. Market E”ciency: Consumer Surplus

$10

$70 $4×10=$40 ($6×10)/2=$30

Demand curve: Willingness to pay

Equilibrium: The price everyone pays

Q0

$4

10

Demand

P

P

Q0

$4

Supply

10

=-Amount received Producer surplusProducer cost

The supply curve reflects the cost firms incur in producing.

We measure producer cost of production by their willingness to sell, i.e. the price they accept at every quantity supplied.

Definition: producer surplus is the difference between producers’ willingness to sell and the amount they actually receive for it is producers’ gains from trade, i.e. the benefit of producers from participating in the market.

Producer surplus is the area between the supply curve and the price line.

3.4.2. Market E”ciency: Producer Surplus

($4×10)=$40 ($3×10)/2=$15

$1

$25

Supply curve: Willingness to sell

Equilibrium: The price every firm receives

P

Q0

$4

Supply

10

=+

Demand

Producer surplus

Consumer surplus

Total surplus

Definition: Total surplus is a measure of the benefit of buyers and sellers from participating in the market, the total gains from trade. It is the sum of consumer and producer surplus.

Conversely, it is the value to buyers minus the cost to sellers.

=- Total

surplus Producer

cost Consumer

value

The total benefit to society is the value of consuming the product minus the cost of producing it.

3.4.3. Market E”ciency: Total Surplus

$15$30 $45

$70 $25 $45

P

0

Demand

Q

Supply

Society should continue to produce more as long as the marginal consumer value is greater than the marginal cost of production

This will maximise total surplus and the gains from trade in this market.

$4

10

$10

3.4.4. Market E”ciency: Marginal Surplus

Total surplus is maximal when marginal surplus is equal to the marginal cost.

1a. During the novel coronavirus (COVID-19) pandemic, people of all incomes from poor to rich are stocking up on different types of product they regard as necessary. Suppliers cannot increase their output quickly enough. Australian government is concerned about profiteering and affordability in the markets concerned and is considering intervening. Using the demand-supply model, explain these phenomena in one or two markets of your choice. Advise which market interventions, if any, government should conduct in these markets.

1b. Bangalore has become India’s third biggest city following a population explosion that doubled the number of residents since 2000 to over 10 million. Public infrastructure development cannot keep up with this rapid urbanisation. A water shortage is looming. As a result the city has introduced a ban of constructing new apartments for five years. Using the demand-supply model, assess the effect on condominium unit prices. In particular comment on the likely size of this effect considering the shape of the supply curve.

1c. Workplace automation involves systems, both software and hardware, to perform repetitive tasks reducing the need for labor in the production process. For example automobile manufacturing plants are introducing industrial robots with very little need fo human intervention on the assembly line. Using the demand-supply model, explain the effect of the introduction of such industrial robots in a suitable market of your choice.

1d. During the 1993 ‘mad cow disease” or BSE outbreak in the UK, evidence emerges regarding the dangers of eating beef from infected animals. Which markets are affected, and what are the effects?

Tutorial 3

2. Open your notes for tutorial 2. Your legal department informs you that government has introduced a per-unit tax of $7 to be collected from the sellers in this market. Your manager is worried what that the tax will affect all firms’ willingness and ability to produce and therefore price. What do you think? Make appropriate changes in your graph and numbers to reflect this tax. What is the impact on the equilibrium price and quantity?

3. What can you say about the products in the following three markets?

3.1. 3.2. 3.3. P

0 Q

Supply

Demand

P

0

Demand

Q

Supply

P

0 Q

Supply

Demand

Behavioural Business

Minor

!16

Government Prices and Markets: Block 2

5.1. Information Failure 5.2. Externalities 5.3. Public Goods 5.4. Common Resources

Lecture 5 
 Market Failure

5. Market Failure

Types of Government Intervention

• Education and information

• Institutions, standards • Enforcing property rights • Taxes and subsidies • Providing/subsidising public goods

• Industry regulation • Redistribution and transfers

Market Model Assumptions

• rational agents • perfect information • zero transaction cost • flexible prices • property rights enforced • perfect competition

Definition: Market failure refers to a situation in which the market on its own fails to allocate resources efficiently in that total surplus is not maximised.

A number of types of market failure exist which correspond to violations of the assumptions of the model of the market. When markets fail, governments intervene to try and correct the failure.

Types of market failure

• Bounded rationality • Asymmetric information • Transactions cost • Externalities • Public goods • Imperfect competition • Inequality

Behavioural
 Business


Minor

5.1. Information Failure: Rationality vs Bounded Rationality Definition: Rationality is the assumption that people are “homo economicus”, i.e. gather information carefully weigh costs and benefits to choose the optimal course of action.

Preferences Information

Decision

Real people sometimes: • fail to understand information and make mistakes; • act against their own self interest; • take excessive risks or act overconfidently; • give too much weight to small no. of vivid observations; • are reluctant to change their minds. • are affected by their peers. • are affected by their past actions.

Definition: Bounded (i.e. limited or imperfect) rationality means that real people are not always able to optimise (choose the best option) because they do not have the necessary information available and/or are unable to process it correctly. They use procedure (routines, habits, rules of thumb) instead that sometimes produce bad decisions.

5.1. Information Failure: Bounded Rationality

Definition: merit goods (bads) are goods or services that government thinks people should (not) consume irrespective of tastes or incomes. In the free market, people under (over) consume merit goods (bads). Government enforces or subsidises (prohibits or taxes) the consumption of merit goods (bads).

Government Intervention • provide information (awareness campaigns) • regulate firms to provide information • regulate consumption/production of goods/services

Behavioural
 Business


Minor

Page of 15

5.1.2. Information Failure: Asymmetric Information

Source: Marginal Revolution Universityhttps://www.youtube.com/watch?v=sXPXpJ5vMnU

Page of 15

Definition: Asymmetric information exists when one party to an economic interaction has more (market-) relevant information than another.

Market Solutions • Signalling (informed party reveals private info to uninformed party) • Screening (uninformed party induces informed party to reveal private info)

Adverse selection (hidden characteristics): the seller knows more about the attributes of the good than the buyer who runs a risk of being sold a good of low quality. Examples: used cars, labour, insurance markets. Moral hazard (hidden action): One side takes actions that are relevant to the other side but cannot be observed (shirking, lack of reasonable care).

Asymmetric information can prevent mutually beneficial trades or cause shortages and surpluses in the market.

5.1.2. Information Failure: Asymmetric Information

Government Intervention • provide information (awareness campaigns) • regulate firms to provide information

Behavioural
 Business


Minor

Page of 15

Positive Negative

Production Innovation Pollution

Consumption Vaccination, education Public drunken disorder

Definition: externalities exist when the production or consumption of a good has positive or negative side-effects on third parties which are not accounted for in the price of the good. Externalities are the uncompensated impact of one person’s actions on the wellbeing of a bystander.

5.2. Externalities

Government Intervention • Regulation (command-and-control): forbidding, limiting or mandating certain activities • Market-based policies: to align private incentives with social efficiency. eg. corrective

taxes and subsidies: tax activities that have negative externalities and subsidise activities that have positive externalities;

Market Solutions • Moral codes and social sanctions • Charities • Self-regulation: firms voluntarily agree to and monitor an industry code of conduct

Price

Quantity0

Demand (private value)

QMarket

Supply (private cost)

Social cost (private cost + externality)Cost of pollution

QOpt

A production process causes air pollution which creates a health risk for those who breathe the air.

The cost to society of producing a unit of the good is the private costs of sellers plus the costs to bystanders who are adversely affected by the pollution.

A benevolent social planner maximises the value to consumers minus the cost of production, including the external costs.

The planner would choose the level of production at which the demand curve crosses the social cost curve.

Below QOpt the value of the good to consumers exceeds the social cost of producing it. Above QOpt the social cost exceeds the value to consumers.

5.2.1. Negative Externalities in Production The Guardian – The smoke that many Australians inhaled this summer contains fine particles, known as PM 2.5, that are especially damaging because they can enter the bloodstream. “It can affect every system in your body, which means you’re not only talking about respiratory-related and heart-related problems, people are linking it to diabetes [and] dementia,” Green says.https://www.theguardian.com/environment/ng-interactive/2020/feb/20/the-toxic-air-we-breathe-the-health-crisis-from-australias-bushfires

Price

Quantity0

Demand (private value)

QMarket

Supply (private cost)

Social cost (private cost – externality)

Value of spillover

QOpt

A production process gives rise to a chance that the producer will make a technological advance. Such advances create benefits for society as a whole, known as spillovers, because they add to our pool of knowledge.

Because of these spillovers, the cost to society of producing a unit is less than the private cost of sellers.

Once again, a benevolent social planner maximises the value to consumers minus the cost of production.

In this case the planner would want to increase production until the social cost is equal to the private benefit.

5.2.2. Positive Externalities in ProductionSource:Infographic: how much does Australia spend on science and research?https://theconversation.com/infographic-how-much-does-australia-spend-on-science-and-research-61094

Price

Quantity0

Demand (private value)

QMarket

Supply (private cost)

Externality

QOpt

Social value (private value – externality)

The consumption of alcohol can yield negative externalities if consumers drive under the influence or engage in violent or antisocial behaviour.

Because of the external costs associated with such consumption, the social value is less than the private value.

The planner would want to lower the quantity produced and consumed to QOpt.

5.2.3. Negative Externalities in Consumption

Price

Quantity0

Demand (private value)

QMarket

Supply (private cost)

Externality

QOpt

Social value (private value +

externality)

Vaccines yield positive externalities because they lower the risk of catching diseases for everyone in the population, even those who are not vaccinated.

Because of the external benefits associated with such consumption, the social value is greater than the private value.

The planner would want to increase the quantity produced and consumed to QOpt.

5.2.4. Positive Externalities in Consumption

Behavioural
 Business


Minor

In the market model, property rights are perfectly defined and enforced. This implies goods and services are excludable and rivalrous in consumption which does not always hold in reality.

Private goods and club goods do not present market failure as they have prices attached to them, i.e. they are excludable

Public goods and common resources, because they are non-excludable, provide incentive for people to free ride (consume without paying).

If a person provides a public good, for e.g. national defence, others would be better off and yet they are not charged for this benefit; little incentive to provide the good

If a person uses a common resources, for e.g. fish in the ocean, others would be worse off and yet they are not compensated for this loss.

Definition: public goods are goods that are non-excludable (once produced, no one can be prevented from using the good) and non-rivalrous (one person’s use of the good does not diminish other people’s use).

Rivalrous Non-Rivalrous

Excludable Private goods (coffee) Club goods (Netflix)

Non-Excludable Common resources (fish stocks) Public goods (national defence,

fireworks, lighthouses)

5.3. Public Goods and Common Resources

Behavioural
 Business


Minor

Page of 15

5.3.1 Public Goods: Government Solutions The government can remedy this problem by providing or subsidising the public good and paying for it with tax revenue, to make everyone better off.

National defence – one of the most expensive public goods. Solution: People may disagree on the appropriate levels, but most will agree that some government spending on defence is necessary.

Basic research (knowledge) – general knowledge is a public good; profit seeking firms have incentive to free ride on the knowledge created by others. Solution: Government subsidises the basic research carried out by universities and other research organisations (this is a corrective subsidy on the positive externality generated).

Fighting poverty – everyone prefers living in a society without poverty, but fighting poverty is not a ‘good’ that private actions will adequately provide. Solution: Many government programs are aimed at helping the poor, for e.g. unemployment benefits, old-age pensions, disability support, funded by tax revenue.

Before providing a public good, government conducts a cost-benefit analysis to determine whether it is efficient to do so.

Definition: cost-benefit analysis is a study that compares the costs and benefits to society from the provision of a public good.

5.3.2 Public Goods: Do we need Government Solutions?

The provision of public goods may not require government intervention.

Free-to-air TV and radio – non-excludable and non- rivalrous, yet provided by private firms as for-profit business. For e.g. Freeview.

How is revenue generated, when consumers enjoy for free? Solution: broadcasters sells a complementary, private good i.e. advertising. Sells airtime to advertisers.

Advertisers are willing to pay more if their ads are shown during a program that has many viewers. This gives broadcasters incentive to show programs that viewers want to watch. Hence, viewer demand drives what is shown.

Other examples of the private provision of public goods: search engines e.g. Google and Bing; and video sharing sites e.g. YouTube and Vimeo. These are funded by the revenue from the ads displayed on the webpages.

Charitable Donation – Contributions to charitable causes can be similar to the provision of public goods. Appealing to consumers to contribute rather than free ride can often lead to individuals contributing towards the public good.

The tragedy of the commons refers to the overuse of communal resources. Each fisherman fishing in the common fish stocks reduces the quantity of fish available for others. Because people neglect this negative externality when deciding how much to fish, the result is an excessive number of fish caught. Overfishing eventually damages the fish population’s ability to renew itself, destroying the common resource for everyone.

Definition: Common resources are goods that are non-excludable but rivalrous. Examples include clean air and climate change, oil deposits, congested non-toll roads, fish, whales and other wildlife stocks.

University of Washington – Most countries are trying to provide long-term sustainable yield of their fisheries … We want to know where we are overfishing. Still, most of the fish stocks in South Asia and Southeast Asia do not have scientific estimates of health and status available. Fisheries in India, Indonesia and China alone represent 30% to 40% of the world’s fish catch that is essentially unassessed.

5.4 Common Resources

The Guardian – Around 90% of the world’s stocks are now fully or overfished and production is set to increase further by 2025, according to report from UN’s food body.https://www.washington.edu/news/2020/01/13/fisheries-management-is-actually-working-global-analysis-shows/?menu2=

5.4.1 Common Resources: Government Solutions Congested roads – yield a negative externality. When one person drives on the road, it becomes more crowded, and other people must drive more slowly. •Solution: Government levies a toll or a congestion charge. A toll is a corrective tax on the externality of congestion. Sometimes congestion is a problem only at rush hour. Government can charge higher tolls at rush hour as an incentive for drivers to alter their schedules.

Many species of animals (fish, whale, other wildlife) – are common resources. Fish, for instance, have commercial value, and anyone can go to the ocean and catch whatever is available. Each person has little incentive to maintain the species for the next year. Just as excessive grazing can destroy the commons, excessive fishing can destroy marine populations. •Solution: ??

Two problems prevent successful Government regulation of fish stocks: (1) many countries have access to the oceans, so any solution would require international cooperation among countries that hold different values; (2) Since oceans are so vast, enforcing any agreement is difficult.

5.4.2 Common Resources: Do we need Government Solutions? Overfishing on the commons – the community can prevent the tragedy in a number of ways. Solution: regulate the number of fishing boats in each waterbody or divide up the waterbody among the families.

Clean air and climate change – greenhouse gasses emitted in one country spread around the world contributing to climate change in every country. When a government in one country regulates emissions, it considers only its own environment, not the effects on other countries. Solution: the Coase Theorem suggests that nations can enter into a treaty (e.g. the Paris Accord) which commits them to reduce their own emissions. The treaty behaves like contract, internalising the externality.

Oil deposits – a large oil field lies under many properties with different owners. Any of the owners can extract the oil, but when one owner extracts oil, less is available for the others. Because each owner who drills a well imposes a negative externality on the other owners, the benefit to society of drilling a well is less than the benefit to the owner who drills it. If owners of the properties decide individually how many oil wells to drill, they will drill too many. Solution: some type of joint action or agreement among the owners is necessary to solve the problem and ensure that oil is extracted at lowest cost.

!33

Government Prices and Markets: Block 2

6.1. Government Failure 6.2. Welfare Effects of Taxation 6.3. Welfare Effects of Subsidies 6.4. Welfare Effects of Trade Restrictions

Lecture 6 
 Government Failure

Reasons for Government Failure

• Administrative cost of intervention (bureaucracy; monitoring, compliance enforcement) exceeds the benefit • Government pursues the wrong objectives

• Vested interest: Government pursues its own political interest and not the public interest • Regulatory capture: Government pursues the interest of special interest groups or firms through lobbying • Paternalism: Government pursues “nanny state” objectives that violate consumer sovereignty • Governments pursues multiple conflicting interests • Policy myopia: Intervention provides quick fixes that work only short term

• Government intervention fails to correct the market failure • Information failure: government lacks knowledge, expertise and information to devise optimal regulation • Compliance cost of firms or consumers is excessive relative to market failure • Intervention has unintended consequences that deepen existing or create new market failures • Intervention disincentivises economic agents

Definition: Government failure happens when government intervention fails to correct or exacerbates market failure.

6.1. Government Failure Government has an important role as an alternative to the market as an allocator of resources. However, just as markets can fail, government intervention can have adverse effects through government failure and by creating a deadweight welfare loss.

Definition: Deadweight loss is the reduction in total surplus that results from a market distortion, such as from direct regulation (tax, subsidy) or trade restrictions (tariffs or quotas).

I think some additional regulation (of Wall Street) is needed. But I don’t think you can rely on regulators, because they fail along with the

market (Gary Becker, 1930-2014)

Government has become too responsive to trivial concerns at the

expense of our liberty, and dependent on where TV journalists point their cameras

(William Niskanen, 1933–2011)

The tax creates a wedge between the price paid by buyers, and the price received by sellers.

The price buyers pay rises, and the price sellers receive falls.

The quantity traded is lower than in the equilibrium without tax.

Price

Quantity0

Price buyers

pay

Quantity without tax

Demand

Supply1

Equilibrium without tax

Quantity with tax

Equilibrium with tax

Price sellers

receive

Tax

Supply2

6.2.1. Welfare Effects of Taxation – Deadweight Loss

Consumer surplus

Producer surplus

Price

Quantity0

Price buyers

pay

Quantity without tax

Demand

Supply1

Quantity with tax

Price sellers

receive

Supply2

Consumer surplus

Tax revenue

The tax reduces the welfare of both buyers and sellers: • Consumer surplus is reduced because buyers purchase

a lower quantity at a higher price. • Producer surplus is reduced because sellers sell a lower

quantity at a lower price.

The government raises tax revenue equal to the size of tax times the quantity traded. It measures the benefit that the government derives from the tax.

Because tax revenue funds the provision of goods and services, households are the ultimate beneficiaries of taxation.

The deadweight loss of taxation is the area of the triangle between demand, supply and the quantity with tax. It was part of the total surplus without tax, but is not part of the total surplus with tax.

The deadweight loss exists because the revenue raised by the tax is less than the loss of consumer and producer surplus due to the tax.

Producer surplus

6.2.1. Welfare Effects of Taxation – Deadweight Loss

Deadweight loss

Tax reduces quantity traded from Q1 to Q2.

At every quantity between Q1 and Q2 the value to the marginal buyer exceeds the cost to the marginal seller.

The difference between these values equals the gains from trade that are lost because the transaction does not occur.

The tax prevents any transaction for which the gains from trade are less than the size of the tax.

Price

Quantity0

Price buyers

pay

Q1

Demand

Supply1

Price sellers

receive

Tax

Supply2

Value to buyers

Cost to sellers

Lost gains from trade

Q2

6.2.1. Welfare Effects of Taxation – Deadweight Loss

A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.

The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less.

Hence the equilibrium quantity in the market shrinks below the optimal quantity.

The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks, and the greater the deadweight loss.

6.2.2. Welfare Effects of Taxation – Elasticity

A small tax has a small effect on buyer and seller behaviour (and vice versa). Because the quantity traded is close to the optimal quantity, the deadweight loss is small. Because the size of the tax is small, tax revenue is small.

As the size of the tax rises, the effect on buyer and seller behaviour also grows. Tax revenue initially increases because the size of the tax is growing proportionately faster than quantity traded is falling. The deadweight loss grows faster than tax revenue because the size of the tax, and the difference between the quantity with and without the tax, both increase.

As the size of tax the continues to increase, it eventually reaches a point where the quantity traded falls proportionately faster than the size of the tax grows. Tax revenue falls. The deadweight loss continues to grow at an increasing rate.

6.2.3. Welfare Effects of Taxation – Size of Tax

Consumer surplus is increased by the subsidy because buyers purchase a higher quantity at a lower price.

Producer surplus is increased by the subsidy because sellers sell a higher quantity at a higher price.

The government pays the cost of the subsidy (the size of the subsidy times the quantity traded).

The cost of the subsidy subtracts from government revenue. Each dollar spent as a subsidy is a dollar that cannot be spent on the provision of goods and services.

6.3.1. Welfare Effects of Subsidies – Cost

Price

Quantity0

Demand

Quantity without subsidy

Subsidy

Supply

Price without subsidy

Price buyers

pay

Quantity with

subsidy

Price sellers

receive

F

A

B C

D E

G

Without subsidy With subsidy Change

Consumer surplus A+B A+B+D+E Gain D + E

Producer surplus D+G B+C+D+G Gain B + C

Cost of subsidy None –(B+C+D+E+F)

Lose B+C+D+E+F

Total surplus A+B+D+G A+B+D+G–F Lose F

6.3.2. Welfare Effects of Subsidies – Deadweight Loss

Deadweight loss The deadweight loss from a subsidy is the amount by which the

cost of the subsidy exceeds the increase in consumer and producer surplus.

At every quantity between Q1 and Q2, the value to the marginal buyer is less than the cost to the marginal seller (the gains from trade are negative).

The subsidy causes buyers and sellers to participate in transactions that would otherwise not have occurred.

Equilibrium without subsidy

The subsidy creates a wedge between the price paid by buyers and the price received by sellers. Both are better off – the price buyers pay falls and the price sellers receive rises. The quantity traded is higher than in the equilibrium without subsidy.

To assess overall efficiency we must compare the increased welfare of buyers and sellers with the government’s cost of the subsidy.

If the world price is higher than the domestic price, the country will be an exporter of the good (it has a comparative advantage). Domestic sellers will want to receive the higher prices available in the world markets. If the world price is lower than the domestic price, the country be an importer of the good. Domestic buyers will quickly start buying the good at lower prices from world markets.

6.4. Welfare Effects of Free Trade

In a closed economy buyers can only purchase goods from domestic sellers who can only sell to domestic buyers. When an economy is opened to international trade, buyers can buy goods from world markets and sellers can sell into world markets. In a small open economy, domestic buyers and sellers have a negligible effect on world markets. They are price takers, they take the world price, the price of a good that prevails in the world market.

When a country allows trade and imports, domestic consumers of the good are better off and domestic producers of the good are worse off. When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off and domestic consumers of the good are worse off. On the whole, free trade raises the overall economic wellbeing of a nation, for the gains of the winners exceed the losses of the losers.

Quantity

Domestic Supply

Domestic Demand

P1

Q1Qd Qs

CS

B

A

C

In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.

If the world price is higher than P1, when this market is opened to international trade, sellers are not willing to accept any price below the world price.

The domestic price rises to the world price and domestic sellers produce the quantity QS.

Because the price has risen, the domestic quantity demanded falls to QD. The difference is exported to world markets.

The increase in the domestic price reduces consumer surplus and increases producer surplus: •Area A is producer surplus in a closed economy. •Area B is surplus that is transferred from consumers to producers when the price rises to the world price. •Area C is the gains from free (international) trade.

6.4. Welfare Effects of Free Trade: exporting country

Exports

World price

CS

PS

A

C

Quantity

Domestic Supply

Domestic Demand

World price

P1

Q1 QdQs

PS

B

In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.

If the world price is lower than P1, when this market is opened to international trade, buyers are not willing to pay any price above the world price.

The domestic price falls to the world price and domestic sellers produce the quantity QS.

Because the price has fallen, the domestic quantity demanded rises to QD. The difference is imported from world markets.

The fall in the domestic price increases consumer surplus and reduces producer surplus: •Area A is consumer surplus in a closed economy. •Area B is surplus that is transferred from producers to consumers when the price falls to the world price. •Area C is the gains from free (international) trade.

6.4. Welfare Effects of Free Trade: importing country

Imports

CS

6.4. Welfare Effects of Trade Restrictions

However, government intervenes and imposes trade restrictions (protectionist policies) for some of the following reasons: • Domestic jobs • National security • Infant industry • Unfair competition • As a bargaining chip

The Sydney Morning Herald- The eternal temptation in international trade is protectionism: please buy all our exports, but we’ll be importing as few as possible of your exports. It’s tempting because, to the voters in every country, it seems just common sense to favour your own industries over their rivals in other countries.

The South China Morning Post- Can China meet US trade war demands on IP theft and forced technology transfer? Systemic IP theft in China costs US companies at least US$50 billion per year, according to a US Trade Representative (USTR) report published in April 2018, following an investigation under Section 301 of the Trade Act of 1974. The US claims the Chinese government is coordinating an espionage campaign designed to capture cutting-edge technology to boost industrial policy. Outright theft of US IP is a key part of this strategy, the US argues.

QdT

PS

6.4. Welfare Effects of Free Trade: Tariff The increase in the domestic price increases producer surplus and decreases consumer surplus: • Area A is surplus that is transferred from consumers

to producers as a result of the tariff. • Area C is the revenue that the government receives

from tariff. This area was part of consumer surplus under free trade.

• Areas B and D are part of consumer surplus under free trade, but do not contribute to the total surplus with a tariff. Therefore, area B + D is the deadweight loss from the tariff.

Notice that areas B and D are part of the gains from free trade. The tariff moves the market closer to the equilibrium without trade.

A tariff causes a deadweight loss because it is a type of tax. The tariff raises the price that domestic producers can charge above the world price, encouraging them to increase production. It also raises the price that domestic buyers pay, encouraging them to reduce consumption.

QsT

New Imports

Quantity

Domestic Supply

Domestic Demand

Pw

Old Imports

Qs Qd

CS

A B DC Pw +Tariff

!33

Government Prices and Markets: Block 2

6.1. Government Failure 6.2. Welfare Effects of Taxation 6.3. Welfare Effects of Subsidies 6.4. Welfare Effects of Trade Restrictions

Lecture 6 
 Government Failure

Reasons for Government Failure

• Administrative cost of intervention (bureaucracy; monitoring, compliance enforcement) exceeds the benefit • Government pursues the wrong objectives

• Vested interest: Government pursues its own political interest and not the public interest • Regulatory capture: Government pursues the interest of special interest groups or firms through lobbying • Paternalism: Government pursues “nanny state” objectives that violate consumer sovereignty • Governments pursues multiple conflicting interests • Policy myopia: Intervention provides quick fixes that work only short term

• Government intervention fails to correct the market failure • Information failure: government lacks knowledge, expertise and information to devise optimal regulation • Compliance cost of firms or consumers is excessive relative to market failure • Intervention has unintended consequences that deepen existing or create new market failures • Intervention disincentivises economic agents

Definition: Government failure happens when government intervention fails to correct or exacerbates market failure.

6.1. Government Failure Government has an important role as an alternative to the market as an allocator of resources. However, just as markets can fail, government intervention can have adverse effects through government failure and by creating a deadweight welfare loss.

Definition: Deadweight loss is the reduction in total surplus that results from a market distortion, such as from direct regulation (tax, subsidy) or trade restrictions (tariffs or quotas).

I think some additional regulation (of Wall Street) is needed. But I don’t think you can rely on regulators, because they fail along with the

market (Gary Becker, 1930-2014)

Government has become too responsive to trivial concerns at the

expense of our liberty, and dependent on where TV journalists point their cameras

(William Niskanen, 1933–2011)

The tax creates a wedge between the price paid by buyers, and the price received by sellers.

The price buyers pay rises, and the price sellers receive falls.

The quantity traded is lower than in the equilibrium without tax.

Price

Quantity0

Price buyers

pay

Quantity without tax

Demand

Supply1

Equilibrium without tax

Quantity with tax

Equilibrium with tax

Price sellers

receive

Tax

Supply2

6.2.1. Welfare Effects of Taxation – Deadweight Loss

Consumer surplus

Producer surplus

Price

Quantity0

Price buyers

pay

Quantity without tax

Demand

Supply1

Quantity with tax

Price sellers

receive

Supply2

Consumer surplus

Tax revenue

The tax reduces the welfare of both buyers and sellers: • Consumer surplus is reduced because buyers purchase

a lower quantity at a higher price. • Producer surplus is reduced because sellers sell a lower

quantity at a lower price.

The government raises tax revenue equal to the size of tax times the quantity traded. It measures the benefit that the government derives from the tax.

Because tax revenue funds the provision of goods and services, households are the ultimate beneficiaries of taxation.

The deadweight loss of taxation is the area of the triangle between demand, supply and the quantity with tax. It was part of the total surplus without tax, but is not part of the total surplus with tax.

The deadweight loss exists because the revenue raised by the tax is less than the loss of consumer and producer surplus due to the tax.

Producer surplus

6.2.1. Welfare Effects of Taxation – Deadweight Loss

Deadweight loss

Tax reduces quantity traded from Q1 to Q2.

At every quantity between Q1 and Q2 the value to the marginal buyer exceeds the cost to the marginal seller.

The difference between these values equals the gains from trade that are lost because the transaction does not occur.

The tax prevents any transaction for which the gains from trade are less than the size of the tax.

Price

Quantity0

Price buyers

pay

Q1

Demand

Supply1

Price sellers

receive

Tax

Supply2

Value to buyers

Cost to sellers

Lost gains from trade

Q2

6.2.1. Welfare Effects of Taxation – Deadweight Loss

A tax has a deadweight loss because it induces buyers and sellers to change their behaviour.

The tax raises the price paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less.

Hence the equilibrium quantity in the market shrinks below the optimal quantity.

The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks, and the greater the deadweight loss.

6.2.2. Welfare Effects of Taxation – Elasticity

A small tax has a small effect on buyer and seller behaviour (and vice versa). Because the quantity traded is close to the optimal quantity, the deadweight loss is small. Because the size of the tax is small, tax revenue is small.

As the size of the tax rises, the effect on buyer and seller behaviour also grows. Tax revenue initially increases because the size of the tax is growing proportionately faster than quantity traded is falling. The deadweight loss grows faster than tax revenue because the size of the tax, and the difference between the quantity with and without the tax, both increase.

As the size of tax the continues to increase, it eventually reaches a point where the quantity traded falls proportionately faster than the size of the tax grows. Tax revenue falls. The deadweight loss continues to grow at an increasing rate.

6.2.3. Welfare Effects of Taxation – Size of Tax

Consumer surplus is increased by the subsidy because buyers purchase a higher quantity at a lower price.

Producer surplus is increased by the subsidy because sellers sell a higher quantity at a higher price.

The government pays the cost of the subsidy (the size of the subsidy times the quantity traded).

The cost of the subsidy subtracts from government revenue. Each dollar spent as a subsidy is a dollar that cannot be spent on the provision of goods and services.

6.3.1. Welfare Effects of Subsidies – Cost

Price

Quantity0

Demand

Quantity without subsidy

Subsidy

Supply

Price without subsidy

Price buyers

pay

Quantity with

subsidy

Price sellers

receive

F

A

B C

D E

G

Without subsidy With subsidy Change

Consumer surplus A+B A+B+D+E Gain D + E

Producer surplus D+G B+C+D+G Gain B + C

Cost of subsidy None –(B+C+D+E+F)

Lose B+C+D+E+F

Total surplus A+B+D+G A+B+D+G–F Lose F

6.3.2. Welfare Effects of Subsidies – Deadweight Loss

Deadweight loss The deadweight loss from a subsidy is the amount by which the

cost of the subsidy exceeds the increase in consumer and producer surplus.

At every quantity between Q1 and Q2, the value to the marginal buyer is less than the cost to the marginal seller (the gains from trade are negative).

The subsidy causes buyers and sellers to participate in transactions that would otherwise not have occurred.

Equilibrium without subsidy

The subsidy creates a wedge between the price paid by buyers and the price received by sellers. Both are better off – the price buyers pay falls and the price sellers receive rises. The quantity traded is higher than in the equilibrium without subsidy.

To assess overall efficiency we must compare the increased welfare of buyers and sellers with the government’s cost of the subsidy.

If the world price is higher than the domestic price, the country will be an exporter of the good (it has a comparative advantage). Domestic sellers will want to receive the higher prices available in the world markets. If the world price is lower than the domestic price, the country be an importer of the good. Domestic buyers will quickly start buying the good at lower prices from world markets.

6.4. Welfare Effects of Free Trade

In a closed economy buyers can only purchase goods from domestic sellers who can only sell to domestic buyers. When an economy is opened to international trade, buyers can buy goods from world markets and sellers can sell into world markets. In a small open economy, domestic buyers and sellers have a negligible effect on world markets. They are price takers, they take the world price, the price of a good that prevails in the world market.

When a country allows trade and imports, domestic consumers of the good are better off and domestic producers of the good are worse off. When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off and domestic consumers of the good are worse off. On the whole, free trade raises the overall economic wellbeing of a nation, for the gains of the winners exceed the losses of the losers.

Quantity

Domestic Supply

Domestic Demand

P1

Q1Qd Qs

CS

B

A

C

In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.

If the world price is higher than P1, when this market is opened to international trade, sellers are not willing to accept any price below the world price.

The domestic price rises to the world price and domestic sellers produce the quantity QS.

Because the price has risen, the domestic quantity demanded falls to QD. The difference is exported to world markets.

The increase in the domestic price reduces consumer surplus and increases producer surplus: •Area A is producer surplus in a closed economy. •Area B is surplus that is transferred from consumers to producers when the price rises to the world price. •Area C is the gains from free (international) trade.

6.4. Welfare Effects of Free Trade: exporting country

Exports

World price

CS

PS

A

C

Quantity

Domestic Supply

Domestic Demand

World price

P1

Q1 QdQs

PS

B

In a closed economy, the domestic equilibrium price is P1 and the quantity traded is Q1.

If the world price is lower than P1, when this market is opened to international trade, buyers are not willing to pay any price above the world price.

The domestic price falls to the world price and domestic sellers produce the quantity QS.

Because the price has fallen, the domestic quantity demanded rises to QD. The difference is imported from world markets.

The fall in the domestic price increases consumer surplus and reduces producer surplus: •Area A is consumer surplus in a closed economy. •Area B is surplus that is transferred from producers to consumers when the price falls to the world price. •Area C is the gains from free (international) trade.

6.4. Welfare Effects of Free Trade: importing country

Imports

CS

6.4. Welfare Effects of Trade Restrictions

However, government intervenes and imposes trade restrictions (protectionist policies) for some of the following reasons: • Domestic jobs • National security • Infant industry • Unfair competition • As a bargaining chip

The Sydney Morning Herald- The eternal temptation in international trade is protectionism: please buy all our exports, but we’ll be importing as few as possible of your exports. It’s tempting because, to the voters in every country, it seems just common sense to favour your own industries over their rivals in other countries.

The South China Morning Post- Can China meet US trade war demands on IP theft and forced technology transfer? Systemic IP theft in China costs US companies at least US$50 billion per year, according to a US Trade Representative (USTR) report published in April 2018, following an investigation under Section 301 of the Trade Act of 1974. The US claims the Chinese government is coordinating an espionage campaign designed to capture cutting-edge technology to boost industrial policy. Outright theft of US IP is a key part of this strategy, the US argues.

QdT

PS

6.4. Welfare Effects of Free Trade: Tariff The increase in the domestic price increases producer surplus and decreases consumer surplus: • Area A is surplus that is transferred from consumers

to producers as a result of the tariff. • Area C is the revenue that the government receives

from tariff. This area was part of consumer surplus under free trade.

• Areas B and D are part of consumer surplus under free trade, but do not contribute to the total surplus with a tariff. Therefore, area B + D is the deadweight loss from the tariff.

Notice that areas B and D are part of the gains from free trade. The tariff moves the market closer to the equilibrium without trade.

A tariff causes a deadweight loss because it is a type of tax. The tariff raises the price that domestic producers can charge above the world price, encouraging them to increase production. It also raises the price that domestic buyers pay, encouraging them to reduce consumption.

QsT

New Imports

Quantity

Domestic Supply

Domestic Demand

Pw

Old Imports

Qs Qd

CS

A B DC Pw +Tariff

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