ECON 201 FINAL REVIEW CH 6 11 Ef ciency of Markets and Costs of Taxation Welfare Economics the branch of economics that studies how allocation of resources affects economic well being Consumer Surplus CS the difference between the willingness to pay for a good and the price that is paid to get it Willingness to Pay WTP the maximum price a consumer will pay for a good re ected by demand curve CS WTP Price Producer Surplus PS the difference between the willingness to sell a good and the price the seller receives Willingness to Sell WTS the minimum price a seller will accept to sell a good or service re ected by supply curve PS Price WTS Total Surplus TS also known as social welfare is the sum of consumer and producer surplus No other surplus is larger than at the equilibrium price and quantity TS CS PS WTP WTS Ef cient Outcome when an allocation of resources maximizes Total Surplus A market is ef cient when it maximizes CS and PS provides goods to consumers who value them most and rewards sellers who can produce goods at lowest cost largest TS Equity fairness of the distribution of bene ts within the society Excise Taxes levied on a particular good or service raises the total price consumers pay and lowers the net price producers receive Incidence the burden of taxation on the party who pays the tax through higher prices regardless of whom the tax is actually levied on Excise taxes paid by consumers are relatively rare because they are highly visible Tax on Buyers demand curve shifts left and equilibrium price drops but buyers must still pay the tax Tax on Sellers supply curve shifts left and equilibrium price increases but tax must still be paid by sellers In both situations the seller and buyer both must pay some of the tax and share the tax burden Deadweight Loss DWL the decrease in economic activity caused by market distortions Occurs because taxes increase purchase price which causes consumers to buy less and producers to supply less Can be minimized by placing tax on a good with inelastic demand or supply Increased Taxes result in higher prices higher taxes also lead to more DWL but higher taxes don t always generate more revenue Gov t Revenue Tax x Quantity 1 Tax on Product with Perfectly Inelastic Demand the incidence is borne entirely by the consumer CS decreases and PS remains the same the decreased amount creates tax revenue 2 Tax on Product with Elastic Demand creates a transfer of welfare from consumers and producers to the government both CS and PS decrease this creates both revenue and DWL since the quantity bought and sold in the market declines 3 Tax on Product with Highly Elastic Demand consumers continue to pay the sam price before the tax but less is produced and sold decreases PS and creates DWL and much smaller tax revenue Market Inef ciencies Externalities and Public Goods Externalities costs or bene ts of a market activity that affect a third party Internal Costs costs of a market activity paid by an individual participant ex CS and PS are internal bene ts External Costs costs of a market activity paid by people who are not participants Social Costs Internal Costs External Costs The Third Party Problem occurs when those not directly involved in a market activity experience negative or positive externalities Negative externalities present a challenge to society because it s dif cult to make consumers and producers take responsibility for the full costs of their actions Government can restore social optimum by encouraging economic activity that harms 3rd parties Positive externalities bene t the community around a market activity Government can restore social optimum by encouraging economic activity that bene ts 3rd parties Social Optimum the price and quantity combination that would exist if there were no externalities An externality is internalized when a rm takes into account the external costs or bene ts to society that occur as a result of its actions Property Rights give the owner the ability to exercise control over a resource Private Property provides an exclusive right of ownership that allows for the use and exchange of property 4 incentives to maintain property to protect property to conserve property and to trade Coase Theorem states that if there are no barriers to negotiations and property rights are fully speci ed interested parties will bargain to correct any externalities that exist Private and Public Goods Rival goods cannot be enjoyed by more than one person at a time Excludable goods consumer must purchase before being able to use them Private Good both excludable and and rival in consumption food clothes Public Good can be jointly consumed by more than one person and non payers are dif cult to exclude rework display national defense non rival and non excludable Free Rider Problem occurs whenever someone receives a bene t without having to pay for it results in under production of good in the market Club Good non rival in consumption and excludable Net ix football game Common Resource Good rival in consumption and non excludable shery public forest Cost Bene t Analysis process that economists use to determine whether the bene ts of providing a public good outweigh the costs Tragedy of the Commons occurs when a good that is rival in consumption but non excludable Common Resource becomes depleted Solution Cap and Trade is an approach used to curb pollution by creating a system of pollution permits that are traded in an open market Business Costs and Production Pro ts and losses are determined by calculating the difference between expenses and revenues Total Revenue TR amount a rm receives from the sale of goods and services it produces Total Cost TC amount a rm spends in order to produce goods services it produces Explicit costs tangible out of pocket expenses Implicit costs opportunity costs of doing business Pro t TR TC TC Explicit costs Implicit costs Accounting Pro t TR Explicit costs Economic Pro t TR Explicit Implicit costs The Production Function relationship between inputs and outputs of a rm Output production the rm creates Factors of Production inputs labor land capital used in producing goods and services Marginal Product change in output associated with one additional unit of an input Diminishing Marginal Product occurs when successive increases in inputs are associated with a slower rise in output Costs in the Short Run Variable costs change with the rate of output Fixed costs unavoidable and do not vary with output in short