microeconomics test 3

Legislative burden of a tax

o   : this is who the law says must physically pay the tax to the government

§  Ex: the producer pays the soda tax

§  Ex: the consumer has a tax added to their purchase to pay the soda tax

   Economic Burden of a tax

§  This is who is actually made worse off by the tax in terms of higher prices paid or lower revenue received

·      Ex: consumers bear the burden if the prices rise, and producers bear the burden if the price they receive falls

·      This depends on ELASTICITY, not who legally pays

o   Key difference between legislative burden and economic burden

§  Legislative the government tells to pay the tax

§  Economic burden=who actually feels the tax in their wallet

·      Ex: the law might say that producers pay the tax, but if price goes up, consumers are the ones really paying more

Suppose the government is concerned about obesity so they place a tax on soda. The tax falls on producers 

shift the production curve left because production cost increases for producers 

price consumers pay-tax=price producers receive 

Suppose the government is concerned about obesity so they place a tax on soda. The tax is paid by consumers

The demand curve will shift left

price consumers pay-tax=price producers receive

consumers and producers are both effected by this

what determines who bears the burden of the tax

elasticity

if demand is elastic, producers can’t change the price as much so they bear more of the burden when demand is more elastic than supply.

suppose consumers will bear the burden and demand is more elastic than supply

demand will shift left which causes price consumers pay to only go up slightly and price producers receive to go down a lot.

In general

if price elasticity of demand is greater than price elasticity of supply, producers bear a greater share of the burden of tax

·      Describe the impact of price elasticity of demand and price elasticity of supply on who bears the economic burden of an excise tax.

The side of the market that is more inelastic bears a greater share of the economic burden of the tax, while the side that is more elastic bears less of the burden.

Inelastic = Stuck = Gets Screwed.

·      Use the model of demand/supply to illustrate who bears a relatively larger share of the economic burden (producers or consumers) of an excise tax.

The side of the market that is more inelastic (steeper curve) bears the larger share of the economic burden, because that side is less able to change its quantity in response to the tax.

Why Trade is Good (Comparative Advantage)

Comparative advantage means:

• Each country should produce the goods it can make at a lower opportunity cost, and

• Trade for the goods it is less efficient at making.

Even if one country is better at making everything, it still benefits by specializing in what it is relatively better at and trading.

Why this makes trade good:

When countries specialize based on comparative advantage:

• Total production increases

• Each country can consume more than it could produce on its own

• Goods become cheaper

• Overall economic welfare increases

So trade allows countries to get more stuff for the same amount of resources.

·      Describe the benefits of free trade.

1. Lower Prices for Consumers
   When countries trade freely, goods are produced where they are cheapest.
   → Consumers pay lower prices and can buy more.

2. Greater Variety of Goods
   Free trade lets countries access products they don’t or can’t produce well.
   → People get more choices (foods, cars, clothes, tech, etc.).

3. Increased Efficiency & Specialization
   Countries specialize in producing goods where they have a comparative advantage.
   → Resources are used more efficiently, increasing total output.

4. Higher Total Economic Welfare
   Trade increases total surplus (consumer + producer surplus).
   → Even though some groups lose, overall society is better off.

5. Bigger Markets for Producers
   Companies can sell products to more people worldwide.
   → Leads to more production, innovation, and growth.

arguments against free trade

1. Domestic Producers May Be Hurt
   When cheaper foreign goods enter the market, domestic firms may lose sales or go out of business.
   → Leads to job losses in affected industries.

2. Infant Industry Argument
   New industries may need protection (like tariffs) until they become competitive.
   Without help, they could be crushed by established foreign companies.

3. National Security Concerns
   A country may not want to rely on foreign suppliers for critical goods (steel, energy, medicine).
   → If trade is disrupted, this could be dangerous.

4. Unfair Competition / Low Standards Abroad
   Other countries may have lower wages, weaker environmental rules, or unsafe working conditions.
   → Domestic firms argue this makes competition unfair.

·      Explain why the market-determined or equilibrium quantity in markets where there are no externalitiesis the “just right” quantity.

In markets without externalities, the equilibrium quantity is “just right” because it is where the marginal benefit to consumers equals the marginal cost to producers, maximizing total surplus and achieving an efficient allocation of resources.

Equilibrium = Benefits match Costs = No waste.

3 ways markets fail

1. don’t produce enough of something we value

   1. Sometimes a good has benefits to society that the buyer doesn’t pay for.

   2. Because of this, the market doesn’t produce enough of it on its own.

   Examples:

   • Education

   • Vaccinations

   • Public parks

   Why: These create positive spillover benefits for others.

   Government Fix:

   • Subsidies or the government provide the good.

2. gives us too much of something we don’t value enough

   1. Sometimes producing or consuming a good hurts other people who aren’t involved.

   2. So the market over-produces it.

   Examples:

   • Pollution

   • Secondhand smoke

   • Excessive alcohol production

   Why: These create negative spillover costs for others.

   Government Fix:

   • Taxes, regulations, or pollution limits.

3. produces unfair outcomes that hurt groups of people 

   1. Even if the total output is “efficient,” the results can still hurt certain groups.

   2. Markets don’t guarantee fairness.

   Examples:

   • Monopolies controlling prices

   • Workers losing jobs due to trade

   • Income inequality

   Government Fix:

   • Regulations, antitrust laws, minimum wage, or social safety programs.

·      Describe and give an example of a negative externality.

A negative externality happens when producing or consuming a good creates a cost for people who are not part of the transaction.
In other words, others get hurt even though they weren’t involved.

Example

Pollution from a factory.

• The factory makes a product for buyers.

• But the pollution it releases hurts nearby residents (dirty air, health problems).

• These people pay the cost, even though they didn’t choose to.

Why This Is a Problem

Because the cost is dumped on others, the market produces too much of the good.

·      Describe and give an example of a positive externality.

A positive externality happens when producing or consuming a good creates benefits for people who are not part of the transaction.
So society benefits more than the individual buyer does.

Getting a vaccine.

• You get the vaccine to protect yourself.

• But you also reduce the spread of illness, which protects others around you.

• Those extra benefits to others are not included in the market price.

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Why This Is a Problem

Since buyers only think about their own benefit, and not the wider social benefit, the market produces too little of the good.

Because if everyone took the full benefit (personal + social) into account, more of the good would be produced and consumed.

But people only see their personal benefit, so they stop too early.

·      Explain why in markets where externalities are present, there is not an efficient allocation of resources.  (i.e., Why don’t markets produce the “just right” amount when an externality is present?)

When externalities are present, individuals only consider their own costs and benefits and ignore the external effects on others, so the market price does not reflect the true social value or cost, causing the market to produce either too much or too little compared to the efficient (just right) amount.

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Memory Trick

Private decisions ≠ Social outcomes → Inefficiency.

pos and neg externality example

Negative Externality Example: Pollution

• The factory produces goods.

• But someone else breathes the pollution.

• The factory doesn’t pay for the harm it causes.

So from the factory’s point of view:

• Producing more looks cheap, because they aren’t paying the full cost.

So they produce more than they should.

→ Too much is produced.

Positive Externality Example: Vaccines

• You get the vaccine.

• Other people benefit because they are less likely to get sick.

• But no one pays you for protecting others.

So from your point of view:

• Getting the vaccine looks less valuable, because you don’t get the extra benefit others receive.

So fewer people get vaccinated than is best for society.

→ Too little is produced.

closed economy

an economy that does not engage in trade.

 

govt policy to address externalities: Command-and-Control

The government sets rules that force people or firms to behave a certain way.

Examples:

• Limits on how much pollution a factory can release

• Banning certain harmful activities

• Requiring specific equipment (like scrubbers on smokestacks)

Key Idea:
Government commands behavior and controls the outcome directly.

govt policy to address externalities: Market-Based Policies

The government uses incentives (prices, taxes, rewards) to encourage people or firms to change behavior on their own.

Examples:

• Taxes on pollution (makes it more expensive to pollute)

• Subsidies for positive actions (like paying you to get solar panels)

• Cap-and-trade (companies buy/sell pollution permits)

Key Idea:
Let the market find the most cost-effective way to change behavior.

·      Explain why the imposition of a tax in a market where an externality is present does not lead to a deadweight loss, as well as why a tax imposed on a market where no externalities are present does lead to a deadweight loss.

When there is no externality, a tax moves the market away from the efficient quantity and causes deadweight loss. However, when a negative externality is present, the market is producing too much, so a corrective tax reduces output to the socially optimal quantity, eliminating deadweight loss.

Bad market + tax = fix.
Good market + tax = problem.

What Are Tradable Pollution Permits?

Think of them like pollution tickets.

• The government decides the total amount of pollution that is allowed in the whole economy.

• It then issues a limited number of permits.

• Each permit allows a company to produce a certain amount of pollution.

So if you don’t have a permit, you’re not allowed to pollute.

Companies are allowed to buy and sell the permits to each other.

• If a company can reduce pollution cheaply, it does so, and then sells its permits for money.

• If a company can’t reduce pollution easily (it’s expensive for them), they buy permits from others instead.

This allows pollution to be reduced in the cheapest possible way.

command and control vs traceable permits 

• Command-and-Control = government tells every firm what to do → rigid and costly.

• Tradable Permits = government sets total pollution allowed, but lets companies figure out the cheapest way to reduce it → efficient.

·      Explain how a system of tradable pollution permits can lead to a more efficient allocation of resources when a negative externality is present compared to a command-and-control policy.

A command-and-control policy gives every firm the same pollution limit, even though some firms could reduce pollution more cheaply than others. This makes reducing pollution more costly than it needs to be.

A tradable pollution permit system sets a total pollution limit but lets firms buy and sell permits. Firms that can reduce pollution cheaply do more of the reduction and sell permits, while firms that have high reduction costs buy permits.

→ This achieves the same pollution reduction at a lower total cost, making it more efficient than command-and-control.

Positive Externality shifts

demand right to show social benefits

Negative exernality shifts

Supply shifts left because its more costly to society than the producer

A corrective tax is used to:

A corrective tax makes the bad/harmful activity more expensive, so less of it happens.

Why?

Because the market was producing too much of the harmful thing (like pollution, smoking, fertilizer runoff).
The tax pushes the quantity down to the socially optimal level.

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Super Simple Definition (Write This Down)

A corrective tax is a tax placed on a good that has negative externalities, used to reduce the quantity produced to the socially efficient level.

Why does a positive externality (a good that benefits others) cause the market to produce too little of that good?

• When someone does something that helps others, they don’t get rewarded for helping those others.

• So they only consider their own benefit, not the extra benefit to society.

• Because they don’t get the full benefit, they are less willing to buy/do the activity.

Result:

The market ends up producing too little of the good compared to what would be best for society.

Example:

Vaccines

• You benefit by not getting sick.

• Others also benefit because disease spreads less.

• But you don’t get paid for helping others → so fewer people get vaccinated → too little vaccination happens.

Why is the social cost (MSC) higher than the private cost (S) when there is a negative externality?

Explanation (Simple):

• The producer only pays their own cost (private cost).

• But their actions also hurt other people (external cost).

• So society pays more than the producer pays.

Result:

Social Cost = Private Cost + External Cost

Example:

A golf course uses fertilizer → fertilizer pollutes water → nearby residents get sick.
Those residents pay the cost, not the golf course → society pays more than the producer does.

What does the distance between the social cost curve and the Supply curve represent?

The external cost per unit — the cost dumped on others that the producer does not pay.

Example (Easy):

If each round of golf causes $5 worth of water contamination, then:

• Private Supply only includes golf course costs.

• MSC = golf course cost + $5 harm per round.

• The $5 difference is the external cost.

Why do we use a tax for a negative externality?

Explanation (Simple):

• A negative externality means the market is producing too much of something harmful.

• A corrective tax makes producing/consuming that thing more expensive.

• This reduces the quantity back down to the socially optimal level.

Example:

A tax on fertilizer use makes golf courses use less fertilizer → less water pollution.

Why do we use a subsidy for a positive externality?

Explanation (Simple):

• A positive externality means the market is producing too little of something good.

• A subsidy makes that good cheaper to buy or more rewarding to do.

• This increases quantity up to the socially beneficial level.

Example:

A bike rebate makes bicycles cheaper → more people buy them → less traffic & pollution.

Corrective Tax vs Subsidy Graphs

• Corrective tax in a negative externality → reduces quantity

• Subsidy in a positive externality → increases quantity

Who Pays the Tax (Elasticity and Tax Incidence)

• If demand is inelastic → consumers pay more

• If supply is inelastic → producers pay more

inelastic- steep and not sensitive to price 

elastic-flat and more sensitive to price 

A Pigovian tax

is a tax on a good or activity that creates a negative externality — meaning it harms others or society.

Purpose:
It makes the producer or consumer pay for the external cost they’re causing, so the market outcome reflects the true(social) cost.

💨 Example

Suppose a factory pollutes a river.

• The factory’s private cost is just what it pays for materials, workers, etc.

• But the social cost is higher because of the pollution harming nearby homes.

A Pigovian tax charges the factory an amount equal to that external cost per unit of output — say, $50 per ton of pollution.

Now:

• The factory has an incentive to produce less or find cleaner methods,

• The price of the product rises to reflect its true cost to society,

• And society gets closer to the socially optimal quantity (the “just right” amount).

💡 In Simpler Terms

Pigovian tax = “You break it, you buy it.”
If your activity harms others (pollution, noise, etc.), the government makes you pay enough to cover that harm.