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AP ECONOMICS:Ch. 7,8,9 Review
Alex Kunkel
MARKETS AND
WELFARE
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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
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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.
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Consumer Surplus (Graph)
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• 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
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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
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Insights toward Market Equilibrium• 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.
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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.
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Chapter 8: The Costs of Taxation• “Taxes are what we pay for civilized society” – Oliver Wendell Holmes Jr. • “Nothing is true but death and taxes” – Ben Franklin
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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.
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Tax Revenue (graph)
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Tax Distortions and Elasticity• 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)
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Chapter 9
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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.
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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.
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Political Cartoons
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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.
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Benefits of International Trade
• 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.
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