Economics 11: Markets and the State I. II. Introduction ● Economy = oikonomos = “one who manages a household” ● Society faces many decisions. ● Scarcity - society has limited resources; it cannot produce all the goods and services people wish to have ● Economics - the study of how society manages its scarce resources through the choices of millions of households and firms ● Economists - study how people make decisions ● Economics needs to be studied in Psychology because it still studies the behavior of people. ○ In psychology, everything is behavioral, we see patterns, and things are based on emotions. Basic Principles of Economics ● How People Make Decisions ○ People Face Trade-Offs ■ Making decisions requires trading off one goal against another. ■ Guns and Butter ■ Efficiency and Equality ➤ Efficiency - society is getting the maximum benefits from its scarce resources ➤ Equality - benefits are distributed uniformly among society’s members ➤ These two goals often contradict when government policies are designed. ○ The Cost of Something Is What You Give Up to Get It ■ Opportunity Cost - what you give up to get that item; “what if” ○ Rational People Think at the Margin ■ Rational People - people who systematically and purposefully do the best they can to achieve their objectives ■ Marginal Charge - a small incremental adjustment to a plan of action ■ A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. ○ People Respond to Incentives ■ Incentive - something that induces a person to act; punishment or reward ■ When policymakers fail to consider how their policies affect incentives, they often end up with unintended consequences. ■ If the policy changes incentives, it will cause people to alter their behavior. ● How People Interact ○ Trade Can Make Everyone Better Off ■ Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. ○ Markets Are Usually a Good Way to Organize Economic Activity ■ Market Economy - an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services ■ Marketplace - where prices and self-interest guide people’s decisions ■ Adam Smith’s Invisible Hand - refers to the self-regulating nature of free markets, where individuals pursuing their own interests unintentionally benefit society by guiding resources to their most efficient uses ■ Prices adjust to guide these individual buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole. III. ○ Governments Can Sometimes Improve Market Outcomes ■ The invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. ➤ Market economies need institutions to enforce property rights so individuals can own and control scarce resources. ■ The invisible hand is powerful, but it is not omnipotent. ➤ The government intervenes in the economy either to promote efficiency or equality. ● How the Economy as a Whole Works ○ A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services ■ Almost all variation in living standards is attributable to differences in countries’ productivity. ■ Productivity - the amount of goods and services produced by each unit of labor input ■ The growth rate of a nation’s productivity determines the growth rate of its average income. ○ Prices Rise When the Government Prints Too Much Money ■ Inflation - an increase in the overall level of prices in the economy ■ Inflation is caused by the growth in the quantity of money. ■ When a government creates large quantities of the nation’s money, the value of the money falls. ○ Society Faces a Short-Run Trade-off between Inflation and Unemployment ■ Most economists describe the short-run effects of monetary injections as follows: ➤ Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. ➤ Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. ➤ More hiring means lower unemployment. ■ This short-run trade-off plays a key role in the analysis of the business cycle. ■ Business Cycle - fluctuations in economic activity, such as employment and production Thinking Like an Economist ● Economists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use their theories to help change the world for the better. ● Economists try to address their subject with a scientist’s objectivity. ○ Like all scientists, they make appropriate assumptions and build simplified models to understand the world around them. ○ Two simple economic models are the circular-flow diagram and the production possibilities frontier. ■ The circular flow diagram illustrates how households and firms interact in markets, with households buying goods and services from firms and selling factors of production to them, while money flows in the opposite direction of goods, services, and resources. ■ The production possibilities frontier (PPF) illustrates the maximum combinations of two goods, that an economy can produce given its resources, with points inside or on the curve being feasible, and the slope representing the opportunity cost of producing one good in terms of the other. ● The field of economics is divided into two subfields: microeconomics and macroeconomics. IV. V. ○ Microeconomists study decision-making by households and firms and the interaction among households and firms in the marketplace. ○ Macroeconomists study the forces and trends that affect the economy as a whole. ● A positive statement is an assertion about how the world is. ● A normative statement is an assertion about how the world ought to be. ○ When economists make normative statements, they are acting more as policy advisers than as scientists. ● Economists who advise policymakers sometimes offer conflicting advice either because of differences in scientific judgments or because of differences in values. ● At other times, economists are united in the advice they offer, but policymakers may choose to ignore the advice because of the many forces and constraints imposed by the political process. Interdependence and the Gains from Trade ● Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services. ● There are two ways to compare the ability of two people to produce a good. ○ The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in producing the good. ○ The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. ■ The gains from trade are based on comparative advantage, not absolute advantage. ● Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. ● The principle of comparative advantage applies to countries as well as to people. Economists use the principle of comparative advantage to advocate free trade among countries. Market Forces of Supply and Demand ● Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price. ○ Highly organized market - buyers and sellers meet at a specific time and place where an auctioneer helps set prices and arrange sales ○ Less organized market - more competition, more innovation, more product differentiation, more product variety, more product choice ○ Competitive market - a market in which there are many buyers and many sellers so that each has a negligible impact on the market price ■ Perfectly competitive market - a market with no barriers to entry, perfect information, homogeneous products, and many small firms selling identical goods ■ Price takers - buyers and sellers in perfectly competitive markets that must accept the price the market determines ■ Monopoly - a business that has a large market share and is able to set prices as it pleases ● The demand curve shows how the quantity of a good demanded depends on the price. ○ Market demand - the sum of the demands of all buyers ○ Demand schedule - a table that shows the relationship between the price of a good and the quantity demanded ○ According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. ○ In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, tastes, expectations, and, the number of buyers. If one of these factors changes, the demand curve shifts. ● ● ● ● ● ■ Normal good - a good for which, other things being equal, an increase in income leads to an increase in demand ■ Inferior good - a good for which, other things being equal, an increase in income leads to a decrease in demand ■ Substitutes - two goods for which an increase in the price of one leads to an increase in the demand for the other ■ Complements - two goods for which an increase in the price of one leads to a decrease in the demand for the other The supply curve shows how the quantity of a good supplied depends on the price. ○ Market supply - the sum of the supplies of all sellers ○ Supply schedule - a table that shows the relationship between the price of a good and the quantity supplied ○ According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward. ○ In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts. The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied. ○ The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus (excess supply) of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage (excess demand), which causes the market price to rise. ○ Market-clearing price - everyone in the market has been satisfied: buyers have bought all they want to buy, and sellers have sold all they want to sell. A change in the good’s price represents a movement along the demand or supply curve, whereas a change in one of the other variables shifts the demand or supply curve. ○ A shift in the supply curve is called a “change in supply,” and a shift in the demand curve is called a “change in demand.” ■ Change in one of the other variables ■ Demand/Supply - position of the demand/supply curve ○ A movement along a fixed supply curve is called a “change in the quantity supplied,” and a movement along a fixed demand curve is called a “change in the quantity demanded.” ■ Change in the good’s price ■ Quantity demanded/Quantity supplied - amount buyers wish to buy/suppliers wish to sell To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity. To do this, we follow three steps. ○ Decide whether the event shifts the supply or demand curve (or perhaps both). ○ Decide in which direction the curve shifts. ○ Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity. Supply and demand together determine the prices of the economy’s many different goods and services. In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. ○ The equilibrium price then determines how much of the good buyers choose to consume and how much sellers choose to produce. VI. Elasticity ● Elasticity - a measure of the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants ● The price elasticity of demand measures how much the quantity demanded responds to changes in the price. ○ Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react to a price change. ○ 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 (𝑄2−𝑄1) ○ Midpoint Method: 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = (𝑄 +𝑄 ) 2 1 2 (𝑃2−𝑃1) (𝑃 +𝑃 ) 2 1 2 ○ The price elasticity of demand determines whether the demand curve is steep or flat. ■ Perfectly Inelastic Demand: Elasticity = 0 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑈𝑛𝑐ℎ𝑎𝑛𝑔𝑒𝑑 ■ Inelastic Demand: Elasticity < 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑠𝑙𝑖𝑔ℎ𝑡 ↓ ■ Unit Elastic Demand: Elasticity = 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑒𝑞𝑢𝑎𝑙 ↓ ■ Elastic Demand: Elasticity > 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑔𝑟𝑒𝑎𝑡 ↓ ■ Perfectly Elastic Demand: Elasticity = Infinity ➤ 𝑃𝑟𝑖𝑐𝑒 𝑎𝑏𝑜𝑣𝑒: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 = 0 ➤ 𝑃𝑟𝑖𝑐𝑒 𝑒𝑥𝑎𝑐𝑡: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 = 𝑎𝑛𝑦 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ➤ 𝑃𝑟𝑖𝑐𝑒 𝑏𝑒𝑙𝑜𝑤: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑒 ○ Total revenue, the total amount paid for a good ■ 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑔𝑜𝑜𝑑 × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑜𝑙𝑑 ■ For inelastic demand curves, total revenue moves in the same direction as the price. ➤ Extra revenue from selling at a higher price > lost revenue from selling fewer units ■ For elastic demand curves, total revenue moves in the opposite direction as the price. ➤ Extra revenue from selling at a higher price < lost revenue from selling fewer units ■ If demand is unit elastic, total revenue remains constant when the price changes. ○ The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. ■ 𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 ○ The cross-price elasticity of demand measures how much the quantity demanded of one good responds to changes in the price of another good. ■ 𝐶𝑟𝑜𝑠𝑠 − 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 1 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 2 ● The price elasticity of supply measures how much the quantity supplied responds to changes in the price. ○ This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run. ○ 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 (𝑄2−𝑄1) ○ Midpoint Method: 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = (𝑄 +𝑄 ) 2 1 2 (𝑃2−𝑃1) (𝑃 +𝑃 ) 2 1 2 ○ The price elasticity of supply determines whether the supply curve is steep or flat. ■ Perfectly Inelastic Supply: Elasticity = 0 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑈𝑛𝑐ℎ𝑎𝑛𝑔𝑒𝑑 ■ Inelastic Supply: Elasticity < 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑠𝑙𝑖𝑔ℎ𝑡 ↑ ■ Unit Elastic Supply: Elasticity = 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑒𝑞𝑢𝑎𝑙 ↑ ■ Elastic Supply: Elasticity > 1 ➤ 𝑃𝑟𝑖𝑐𝑒 ↑: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑔𝑟𝑒𝑎𝑡 ↑ ■ Perfectly Elastic Supply: Elasticity = Infinity ➤ 𝑃𝑟𝑖𝑐𝑒 𝑎𝑏𝑜𝑣𝑒: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑒 ➤ 𝑃𝑟𝑖𝑐𝑒 𝑒𝑥𝑎𝑐𝑡: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 = 𝑎𝑛𝑦 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ➤ 𝑃𝑟𝑖𝑐𝑒 𝑏𝑒𝑙𝑜𝑤: 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑 = 0 ● The tools of supply and demand can be applied in many different kinds of markets. This chapter uses them to analyze the market for wheat, the market for oil, and the market for illegal drugs. VII. Supply, Demand, and Government Policy ● Price controls are usually enacted when policymakers believe that the market price of a good or service is unfair to buyers or sellers. ● Price ceiling is a legal maximum on the price of a good or service ○ An example is rent control. ○ If the price ceiling is below the equilibrium price, then the price ceiling is binding, and the quantity demanded exceeds the quantity supplied. Because of the resulting shortage, sellers must in some way ration the good or service among buyers. ■ Free markets ration goods with prices. VIII. ○ Even though the price ceiling was motivated by a desire to help buyers, not all buyers benefit from the policy. ● Price floor is a legal minimum on the price of a good or service ○ An example is the minimum wage. ■ Labor surplus = unemployment ○ If the price floor is above the equilibrium price, then the price floor is binding, and the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers’ demands for the good or service must in some way be rationed among sellers. ■ In a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price. ● There are alternative policies often better than price controls, but they are still not perfect. Rent and wage subsidies cost the government money and, therefore, require higher taxes. ● Tax - a policy instrument used to raise revenue for public projects ○ Tax incidence - refers to how the burden of a tax is distributed among the various people who make up the economy ● Taxes levied on sellers and taxes levied on buyers are equivalent. ○ When the government levies a tax on a good, the equilibrium quantity of the good falls. That is, a tax on a market shrinks the size of the market. ○ Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less. ● A tax on a good places a wedge between the price paid by buyers and the price received by sellers. ● Incidence of a tax - division of the tax burden ○ The incidence of a tax depends on the price elasticities of supply and demand. Most of the burden falls on the side of the market that is less elastic because that side of the market cannot respond as easily to the tax by changing the quantity bought or sold. ■ When supply is more elastic than demand the incidence of the tax falls more heavily on buyers than on sellers. ■ When demand is more elastic than supply the incidence of the tax falls more heavily on sellers than on producers. Consumers, Producers, and the Efficiency of Markets ● Welfare Economics - the study of how the allocation of resources affects economic well-being ○ In any market, the equilibrium of supply and demand maximizes the total benefits received by all buyers and sellers combined. ● The demand curve reflects buyers’ willingness to pay and measures consumer surplus. ○ Willingness to Pay - the maximum amount that a buyer will pay for a good ○ Consumer Surplus - buyers’ willingness to pay for a good - the amount they actually pay ■ Measures the benefit buyers get from participating in a market ■ The area below the demand curve and above the price measures the consumer surplus in a market. ■ Marginal Buyer - the buyer who would leave the market first if the price were any higher ■ A lower price raises consumer surplus by benefiting both existing buyers, who now pay less, and new buyers, who can now afford to enter the market. The total increase in consumer surplus is the sum of these two benefits, shown as the combined area (BCFD). ● The supply curve reflects sellers’ costs and measures producer surplus. ○ Cost - the value of everything a seller must give up to produce a good ○ Producer Surplus - amount a seller is paid for a good - the seller’s cost of providing it ■ Measures the benefit sellers get from participating in a market IX. ■ The area below the price and above the supply curve measures the producer surplus in a market. ■ Marginal Seller - the seller who would leave the market first if the price were any lower ■ A higher price increases producer surplus by benefiting existing sellers who earn more and attracting new sellers to the market, boosting their overall well-being. ● The benevolent social planner aims to maximize society’s well-being by ensuring the market efficiently allocates resources to maximize total surplus (the combined benefits of buyers and sellers), while also considering equality in how those benefits are distributed. ○ 𝑇𝑜𝑡𝑎𝑙 𝑠𝑢𝑟𝑝𝑙𝑢𝑠 = 𝑉𝑎𝑙𝑢𝑒 𝑡𝑜 𝑏𝑢𝑦𝑒𝑟𝑠 − 𝐶𝑜𝑠𝑡 𝑡𝑜 𝑠𝑒𝑙𝑙𝑒𝑟𝑠 ● In a market equilibrium, free markets ensure goods are sold to buyers who value them the most and produced by sellers with the lowest costs. ○ When the quantity of goods in the market is below equilibrium, buyers value the goods more than it costs sellers to produce them, so increasing production would benefit both buyers and sellers, raising total surplus. ○ However, when the quantity is above equilibrium, it costs sellers more to produce the goods than what buyers are willing to pay, so reducing production would increase total surplus. ○ Increasing or decreasing the quantity of goods away from the equilibrium level reduces total surplus. Therefore, a benevolent social planner cannot improve market outcomes beyond this natural state. The idea of laissez-faire, or "letting markets operate freely," is supported by economists because the "invisible hand" of the market guides buyers and sellers to the best outcome without the need for central intervention. ● Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities. Costs of Taxation ● Taxes reduce the welfare of both buyers and sellers more than the revenue gained by the government, as they raise prices for buyers and lower earnings for sellers. ○ Tax Wedge - the difference between the price buyers pay and the price sellers receive in a market due to the imposition of a tax ○ When a tax is levied on buyers, the demand curve shifts downward by the size of the tax; when it is levied on sellers, the supply curve shifts upward by that amount. ● Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink the size of the market below the level that maximizes total surplus. ○ Consumer surplus (the benefit to buyers) and producer surplus (the benefit to sellers) decrease when a tax is imposed, as the price buyers pay increases and the price sellers receive decreases. ○ The government collects tax revenue from the tax, which can be used to provide public services. ■ Tax Revenue - the size of the tax T times the quantity sold Q; area of the rectangle between the supply and demand curves ○ However, the overall market shrinks, resulting in a fall in total surplus (the sum of consumer and producer surplus), called deadweight loss (if with tax revenue, deadweight loss of the tax), caused by a market distortion such as tax. ● The lost gains from trade create the deadweight loss. ● Larger elasticities imply larger deadweight losses. ● As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. Because a tax reduces the size of the market, however, tax revenue does not continually increase. It first rises with the size of a tax, but if the tax gets large enough, tax revenue starts to fall. X. ○ Laffer Curve - as tax rates increase, revenue initially rises but eventually falls if rates become too high, as high taxes can discourage work and economic activity ■ Arthur Laffer proposed that lowering high tax rates could increase revenue by encouraging more economic activity, a theory embraced by Ronald Reagan but debated by economists due to its reliance on how taxes affect behavior and market elasticity. Externalities and Public Goods ● Market Failure - a situation in which a market left on its own fails to allocate resources efficiently ○ Causes ■ Market Power - the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices ■ Information Failure - insufficient information available to certain participants in the market ■ Public Goods - goods that are neither excludable nor rival in consumption Free rider problem ● When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. ○ If an activity yields negative externalities, such as pollution, the socially optimal quantity in a market is less than the equilibrium quantity. ■ Negative externalities lead markets to produce a larger quantity than is socially desirable. ○ If an activity yields positive externalities, such as technology spillovers, the socially optimal quantity is greater than the equilibrium quantity. ■ Positive externalities lead markets to produce a smaller quantity than is socially desirable. ● To remedy the problem, the government can internalize the externality by taxing goods that have negative externalities and subsidizing goods that have positive externalities. ○ Internalizing the Externality - altering incentives so that people take account of the external effects of their actions ○ Subsidy - benefit given by the government to an individual, business, or institution ● 2 ways that the government respond to externalities: ○ Command-and-control policies regulate behavior directly. ■ Regulation by either requiring or forbidding certain behaviors. ○ Market-based policies provide incentives so that private decision makers will choose to solve the problem on their own. XI. ■ Corrective Tax/Pigovian Taxes - a tax designed by Arthur Pigou to induce private decision-makers to take account of the social costs that arise from a negative externality ➤ Ideal corrective tax → External cost ■ Sin Tax Reform Law (Republic Act No. 10351) ➤ Ideal corrective subsidy → External benefit ■ Tradable Pollution Permits - managing environmental pollution, where firms are given rights to emit a certain amount of pollutants ➤ The result of this policy is largely the same as imposing corrective taxes on polluters. ● Private Solutions to Externalities ○ Moral codes and social sanctions ○ Charitable organizations ○ Contracting between private parties ○ Coase Theorem - by Ronald Coase is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own ■ Transaction costs - costs that parties incur in the process of agreeing to and following through on a bargain ■ Each party tries to hold out for a better deal ■ Reaching an efficient bargain is especially difficult when the number of interested parties is large ● Market forces, properly redirected, are often the best remedy for market failure. ● Goods differ in whether they are excludable and whether they are rival in consumption. ○ A good is excludable if it is possible to prevent someone from using it. ○ A good is rival in consumption if one person’s use of the good reduces others’ ability to use the same unit of the good. ● 4 Kinds of Goods ○ Private Goods - both excludable and rival in consumption; purchased to be consumed ○ Public Goods - neither excludable nor rival in consumption; everyone can use this good ■ Free Rider - a person who receives the benefit of a good but avoids paying for it ■ Examples: national defense, basic research, fighting poverty ■ Cost–Benefit Analysis - a study that compares the costs and benefits to society of providing a public good; to estimate the total costs and benefits of the project to society as a whole ➤ The findings on the cost-benefits of public projects are rough approximations at best. ○ Common Resources - rival in consumption but not excludable; first come, first serve ■ Tragedy of the Commons - a parable that illustrates why common resources are used more than is desirable from the standpoint of society as a whole ■ Because people are not charged for their use of common resources, they tend to use them excessively. Therefore, governments use various methods to limit the use of common resources. ■ Examples: clean air and water, congested roads, fish, whales, and other wildlife ○ Club Goods - excludable but not rival in consumption; membership ● In all cases, the market fails to allocate resources efficiently because property rights are not well established. The Design of the Tax System ● Government can improve market outcomes by providing public goods, regulating common resources, and addressing externalities. ● Taxes - are mandatory charges collected by the government from taxpayers to cover the costs of different government services ● Taxation - the act of taxing authority, usually a government, imposing a financial obligation on its citizens or residents ● Income Tax > Government Services ● 4 Rs of Tax ○ Revenue ○ Repricing ○ Representation ○ Redistribution ● 4 Stages of Taxation ○ Levy or Imposition ○ Assessment & Collection ○ Payment ○ Refund ● The U.S. government raises revenue using various taxes. ○ The most important taxes for the federal government are individual income taxes and payroll taxes for social insurance. ■ Receipts ➤ Individual Inome Tax ■ Tax Liability - how much it owes ■ Marginal Tax Rate - the tax rate applied to each additional dollar of income ➤ Payroll Tax/Social Insurance Tax - a tax on the wages that a firm pays its workers ➤ Corporate Income Tax - double taxed ➤ Excise Tax - gasoline, cigarettes, alcohol ■ Spending ➤ Transfer Payment - a government payment not made in exchange for a good or service ➤ Health ➤ National Defense ➤ Net Interest ➤ Budget Deficit - an excess of government spending over government receipts ➤ Budget Surplus - an excess of government receipts over government spending ○ The most important taxes for state and local governments are sales taxes and property taxes. State and local governments also receive substantial funds from the federal government. ● The efficiency of a tax system refers to the costs it imposes on taxpayers. A more efficient tax system raises the same revenue with lower costs to taxpayers. ○ Costs to Taxpayers: ■ Direct tax payment ■ Deadweight losses ➤ Income Tax - imposed directly on individuals or corporations based on their earnings ➤ Consumption Tax - tax on goods and services purchased by consumers ■ Administrative burdens - inefficiency created by the tax system; type of deadweight loss ➤ A solution is to simplify the tax laws however, not everyone will be supportive of this because some loopholes benefit others. ➤ Tax lawyers and accountants help taxpayers with a higher tax bracket by reducing the amount of taxes owed also known as, “legal tax avoidance.” ● Two Notions of the Tax Rates: ○ Average Tax Rate - gauges the sacrifice made by the taxpayer ■ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑇𝑎𝑥𝑒𝑠 𝑃𝑎𝑖𝑑 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 ○ Marginal Tax Rate - gauges how the tax system distorts incentives; determines the deadweight loss of an income tax; the amount that taxes increase from an additional dollar of income ● Lump-sum Tax - a tax that is the same amount for every person ○ Most efficient tax possible; does not alter the amount owed thus, no deadweight loss ○ Said to be unfair as it takes the same amount of tax from the poor and the rich. ● The equity of a tax system concerns whether the tax burden is distributed fairly among the population. ○ Gasoline tax ○ According to the benefits principle, it is fair for people to pay taxes based on the benefits they receive from the government. ■ Wealthy citizens should pay higher taxes to fund anti-poverty programs. ○ According to the ability-to-pay principle, it is fair for people to pay taxes based on their capability to handle the financial burden. ■ Leads to two (2) corollary notions of equity: ➤ Vertical Equity - taxpayers with a greater ability to pay should contribute a larger amount ■ Proportional Tax - a tax for which high-income and low-income taxpayers pay the same fraction of income ■ Regressive Tax - a tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers ■ Progressive Tax - a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers ➤ Horizontal Equity - taxpayers with similar abilities to pay should contribute the same amount ○ When evaluating the equity of a tax system, it is important to remember a lesson from the study of tax incidence: The distribution of tax burdens is not the same as the distribution of tax bills. ■ Flypaper Theory of Tax Incidence - the burden of a tax, like a fly on flypaper, sticks wherever it first lands ● When considering changes in the tax laws, policymakers often face a trade-off between efficiency and equity. Much of the debate over tax policy arises because people give different weights to these two goals. ● “Tax Reform for Acceleration and Inclusion” (TRAIN) Law ○ National Laws ○ ○ ○ ○ ○ ○ ○ ○ ■ R.A. No. 8424 (Tax Reform Act of 1997) ■ R.A. No. 10963 (TRAIN Law) Local Law ■ R.A. No. 7160 (Local Government Code of 1991) Comprehensive Tax Reform Program (CTRP) has five packages each targeting specific areas of tax policy. Package 1 or Tax Reform for Acceleration and Inclusion (TRAIN) Act took effect on January 1, 2018 under Duterte. Goals: ■ Simplify the tax code. ■ Enhance efficiency and equity. ■ Promote investments, create jobs and reduce poverty. ■ Increase revenue to support the “Build, Build, Build” infrastructure program. ■ Finance investments in people through enhanced education, health and social services. Key Provisions ■ Lowered tax rates ■ Broaden the VAT base ■ Excise Tax Increases ■ Excise taxes on cigarettes ■ Simplifying the Estate and Donor’s Tax ■ Introduction of the Conditional Cash Transfer (CCT) program enhancements ■ Compliance/ Administrative Requirements/Penalties ■ Tax on Non-Performing Assets Personal Income Tax ■ Aims to address the high marginal tax rates relative to ASEAN neighbors and the increase in income taxes without an increase in real income due to the non-indexation of tax brackets to inflation - bracket creep. ■ Includes specific income tax brackets and marginal tax rates for various income levels Value-Added Tax ■ Aims to broaden the VAT base by eliminating numerous exemptions that narrow revenue, address the significant VAT gap, and reduce economic distortions within the current VAT system ■ Focuses on increasing tax efficiency while limiting exemptions; raised the VAT threshold to PhP 3 million, limited exemptions on certain goods and services, and maintained zero-rating for specific indirect exports to enhance tax efficiency and broaden the tax base ■ The VAT provisions under RA 10963 (TRAIN) are expected to increase government revenues by ₱15.5 billion, or roughly 0.1% of GDP. However, this increase is only about half of what was anticipated from a different proposed bill (HB 4744). ■ Under TRAIN, the VAT system becomes slightly more regressive, placing a higher burden on lower-income households, while higher-income households face increased VAT rates as their income rises. Excise Tax on Petroleum Products ■ Before TRAIN, excise tax rates on petroleum products were fixed in nominal peso terms or reduced to zero for certain products like diesel and kerosene, leading to a decline in revenue over time due to inflation and the faster rise of petroleum product prices compared to the inflation rate. ■ Raises fuel costs and government revenue but reduces consumer purchasing power and hits low-income households the hardest ■ The excise tax on automobiles under TRAIN is an ad valorem tax, meaning it is directly applied as a percentage of the net manufacturer's price or importer's selling price, rather than using marginal tax rates. ■ The Comprehensive Automotive Resurgence Strategy (CARS) Program aims to attract new investments in motor vehicle and parts manufacturing through time-bound, performance-based fiscal support, but RA 10963 (TRAIN Law) hampers its growth due to the higher taxes it imposes. ○ Excise Tax on Sweetened Beverages ■ Based on the type of sweetener used: ➤ PhP 12 per liter for those with high fructose corn syrup (alone or mixed) ➤ PhP 6 per liter for drinks with purely caloric or non-caloric sweeteners (or a mix of both) ➤ Beverages with purely coconut sap sugar or steviol glycosides are exempt from the tax ■ The tax addresses the negative externalities associated with SB consumption and has been shown to effectively decrease SB consumption rates. ■ The increase in excise tax on sweetened beverages (SBs) is mildly regressive, impacting lower-income households more, while the Department of Finance projects significant revenue gains of approximately PhP 49 billion in 2018, PhP 51 billion in 2019, and PhP 55 billion in 2020, although no independent estimates have been made. ○ Excise Tax on Cigarettes ■ RA 10963 (TRAIN Law) raised excise tax rates on cigarettes, shifting from a flat ₱30 rate to a consistent annual increase of 4% starting January 1, 2024, similar to the previous Sin Tax Reform under RA 10351. ■ The increase in excise tax on "sin" products aims to raise revenue and discourage consumption, resulting in a decline in cigarette sales from 4.6 billion packs in 2013 to 3.5 billion packs in 2017, with government revenues expected to rise as long as cigarette consumption remains at those levels. ■ ET on cigarettes is regressive as the tax liability is being heavily carried by those in lower income deciles. ○ Excise Tax on Coal and Coke and Non-Metallic and Metallic Minerals ■ Before RA 10963 (TRAIN), coal and coke were taxed at PhP 10 per metric ton, but this rate increased to PhP 50 in 2018, PhP 100 in 2019, and PhP 150 in 2020; additionally, taxes on non-metallic minerals and metallic minerals were raised from 2% to 4%, while the tax on indigenous petroleum increased from 3% to 6%. ■ The increase in excise tax aims to discourage the use of coal and coke for energy, while also helping the government generate more income from non-metallic and metallic minerals, with projected revenues of approximately PhP 696 million from coal and coke in 2018, rising to PhP 2.4 billion in 2020, and about PhP 2.1 billion from non-metallic and metallic minerals in 2018 and 2019, increasing to PhP 2.2 billion in 2020. ■ Despite the hefty tax increase, the overall tax burden is small on poorer households. The tax on coal and coke is marginally progressive.
