Taxes Excise tax sin tax tax on the sale of a particular good or service i e cigarettes Income tax sales tax property tax alcohol wine gas cell phones Tax changes 1 Changes market equilibrium 2 Changes consumer producer behavior 3 Decreases quantity sold 4 Increases market price 5 Decreases market efficiency Tax incidence who bears the burden of tax does NOT equal legal responsibility who sends money to gov t Tax creates loss of efficiency loss of economic surplus due to loss of transactions A tax is considered efficient if the tax revenue raised is large relative to excess burden Big tax area little DWL Principles of Tax Fairness 1 Benefits received principle people who use good service should pay the tax Ex gas tax goes to cost of highways 2 Ability to pay principle those who can afford it most should pay more Ex federal income tax progressive tax 3 Horizontal equity principle people in same economic situation should be treated equally Income Inequality Milton Friedman taking chances must have rewards and consequences Richard Wilkinson extreme inequality with a society is harmful Gary Becker income inequality is essential to reward investment in education and skill Robert Solow some sources of inequality are a good some are bad Shows the distribution of income Cumulate of income earned by each fraction of households on vertical axis Incomes from lowest to highest on horizontal axis Lorenz Curve EX Gini Coefficient A A B A commonly used statistical tool to measure income distribution during a given period If income distribution is totally equal Gini 0 area A doesn t exist If income distribution is totally unequal Gini 1 area B doesn t exist Poverty line a level of annual income equal to 3 times the amount of money necessary to purchase minimum quantity of food required for adequate nutrition Poverty rate of population that is poor according to federal gov t definition Problems of Measuring Poverty 1 Measures are snapshots in time 2 They ignore the effect of gov t transfer programs meant to reduce poverty Positive Externalities Exist when a 3rd party not involved in production or consumption benefits from a good or service i e vaccinations education flowers When positive externalities exist market outcome is not economically efficient because MB MC Negative Externalities Exist when a 3rd party not involved in production or consumption is hurt by a good or service i e 18 wheeler on highway cigarettes When MC MB economic surplus is negative which DWL Market failure when the market fails to produce the efficient level of output to maximize economic surplus Solutions to Market Failures Cause by Externalities 1 Coase theorem with clear property rights parties will come to solution through negotiation Well defined how are rights exercised Divisible can they be traded Defendable recognized and enforceable 2 Gov t intervention taxes and subsidies Enforce tax equal to externality to internalize cost due to negative externality Pay subsidy directly to consumers equal to externality to internalize positive externality 3 Gov t interventions regulations LEAST efficient creates most DWL Specific technology tell how is it to be done Quota set quantity set how many may exist 4 Categories of Goods 1 Rival 1 person or limited number of people can consumer at one time 2 Non rival everyone can consume at the same time 3 Excludable have to pay to consume 4 Non excludable anyone can consume without paying Common resources without intervention we consume common resources to extinction due to lack of property rights and economic incentives Quasi public artificially scarce goods non rival goods have MC of 0 but suppliers charge some higher prices just because they can Price MC inefficiently low consumption Public goods generally subsidized or provided by gov t due to positive externalities and free riders Elasticity Measures the responsiveness of one economic variable to changes in another Large reaction elastic Small reaction inelastic 1 Price Elasticity of Demand 2 Income Elasticity 3 Cross Price Elasticity 4 Price Elasticity of Supply Price Elasticity of Demand Tells us how price sensitive consumers are What change in Qd will we get from change in Price Negative relationship Just a that represents consumer responsiveness to change in Price E is most commonly calculated elasticity Will always be negative To make things easier we us E As E gets bigger demand gets more elastic o If E 1 demand is elastic o If E 1 demand is inelastic o If E 1 demand is unit elastic o If E 0 demand is perfectly inelastic and demand curve is vertical o If E demand is perfectly elastic and demand curve is horizontal Determinants of Elasticity of Demand Number of close relatives o The more close substitutes the more elastic demand is o The fewer close substitutes the less elastic demand is Passage of time o As time goes by demand becomes more elastic o In short periods demand is less elastic Share of consumer s budget o With lower price items that are smaller of budget demand is less elastic o More expensive more elastic Luxury vs necessity o Demand for necessity less elastic o Demand for luxury more elastic Definition of the market o Narrower the market more elastic demand is Income Elasticity Helps us determine if a good is inferior a normal necessity or a normal luxury If IE is positive good is normal If IE is negative good is inferior Cross Price Elasticity Helps us determine how closely goods are related If CPE is positive goods are substitutes If CPE is negative goods are compliments If CPE 0 goods are unrelated Price Elasticity of Supply Supply is often inelastic in the short run elastic in the long run Es is positive If Es 1 supply is elastic If 0 Es 1 supply is inelastic If Es 1 supply is unit elastic Determinants of Elasticity of Supply 1 Period of time short run inelastic long run more elastic 2 Availability of inputs if inputs are restricted supply will be inelastic Firms Unincorporated sole proprietors partnerships general LLC LLP Incorporated corporations non profit for profit S Corp and C Corp Shareholders owners of a corporation s stock whose interests are represented by Board of directors which appoint Executives Principal agent Problem A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him How to address this problem o 1 Salaries tied to firm s profits o 2 Stock as compensation o 3 Closer supervision to eliminate shirking Law of Diminishing Returns