ECON 202 Exam 2

The Main Question of Welfare Economics

How does our allocation of resources impact our buyers & sellers?

Willingness to Pay

the maximum amount that a buyer will pay for a good

Consumer Surplus

the benefit consumers receive from paying less than the most that they are willing to

Individual Consumer Surplus Equation

willingness to pay - actual price

Market Consumer Surplus Calculation

add all the individuals' Consumer Surplus

Where to find the Consumer Surplus on a Demand Model

the area beneath demand & above price

Cost

the value of everything a seller must give up to produce a good

Producer Surplus

the benefit producers receive by selling at a price above their bottom dollar cost

Individual Producer Surplus Equation

actual price - cost

Market Producer Surplus

add all the individuals' Producer Surplus

Where to find the Producer Surplus on a Supply Model

the area beneath price & above supply

Consumer & Producer Surplus Equation

1/2 x base x height

Total Surplus

Consumer Surplus + Producer Surplus

2 goals for the social planner

1) Efficiency

2) Equity

Efficiency

maximizing total surplus

Equity

uniformly distributing economic prosperity

Equation for the goal of efficiency

Total Surplus = (willingness to pay - price) + (price - cost)

How to maximize total surplus

willingness to pay is as high as possible & cost is as low as possible

markets allocate such that…

1) supply goes to buyers that will pay the most

2) demand goes to sellers that will produce at lowest cost

3) total surplus is maximized

the big idea of rational

When consumers and producers are acting rationally, free markets maximize human wellbeing. Do economic factors always behave rationally?

Price ceiling

a legal maximum on the price of a good

Shortage

when sellers sell less than buyers want to buy

Deadweight Loss (DWL)

loss in total surplus that arises due to a market distortion (occurs because of lost transactions)

Binding price ceiling impact

1) Shifts surplus from producers to consumers

2) Causes shortages

3) Creates DWL

Price controls

legal mechanisms to reduce the price of goods (in pursuit of equity)

Non-binding price ceiling

when the price ceiling is above what is already being charged for a good

Binding price ceiling

when the price ceiling is below what is already being charged for a good

Price floor

A legal minimum on the price at which a good can be sold (helps sellers)

Non-binding price floor

beneath the equilibrium price

Binding price floor

above the equilibrium price

Causes of a binding price floor

1) shifts surplus from consumers to producers

2) causes surpluses (Qs > Qd)

3) creates DWL

Pros of raising the minimum wage

• people make more money (impacts low income people)

• tax revenue

• keep up with inflation

• reduce strain on government services

• “Living wage”

Cons of raising the minimum wage

• prices will rise

• unemployment

• increased labor costs

• regional level

Statutory Tax Incidence

who the law indicates will pay a tax to the government

Economic Tax Incidence

who must sacrifice more in actuality in response to a tax

Excise Tax

a tax on a good by the unit

What does the supply curve represent?

cost to sellers

What does the demand curve represent?

the value to buyers

How do you find the size of tax?

It is between the price buyers pay and the price sellers get

Does it matter if a tax is on a seller or a buyer?

No, buyers and sellers will share the burden

What determines who pays?

elasticity

How to determine who will have the greater economic burden of a tax?

The party that is more inelastic will bear the majority of the tax.

What do we want taxes to do?

Generate lots of revenue and little deadweight loss

Which market is more beneficial to tax? Elastic or Inelastic? Why?

Inelastic because it will lead to a larger tax revenue and a smaller deadweight loss than if we taxed an elastic market.

Laffer Curve

a theoretical concept in economics that illustrates the relationship between tax rates and tax revenue

Land Value Tax

a method of assessing property taxes that only considers the value of the land itself and related improvements (does not include buildings)

What do economists agree & disagree with regarding the Laffer Curve?

Economists agree with the concept of the Laffer Curve, but disagree on the numbers on the axis.

What portion of the economy is the government in the U.S.?

Roughly 25% is spent in taxes

How does the U.S. compare to other developed countries regarding taxes?

The U.S. spends less of its income in taxes than other developed countries because its government does not do as much in comparison. (ex: Denmark spends 49% of its income on taxes)

Where does the federal government get its revenue?

Majority from income & payroll taxes (excise taxes, tariffs, and all other taxes make up the remaining 9%)

Where do state governments get their revenue?

Majority from sales and property taxes (some states do not have income taxes, so they have higher sales taxes--like TN)

Administrative Burden

the time, money, and energy expended in determining taxes owed

"Lump-Sum" Taxation

tax everyone a dollar amount; meant to be a solution to costs of taxation; not considered "fair"

2 Principals of fair taxation

1) Benefits Principle

2) The Ability to Pay Principle

Benefits Principal

people should pay for the benefits they receive from the government

The Ability to Pay Principle

taxes should be paid by those who can afford to bear the burden

2 ways of achieving tax equity

1) Vertical Equity

2) Horizontal Equity

Vertical Equity

People who make more should pay more in taxes

Horizontal Equity

People in similar situations should pay a similar amount in taxes

Steps of paying taxes (in order)

1) Add up income

2) Take out deductions

3) Calculate taxable income

4) Apply Tax Brackets

5) Apply Tax Credits

Standard tax deduction

A fixed dollar amount that reduces the income on which you are taxed, available to all taxpayers.

Itemized tax deduction

An eligible expense that individual taxpayers in the US can report on their federal income tax returns in order to decrease their taxable income. (ex: charity, losses - not gambling, medical, small business expenses, Morgage interest, and student loan interest)

What kind of tax deduction is preferable? Bigger or smaller?

Bigger

Tax credit definition (with examples)

an amount of money that taxpayers can subtract directly from the taxes they owe (ex: children, low earned income, some tuition, electric vehicle)

Total income on taxes

adjusted gross income

When can you receive a check from the government from your taxes?

When the taxes you owe are negative AND you are low income.

What is a big flaw of the U.S. tax system?

The IRS will not give you a number, they will compare the number you got to the number they got.

Who puts a higher percentage of their income to sales tax? The rich or the poor?

The poor because they make less income but still have to pay sales tax.

Market Failure

an inefficient distribution of goods in the free market (ex: monopolies, information asymmetry, externalities)

Externality

the uncompensated impact of the action of one person on the well-being of a bystander

Positive externality

the uncompensated impact is helpful (ex: home restoration)

negative externality

the uncompensated impact is harmful (ex: smoking)

What is the issue with trying to get external cost?

measurement issue

"Pigouvian" or corrective taxes

taxes to address an externality

What was Aurthor Pigou's philosophy?

To solve the problem of negative externalities, a tax should equal the externality (Pigouvian tax).

What is the issue with Aurthor Pigou's philosophy?

It can be hard to measure the dollar amount of the harm a negative externality can cause.

Coase Theorem

people can bargain to solve externalities on their own if there are no transaction costs and clearly defined property rights

Transaction Cost

the cost of coming to and following through an arrangement

Issue with Coase Theorem

Assumes no transaction costs and clearly defined property rights

Unintended consequences to trying to solve externalities

If we try to assign a solution rather than nudging in the right direction, we may cause unintended side effects.

Ex: Cobras

2 important ideas of public goods

1) Excludable

2) Rival in Consumption

Excludable

people can be prevented from using it

• usually by price

Rival in Consumption

one person's use diminishes the ability of others to use it

What is excludable and rival-in consumption?

private goods

What is excludable but NOT rival-in-consumption?

club goods

What is NOT excludable but is rival-in-consumption?

common resources

What is NOT excludable and NOT rival-in-consumption?

public goods

Issues with public goods

1) Free Rider Problem

2) Cost/Benefit Analysis

Free Rider Problem

there is an incentive to receive the good, but not contribute (since the good is not excludable)

Free Rider

someone who receives the benefit without paying

Cost/Benefit Analysis

as we decide whether to invest in a public good, we must weigh the pros and cons

2 things to consider for Cost/Benefit Analysis

1) This must be done in a mathematical way

2) How do we measure the benefits of a public good?

Tragedy of the Commons

a parable that shows that commonly held resources tend to be overused

• Exs: sheep in England, American Bison, fisheries today

What is the issue with shared resources?

Tragedy of the Commons

2 costs of taxation

1) DWL

2) Administrative Burden