AP ECONOMICS:
Ch. 7,8,9 Review
MARKETS
AND
WELFARE
Alex Kunkel
Chapter 7: Consumers, Producers, and
the Efficiency of Markets
• The study of market allocation
• Analysis using positive statements
(how it is) and normative statements
(how it ought to be)
• Welfare economics – the study of
how the allocation of resources
affects economic well-being
• Willingness to pay – the maximum
amount that a buyer will pay for a
good
Example of Willingness to Pay
Principle and Consumer Surplus
• Say I want to sell a guitar for $1000.
• I have four potential buyers at an auction; Jimi, Angus, Pete,
and Tom.
• Jimi has $250, Angus has $500, Pete has $900 and Tom has
$1200.
• Tom and I agree on $1000 as the price.
• As a result Tom has a consumer surplus of $200, due to
paying $1000 for a good he values at $1200.
• Hypothetically, if I chose to be a bit greedier and sell the
guitar for $1500, Tom would chose not to buy it because it
is more than he is willing to pay. He would be an example of
a marginal buyer in that case.
• Consumer Surplus – the amount a buyer is willing to pay for
a good minus the amount the buyer actually pays for it.
Consumer Surplus (Graph)
• Cost – the value of everything a seller
must give up to produce a good. (For
example the guitar cost me $1100
when I bought it.)
• Producer Surplus – the amount a seller
is paid for a good minus the seller’s
cost of providing it.
• Efficiency – the property of a resource
allocation of maximizing the total
surplus received by all members of
society.
• Equality – the property of distributing
economic prosperity uniformly among
the members of society
Note: This is not an actual graph
Some Equations
• Consumer Surplus = Value to buyers – amount
paid by buyers
• Producer Surplus = amount received by sellers
– cost to sellers
• Total surplus = (values to buyers – amount
paid by buyers) + (Amount received by sellers
– cost to sellers)
• Total surplus = value to buyers – cost to sellers
Insights toward Market Equilibrium
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Free markets allocate the supply of goods to
the buyers who value them most highly, as
measured by their willingness to pay.
Free markets allocate the demand for goods to
the sellers who can produce them at the least
cost
Free markets produce the quantity of goods
that maximizes the sum of consumer and
producer surplus
At quantities less than equilibrium the value to
buyers exceeds the cost to sellers.
At quantities greater than equilibrium the cost
tot sellers exceeds the value to buyers.
Market equilibrium maximizes the sum of
producer and consumer surplus.
Market Efficiency and Failure
• In the analysis of welfare economics,
consumer and producer surplus are shown to
evaluate efficiency. In a “perfect” market,
Adam Smith’s “Invisible hand” theory guides
this efficiency
• In certain markets a seller may be able to
control prices (cough, cough monopoly)
• These “certain sellers” have market power,
and some side effects called externalities may
occur due to inefficiency.
Chapter 8: The Costs of Taxation
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“Taxes are what we pay for civilized society” – Oliver Wendell Holmes Jr.
“Nothing is true but death and taxes” – Ben Franklin
Effects of Taxes
• Taxes place a “wedge” of deadweight loss in the market,
this due to its added cost of the purchase of a good. This
varies on whether the tax is on consumers or producers.
Either way it creates unwanted fall in total surplus, due to
extra money spent on good/raw material. That is why
taxes can be considered a “market distortion” from the
normal price/cost.
• Tax revenue equals Tax multiplied by quantity.
• Taxes cause deadweight loss because they prevent buyers
and sellers from realizing some of the gains from trade. It
it the lost gain from trade.
Tax Revenue (graph)
Tax Distortions and Elasticity
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What determines the size of deadweight
loss from a tax that is large or small?
The elasticity of supply and demand can
further distort the size of tax.
When supply is relatively inelastic, the
deadweight loss of the tax is small.
When supply is relatively elastic, the
deadweight loss of a tax is large.
When demand is relatively inelastic, the
deadweight loss of a tax is small
When demand is relatively elastic, the
deadweight loss of tax is large.
The graph to the right shows the
distribution of tax due to price elasticity.
In overview, the greater the elasticity of
supply and demand, the greater the
deadweight loss caused by the tax.
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Deadweight Loss due to Tax Size;
Laffer Curve
With larger taxes, the deadweight loss caused
by its application is much higher, and tax
revenue is very slim.
With smaller taxes the deadweight loss is
quite small, but tax revenue isn’t as big as the
Feds would like.
A medium tax would settle this difference
This is shown in the Laffer Curve, which
demonstrates the trade-off caused through
tax revenues and tax size.
It caused the government to realize the cut in
tax rates would allow an increased
production. This application to taxes became
known as supply-side economics.
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Of course some transactions occur
illegally through the underground
economy, which is of course where taxes
don’t apply and most transactions involve
illegal goods.
These “career criminals” that engage in
this compare the opportunity cost before
them; they can earn more through
breaking the law rather than with a wage
they could earn legitimately. Risk
aversion is mostly low.
A good example of a rise in the
“underground economy” is during
Prohibition. (Note: Al Capone, Meyer
Lansky, and Arnold Rothstein; Organized
Crime Kingpins during Prohibition)
(Rothstein is also noted as the man that
fixed the 1919 World Series)
Chapter 9
No International Trade
• With no given international
trade, the price adjusts to
balance domestic supply and
demand, as shown for a
random good.
• With international trade the
price of a good on
international level will prevail
the domestic price. This is
called the world price.
Trade
• With a country that has a higher
domestic price for a good, that country
will import goods due to the lower
world price.
• With a country that has a lower
domestic price for a good, that country
will export goods to make profit from
this international trade.
• The areas represented show the
consumer and producer surplus, and
the imports or exports.
Political Cartoons
Tariffs
• However, in some cases,
domestic governments will
impose a tax on foreign goods
coming into their country. This is
a tariff.
• In most cases it causes domestic
producers to not be completely
undercut in competition by
cheaper priced foreign goods.
• Tariffs provide a further
deadweight loss, which increases
cost from world price.
• The argument on tariffs and
international trade is continuous.
Benefits of International
Trade
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Increased variety of goods – free trade allows consumers a wider choice, greater
variety and quality.
Lower costs through economies of scale – some goods are produced at low cost
only at large quantities. Free trade allows access to these world markets.
Increased competition – When shielded from foreign competition, a firm has much
more control over domestic markets and prices. Free trade allows the “invisible
hand” to reach a much larger spectrum.
Enhanced flow of ideas – Technological advances around the world are best linked
to trade. Ideas flow on a bigger scale.
Those who argue against free trade say there are benefits that would arise from
closing off world markets as well, but isn’t widely supported. Some of these
arguments include off-shoring of jobs, national security (with certain traded
goods), the “infant-industry” (newer companies attempting to enter the global
market) and unfair competition through undercutting prices.