PRINCIPLES OF ECONOMICS
Class 11
International trade, Taxation,
Distribution of income
dr. sc. Tomislav Herceg
International trade
• International trade has to take into account different
culture and exchange rates.
• Sources of I.T. are different costs, natural resources and
tastes.
• Absolute advantages (Adam Smith): countries can have
mutually beneficial trade if countries specialize in
production at which they are the best.
• Comparative advantages (David Ricardo): countries can
have mutually beneficial trade even if some countries
are less productive in all production if they differ in
productivity ratio
2
Protectionism
• It is a set of activities made by the state in order
to protect young industries and increase
domestic income and employment.
• Forms of protectionism:
1. Tariffs (preferred by World Trade Organisation)
are taxes on I.T.
2. Quotas are quantity limitations on I.T.
3. Subsidies
• All these interventions cause dead weight loss
(DWL)
3
Import tariff analysis
Autarky:
p
CSA = f, PSA = g + i + l, p*, q*
Open economy (pW)
IMW = qd – qs (𝐴𝐵)
ps
f
p*
g
pt
pw i
l A
0
qs
qd
CSW = f + g + h + i + j + T + k
PSW = l
E
C
j
h
T
D
k
B
qs’
q*
qd’
pd
q
Import tariff (t or t%)
𝑝𝑡 = 𝑝𝑊 + 𝑡 = 𝑝𝑊 (1 + 𝑡%)
IMW = qd’ – qs’ (𝐶𝐷)
CSW = f + g + h
PSW = i + l
DWL = j + k
State income = T
4
Taxation
• Taxes are the income of the state (price of public
goods)
• An instrument of fiscal policy
• Taxation principles:
1. Utility (those who use more public goods should
pay more)
2. Ability to pay (taxes should be proportional to
the payment ability)
3. Horizontal justice (those who have equal income
should pay equal T) and vertical justice (those
who have more should pay more)
5
Direct and indirect taxes
• Direct taxes are taxes charged to specific entity
(company: profit tax (20%), person: income tax
(12%, 25%, 40%), property tax(0%) )
• Indirect taxes are taxes are charged on goods and
services:
• VAT in Croatia: 25%, 13% (tourism) and 5%
(basic food, baby items)
• Beverage taxes (3%)
• Real estate sales tax (5%)
6
Tax progression
• Marginal tax rate (Mt%) is a tax rate in a specific tax
class (e.g. 0% up to 2200 HRK, 40% above 13200
HRK, etc.)
• Average tax rate (At%) is the total tax paid divided
by the tax base: At% = T/B
• Progressive tax: a tax under which At% increases
• Regressive tax: a tax under which At% decreases
• Proportional tax: a tax under which At% is constant
• Important: under all taxes those who have more pay
more, even in regressive tax!
7
Tax progressivity
Progressive
At%
Proportional
Regressive
Tax base
(B)
8
Laffer effect
• Laffer effect: at low At% tax revenues at first
increase and under high At% they start
decreasing.
T
Laffer
curve
O
100%
At%
• It is crucial to find At% at which tax revenues are
at its maximum
9
10
Supply side economics
•Reagan and Thatcher faced AS contraction in the 70’s
(oil shocks)
•They assumed that UK and USA are at A and thought
that decline in At% would move their countries to B
•In reality Laffer curve was assymetric and their
actions moved them to C (deficit went up)
T
B A
C
O
50%
75%
100%
At%
Ramsey rule
p
s
d
0
q
•When Es > Ed then
consumers pay more
•When Es < Ed then sellers
pay more
•Ramsey rule: Taxation of
perfectly inelastic supply
and demand is the most
efficient
11
Distribution of income
• Basic trade off: justice and efficiency
• Welfare state: the government redistributes
the income
• People differ with respect to their income and
wealth.
• Wealth: financial and material property minus
loans taken
• Disposable income: w, i, r, Pf, TR
12
Poverty
• Absolute poverty is a state at which
somebody cannot cover their own food,
housing and clothing
• Existential minimum: food expenditures × 3.
• Consumer basket contains expenditures for
food, housing, clothing, health, education and
entertainment (culture, sport)
• Relative poverty is a state at which the
income is less then consumer basket.
13
Lorenz curve and Gini coefficient
• Lorenz curve shows a share of first n poorest
quintiles in the total income or wealth.
Absolute inequality line
• Absolute equality line (AEL)
(everybody has and earns the
Lorenz curve
same) – Diagonal (G = 0)
• Absolute inequality line (AIL)
is a lower and left border of
the box (1 has everything) –
(G = 1)
• Gini coefficient is a share of
the area between AEL and
Lorenz curve in the lower
triangle:
0≤G≤1
14
20% 40% 60% 80% 100%
0%
Distribution of wealth and income
• The greater the inequality, the greater the
curvature of Lorenz curve
• Wealth is more unevenly distributed than income
• Inequality rises with industrialization and falls in
highly developed countries
Income
distribution
Wealth
distribution
15
0%
20%
40%
60% 80% 100%
Sources of wage and wealth
differences
Sources of wage differences are:
• Skills
• Intensity of labour
• Education
• Supply and demand for certain occupation
• Discomfort of the job
• Discrimination
Sources of wealth differences are:
• Savings
• Entrepreneurship
• Inheritance
16
Redistribution of income
• State ensures justice by taking care of the people
who cannot cover their basic needs: some of the
money has to be taken from the rich and given to
the poor
• Okun’s leaky bucket: redistribution costs
• How to redistribute? Progressive taxation and
transfer payments
• Side effects: transfer payments discourage working
• Benefits: better education and health care increase
human capital which increases future production
17
Income of the poorer half
Redistribution costs diagram
E
Z
B
A
45°
45°
• Point A: efficiency with no
redistribution
• Ideally a country should be at E
• Redistribution costs so equality
can be reached only at Z
• B is a trade off between
efficiency and justice where
redistribution does not cost so
much
Income of the richer half
18
Friedman’s income tax
Gross salary
Net salary
Net salary
Income tax
Unemployment
aid
45°
O
Y0
Gross salary
• Idea: negative tax (transfers) bellow certain income
level, postive tax above it:
T = (Y – Y0)×t%
19
Exercise 1: absolute advantages
• France has 1000 working hours and Scotland
500. Maximum production of wool and wine is
the following:
France
Scotland
wine
5000
500
wool
500
1000
20
solution
• Productivity of labour:
France
Scotland
wine
5000/1000 = 5
wool
500/1000 = 0,5
500/500 = 1
1000/500 = 2
• Scotland is 4× better at wool (2>0.5) and France
is 5× better at wine ( 5>1). Hence France sould
produce only wine and Scotland only wool.
Graph
wool
500
PPFFRC
5000
0
wine
wool
1500
PPFFRC
A
wool
1000
1000
PPFŠKT
PPFŠKT
0
5000 5500 wine
0
500
wine
22
Problem 2: comparative advantages
• Croatia has 400 working hours and Slovenia
200. Maximum olive and salt production is the
following:
Croatia
Slovenia
Olives
800
320
Salt
600
150
23
Solution:
• Productivity of labour is:
Croatia
Slovenia
Olives
800/400 = 2
320/200 = 1,6
Salt
600/400 = 1,5
150/200 = 0,75
• Croatia is 25% more productive in olives
(2>1,6), and 100% more productive in salt (
1,5>0,75). Croatian superiority is more
intensive in salt, hence Slovenia should
specialize in olives.
Olives
800
Graph
PPF HRV
0
600
Salt
Olives
1120
PPF HRV
Olives
A
320
320
PPFSLO
PPFSLO
0
600 750
Salt
25
0
150 Salt
Exercise 3
The income and the corresponding taxes paid
are given in the table below. Find average and
marginal tax rate.
Income
Tax
1000
0
2000
200
3000
500
4000
800
At%
Mt%
• Average tax rate: At% = T/Y
• Marginal tax rate : Mt% = ΔT/ ΔY
Income
Tax
At%
Mt%
1000
0
0%
0%
2000
200
10%
20%
3000
500
16,7%
30%
4000
800
20%
30%
• At% increases (progressive tax)
• Income tax is a direct tax
Problem 4: Friedman’s tax
Let 3000 HRK be a 0 tax income. Friedman’s
income tax is 20%. How much taxes would be
paid if the income were 0, 2000 or 6000 HRK?
Unemployed: T = (0 – 3000)×20% = -600 HRK
(600 HRK of unemployment aid)
2000 HRK: T = (2000 – 3000)×20% = -200 HRK
(200 kn of transfers)
6000 HRK: T = (6000 – 2000)×20% = 800 HRK
taxes
Problem 5
• Demand and supply are as follows:
P
Qs (supplied
quantity)
Qd (demanded
quantity)
5
0
150
10
20
120
15
40
90
20
60
60
25
80
30
a) If the world price were pw = 10 HRK what would be
the amount of export/import?
b) If the government introduces a tariff equal to 5 HRK
what would be the amount of export/import?
P
Qs
(supplied
quantity)
Qd
(demanded
quantity)
Difference
5
0
150
Import = 150
10
20
120
Import = 100
15
40
90
Import = 50
20
60
60
Equilibrium
25
80
30
Export = 50
a) At price p = 10 HRK the import would be 100.
b) Import tariff increases price: pt = 10+5 = 15,
hence 50 pieces would be imported. Tariff
revenue: T = 5×50 = 250
Problem 6
• Consumer’s basket in Croatia was 6700 kuna
in 2014, where 40% were food expenditures.
A. Find absolute and relative poverty line.
B. Is a family with income of 7000 HRK poor?
Solution
a)
• Absolute poverty line
• 6700×0,4×3 = 8040 HRK
• Relative poverty line = 6700 HRK.
b)
• 7000 HRK is above relative poverty line, but
bellow absolute poverty line.
Problem 7
• Distribution of income and wealth is given in
the following table. Draw Lorenz curves.
Where is Gini coefficient greater?
% population
…owns
income:
…owns wealth:
The poorest 20%
5%
1%
20-40%
10%
4%
40-60%
15%
5%
60-80%
20%
20%
80-100%
50%
80%
% population
…owns
income:
…owns
wealth:
Income
cumulative
Wealth
cumulative
The poorest 20%
5%
1%
5%
1%
20-40%
10%
4%
15% = 10+5
5% = 1+4
40-60%
15%
5%
30% = 15+15
10% = 5+5
60-80%
20%
20%
50% = 30+20
30% = 10+20
80-100%
50%
80%
100% = 50+50 100% = 30+70
• First find cumulative for both wealth and
income!
34
Lorenz curve
100%
90%
80%
70%
60%
Income
50%
Wealth
40%
Absolute equality
30%
20%
10%
0%
0
0.5
1
• The farther Gini
coefficient from
the diagonal the
greater the
value of G and
greater the
inequality.
• Wealth
inequality is
greater
Problem 8
What kind of takeover would it be if Tesco bought:
a) Carrefour
b) Rijeka Shipyard
c) Postira tuna fish industry
Solution:
a) Horizontal acquisition
b) Conglomerate
c) Vertical acquisition
Why would some governments demand Tesco to
sell some of their Carrefour shops?
Because of the HHI index