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Overview of Welfare Economics
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•
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•
•
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Pareto Efficiency
Supply & Demand
Market Equilibrium
Marginal Costs & Marginal Benefits
Market Failure
Externalities
Public Goods
Common Resources
“A planner’s primary obligation is to serve the
public interest.”
- AICP Code of Ethics and Professional Conduct
Welfare Economics:
The study of how different forms of economic activity
and different methods of allocating scarce resources
affect the well-being of individuals or communities
Pareto Efficiency:
An allocation of resources is considered Pareto
efficient if no alternative allocation can make at least
one person better off without making someone else
worse off
Supply & Demand
Marginal Cost & Marginal Benefit
Demand (Benefit to Consumers or Society)
The relationship between the price of a good/service
and the quantity purchased by consumers
Law of Demand:
All else being equal, quantity demanded decreases as
price increases. (The number of people whose benefit
exceeds the price decreases as price increases)
(Negative relationship between price and quantity =
downward slope)
Demand
$2.25
Price
$ -
Quantity
Demanded
$2.00
$1.75
100
89
$1.50
$ 0.50
75
$1.25
$ 0.75
62
$ 1.00
50
$ 1.25
37
$ 1.50
25
Price
$ 0.25
$1.00
$0.75
$0.50
$0.25
$ 1.75
12
$ 2.00
0
$0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Supply (Cost to Producers or Society)
The relationship between the price of a good/service
and the quantity that producers are willing to supply
Law of Supply:
All else being equal, quantity produced increases as
price increases. (The number of producers whose cost
is lower than the price increases as price increases)
(Positive relationship between price and quantity =
upward slope)
Supply
$2.25
$2.00
Price
$1.75
$ -
Quantity
Supplied
0
$0.25
12
$0.50
25
$0.75
37
$1.00
50
$0.75
$1.25
62
$0.50
$1.50
75
$0.25
$1.75
89
$2.00
100
$1.50
Price
$1.25
$1.00
$-
0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Supply and Demand
$2.25
$2.00
$1.75
Price
$1.50
$1.25
$1.00
$0.75
$0.50
$0.25
$0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Price
$
$
$
$
$
$
$
$
$
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
Quantity
Demanded
100
89
75
62
50
37
25
12
0
Quantity
Supplied
0
12
25
37
50
62
75
89
100
Outcome
Price Will:
Shortage
Rise
Shortage
Rise
Shortage
Rise
Shortage
Rise
EQUILIBRIUM
Surplus
Fall
Surplus
Fall
Surplus
Fall
Surplus
Fall
Nicholas' Demand
$3.50
$3.50
$3.00
$3.00
$2.50
$2.50
$2.00
$2.00
Price
Price
Catherine's Demand
$1.50
$1.50
$1.00
$1.00
$0.50
$0.50
$-
$0
2
4
6
8
Quantity
10
12
14
0
2
4
6
8
Quantity
10
12
14
Price
Catherine's
Demand
Nicholas'
Demand
$ -
12
$ 0.50
10
6
16
$ 1.00
8
5
13
$ 1.50
6
4
10
$ 2.00
4
3
7
$ 2.50
2
2
4
$ 3.00
0
1
1
+
7
Market
Demand
=
19
Market Demand
$3.50
$3.00
Price
$2.50
$2.00
$1.50
$1.00
MB
$0.50
$0
5
10
Quantity
15
20
Social Surplus
Consumer Surplus:
The difference between what consumers are willing-to-pay and
what they have to pay
Graphically, the area under the demand curve and above the
price
Producer Surplus:
The difference between producers’ total revenue and marginal
cost
Graphically, the are above the supply curve (MC) and below the
price
Consumer Surplus
$2.25
$2.00
$1.75
Price
$1.50
$1.25
$1.00
$0.75
$0.50
$0.25
$0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Producer Surplus
$2.25
$2.00
$1.75
Price
$1.50
$1.25
$1.00
$0.75
$0.50
$0.25
$0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Social Surplus
Consumer Surplus:
The difference between what consumers are willing-to-pay and
what they have to pay
Graphically, the area under the demand curve and above the
price
Producer Surplus:
The difference between producers’ total revenue and marginal
cost
Graphically, the are above the supply curve (MC) and below the
price
Social Surplus
$2.25
$2.00
$1.75
Price
$1.50
$1.25
$1.00
$0.75
$0.50
$0.25
$0
10
20
30
40
50
60
Quantity
70
80
90
100
110
Realities of the Market
The private market only ensures efficiency under strict
conditions, including:





Many buyers and sellers (no monopolies)
Identical goods and services
Perfect information
No barriers to entry
No externalities (side effects)
 …
Even a “perfectly competitive” private market:


cannot effectively allocate public goods or common resources
Does not address issues of distribution or equity…
“Four Vital Functions of Planning”
(Klosterman, 1985) Argument for and Against Planning
1. Improves information for public and private
decision making
2. Considers external effects of individual and group
action
3. Promotes collective interest, esp. w/ respect to
public goods
4. Considers distributional effects of market actions
(equity)
Zero Economic Profit?
A firm that earns zero economic profit is said to earn “normal profits”
Two ways to measure profit:
1. Economic Profit = Total Rev. – (Explicit Costs + Implicit Costs)
2. Accounting Profit = Total Rev. – (Explicit Costs)



Explicit Costs include: capital, labor, etc. (actual $ payments)
Implicit Costs include: the value of resources used in production for which no
monetary payments are made (opportunity costs)
e.g., implicit cost to the farmer is salary he could have made had he chosen
another pursuit)
A firm that just covers its operating costs and its implicit costs makes ZERO economic profit, but still
makes an accounting profit
4 bushels @ $10 =>
TR
40k
cap. costs
-3k
taxes
-1k
explicit costs
labor
-1k
rent
-10k
acct. prof. =
25 k
forgone income - 20k
implicit costs
savings invested - 5k
Economic Profit =
0
Monopolist’s Marginal Revenue
Price
Total
Revenue
Quanity
-
$
Marginal
Revenue
$
22
-
$
20
1
$
20
$
20
$
18
2
$
36
$
16
$
16
3
$
48
$
12
$
14
4
$
56
$
8
$
12
5
$
60
$
4
$
10
6
$
60
$
$
8
7
$
56
$
(4)
$
6
8
$
48
$
(8)
$
4
9
$
36
$
(12)
$
2
10
$
20
$
(16)
-
Price
Total
Revenue
Quanity
Marginal
Revenue
Monopolist’s
Marginal
$ 20
1
$
20 $
20 Revenue
$
22
-
$
-
$
18
2
$
36
$
16
$
16
3
$
48
$
12
$
14
4
$
56
$
8
$
12
5
$
60
$
4
$
10
6
$
60
$
$
8
7
$
56
$
(4)
$
6
8
$
48
$
(8)
$
4
9
$
36
$
(12)
$
2
10
$
20
$
(16)
-
$25
$20
$15
D
$10
$5
$-
2
4
6
8
10
12
Market Failure
Externalities:
Economic side effects or “spillovers.” costs or benefits that
stem from an economic activity, but that affect people
other than those directly involved in a market transaction.
Can be POSITIVE or NEGATIVE
Market Failure
Example of negative externality
Driving involves direct cost: gas, driver’s time
…and creates indirect, or external, costs: pollution,
congestion, road maintenance, etc.
The individual driver does not bear the indirect costs,
and does not consider them in his/her decision-making
process
Market Failure
Example of positive externality:
A beekeeper’s bees create benefits that can be
captured: honey, sold to customers
… and external benefits that cannot be captured: bees
pollinate nearby orchards
The orchard farmers do not pay the beekeeper for this
benefit, so the beekeeper does not consider it in his
decision-making process
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Figure 3 Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Copyright © 2004 South-Western
Market Failure
Public Goods: Defined by non-rivalrous consumption
and non-excludability
 Non-rivalrous consumption: Good or service can be used
by one person without detracting from the ability of other
to use it
 Non-excludability: Impossible or impractical to exclude
some people from enjoying the benefits of a good service,
even if they are unwilling to pay for it
Topics
 Budgets
 especially revenue sources,
– Especially taxes
 Guidelines for Evaluating Taxes
 Equity: Progressive / Regressive Taxes
 The Tax Wedge, Elasticity, and Incidence
Guidelines for Evaluating Taxes
Ease of Administration
Equity
1. Ability to pay (progressivity vs. regressivity)
2. Benefit principle of taxation
Efficiency
1. Effect on social surplus (welfare)
2. Ability to raise revenue
Tax Equity
Progressive:
Burden of tax increases w/ income. Higher inc households
spend a greater percentage of their income on the tax than
lower income households.
Regressive:
Burden of tax decreases w/ income . Higher inc households
spend a smaller percentage of their income on the tax than
lower income households
Proportionate:
Burden of the tax remains the same over all levels of income
Major State and Local Taxes as Percent of Income for Family of Four
$
Income
Property
Sales
Auto/Gas
25,000 $
1.28%
3.46%
1.84%
0.89%
50,000
3.10%
3.60%
1.75%
0.50%
Income Level
$
75,000 $
3.75%
3.67%
1.75%
0.61%
100,000 $
4.17%
3.53%
1.66%
0.60%
150,000
4.61%
3.40%
1.57%
0.43%
Source: District of Columbia Office of Revenue Analysis. (2004). Tax Rates and Tax Burdens in the District of Columbia: A Nationwide Comparison.
The Efficiency Effects of a Tax
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
The Effects of a Tax Levied on Sellers
Price
P* + t
Size of tax
Supply (MC)
P*
Demand
0
Q*
Quantity
Copyright © 2004 South-Western
The Effects of a Tax Levied on Sellers
Price
Supply (MC)
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand (MB)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
The Effects of a Tax Levied on Buyers
Price
Supply (MC)
P*
Size of tax
P* - t
Demand
0
Q*
Quantity
Copyright © 2004 South-Western
The Effects of a Tax Levied on Buyers
Price
Supply (MC)
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
Demand (MB)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
The Efficiency Effects of a Tax
Price
Supply (MC)
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
Tax Incidence
The party that actually pays the tax to the government
(whether that is the seller or buyer) can pass part of
that tax forward to consumer, or backward to the
producer.
The party that the tax is shifted to bears the tax
incidence
The incidence depends on price elasticity of supply
and demand
Elasticity
The incidence of taxation, the amount of
deadweight loss caused by a tax, and the
amount of revenue raised by a tax all depend on
how responsive the quantity supplied and
quantity demanded are to changes in price
The Efficiency Effects of a Tax
Price
Supply (MC)
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
The Efficiency Effects of a Tax
Price
MC
Size of tax
2.50
Supply (MC)
Size of tax
2.00
1.50
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Incidence and Elasticities
Inelastic Demand
Price
Supply
2.75
Size of tax
Size of tax
2.00
1.75
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Incidence and Elasticities
Elastic Demand
Price
Supply
2.25
2.00
Size
of
tax
Size of tax
Demand
1.25
0
Quantity
Copyright © 2004 South-Western
Tax Incidence and Elasticities
Inelastic Supply
Price
Supply
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Incidence and Elasticities
Elastic Supply
Price
Size
of
tax
Supply
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Copyright © 2004 South-Western
Corrective Tax (negative externalities)
(Social MC)
Price
Size of tax
Supply (Pvt MC)
P*
P
Demand (MB)
0
Q*
Q
Quantity
Copyright © 2004 South-Western
The Effects of a Tax on Social Surplus
Price
Supply
Price
without tax
Demand
0
Quantity
without tax
Quantity
Copyright © 2004 South-Western
The Effects of a Tax on Social Surplus
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
Copyright © 2004 South-Western
Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
Sprawl Traits
1.
2.
3.
4.
5.
6.
7.
Unlimited outward extension of development
Low-density residential/comm. development
Widespread strip commercial
Leapfrog development
Auto dependence (private auto)
Segregation of land uses by zones
Reliance on trickle down or filtering process to provide housing to low
income HH
8. Lack of centralized control of land uses
9. Fragmentation of power over land use (many localities)
10. Great fiscal disparity among localities
Burchell, Robert. (1998) The Costs of Sprawl – Revisited. Transportation Cooperative
Research Program Report 39. Washington, DC: National Academy Press.