ECO2030 1nd EditionExam # 2 Study Guide Lectures: 16 - 29Chapter 7:Welfare economics - the study of economic well-being, which is affected by the allocation of resources● Willingness to pay (WTP) - how much a consumer is willing to pay for a good● Consumer surplus (CS) = WTP - P (of a good)○ eg. if John is willing to pay $200 for something and the price is $100, then his CS is $100○ Total CS is the area/triangle under the demand curve down to the price. ○ Individual CS is the difference between the price of the good and the WTP of theindividual○ The two reasons CS falls: Buyers leave the market because the price increases above their WTP and the fall in CS because the remaining buyers have to pay a higher price● Producer surplus (PS) = P - Cost (to supply good/service)○ eg. If Johns cost to cut a tree is $100 but the price is $200, then his PS is $100○ Total PS is the area/triangle above the supply curve and up to the price of the good/service○ The two reasons PS falls: Sellers leave the market because price falls to where it exceeds their cost and the fall in PS because the sellers still in the market receiving less for their goods/services● Total Surplus = CS + PS○ Efficiency - when total surplus is maximized■ Efficiency is when the goods are consumed by those that value them most and produced by those that can produce them at the lowest cost■ Changing the price or quantity of a good does not increase total surplus ■ Total surplus is maximized at the market equilibrium quantity (efficient)○ Government cannot increase total surplus by changing the allocation of resources■ The market equilibrium is the most efficient■ This is why free market economies are much more efficient than centrally planned economies○ There is a role for government if there is a market failure, eg, externalities, marketpower. Chapter 8:● If buyers have to pay a tax on a good - demand curve shifts left by the amount of the taxSDprice buyers payPrice w/o taxPrice Sellers receiveQuantity w/ taxQuantity w/o taxAEBCFD● If sellers have to pay a tax on a good they sell - supply curve shifts left by the amount of the tax○ If you draw this out you will notice that the result is the same regardless who paysthe tax○ In both situations - the price buyers pay rises and the price sellers receive falls■ Either way, there is a lower quantity sold○ The tax burden is shared by the producers and the consumers■ Who pays more depends on the elasticity of the supply and demand for thegood■ A tax always decreases the size of the market because quantity sold decreases● A tax on a good: (reduces welfare)○ decreases both CS and PS○ creates government tax revenue■ Tax revenue = the size of thetax times the quantity sold○ In the graph - the tax revenue is equalto A + B○ The Deadweight Loss = C + E● Total surplus with a tax - Government revenueis included in the total surplus with a taxbecause we assume the tax is for our benefit,therefore, total surplus with the tax is A + B+ D + F○ w/o the tax Total surplus = A + B + D+ F + C + E● For every tax - the deadweight loss is > therevenue raised from the tax● The amount of the deadweight losses depends on the elasticities of the supply and demand curves○ Remember - the less steep the demand/supply curve the more elastic it is○ The more elastic either curve - the greater the deadweight losses from the tax■ you can draw this out to get a better understanding● The argument about taxes raises the question about how be government should be:○ The larger the deadweight losses from taxes - the more expensive the government program is○ So if these taxes cause large deadweight losses - we should have a smaller government○ If the taxes cause small deadweight losses - the government program costs less○ Labor tax - if the supply of labor is inelastic (steep) then the deadweight losses due to taxation are small○ If the supply of labor is elastic, then the deadweight losses from taxation will be large. ● As the tax increases the deadweight losses increase even more!Domestic SupplyDomestic DemandPrice Before tradeDomestic Quantity demandedQuantity BAprice After trade CDDomestic Quantity suppliedWorld PriceExportsTax RevenueTax Size○ Tax revenue increases as the tax increases to a certain point before it begins to fall■ This is because the tax distorts incentives to much (a higher tax reduces the size of the market)● The laffer curve:○ Shows how increasing the size of a tax increasesrevenue to a certain point, if the tax gets to great,revenue falls! ○ Ronald Reagan - actually ran on the Lafferplatform - promising people to cut taxes andsaying it would increase revenue (he was right)○ He noticed that high taxes reduced peopleswillingness to work and that lower taxes increasedmotivation to work Chapter 9: International Trade● Trade makes everyone better of● The Equilibrium without trade - has only domesticconsumers and producers○ The price and quantity is determined by the domestic market○ Total benefits = CS and PS● World price = the price of the good established in the world economy● Domestic price = the opportunity cost of producing the good in the domestic market● Allowing for free trade:● Comparative Advantage: If domestic price < world price (the country has the comparative advantage○ If the world price < domestic price (world has comparative advantage)● When a country opens up free trade - the price of the good will drop or increase to match world price○ If a country has a comparative advantage (price will rise) they should export the good○ If world has comparative advantage (price will fall), country should import the good○ In other words - if the world price is lower than the domestic price, country should import good, if would price is higher than domestic price, country should export good● In the graph on the right - worldprice is higher than domestic price socountry exports○ So when trade is allowed, thedomestic price increases toreach the world price○ The area D is the increase intotal surplus due to trade.Domestic SupplyDomestic DemandPrice Before tradeImports w/o tariffQuantity cAprice w/ tariffBWorld PriceImportsw/ tariffGFEDprice w/o tariffTariff Domestic SupplyDomestic DemandPrice Before tradeDomestic Quantity demandedQuantity BAprice After trade CDDomestic Quantity suppliedWorld PriceImportsDomestic Quantity demandedDomestic Quantity supplied○ As