05/17/08

Micro Unit 5 

 Lesson 1

Circular Flow diagram with the government included.

You can add the government to the circular flow model.  It is in the middle of everything.  It takes money from the Households and Business and provides goods and services to them. 

The government also enters the product and factor markets.  It takes finished products from the product market and factors of production from the factor market.   In return, it has to make payments to these markets.

The government serves many functions in the economy. Some of the major ones are:

1) Legal and Social Framework: Through the laws the government sets the rules of the game. It will then go after people or businesses that do not follow the rules.

2) Maintains competition: Without competition the rules of supply and demand would not work. As you can see a monopoly will alter the economic game.

3) Redistribution of Income: The government attempts to reallocate income so that the uneducated and unskilled have a chance in society. It does this through

      a) transfer payments: relief to the destitute, aid to the dependent and handicapped and unemployment compensation to the unemployed. Social Security and Medicare for the retired and the aged sick.

     b) Market Intervention: setting minimum prices for farmers, minimum wages...

    c) Personal income taxes take a larger portion of income from the rich than from the poor.

4) Reallocation of Resources: We assume that the market will allocate resources to the fullest. The problem is that this fails to take into account spillovers (externalities):

Public Good: a good or service to which the exclusion principle is not applicable; and which is provided by government if it yields substantial benefits to society. (They must be non exclusive and shared consumption)

Exclusion Principle: The exclusion of those who do not pay for a product from the benefits of the product.

Shared consumption: everyone can use it.

                    Exclusive: a hamburger
                    Nonexclusive: national defense
                    Non shared: any private good
                    Shared: Education

What happens if someone refuses to pay for a public good. (Free Rider)  Can they be excluded. Are public goods shared?

Micro Unit 5 Lesson 2

 Externality (also called spillovers): some of the benefits or costs of production or consumption of a good spill over to a third party.  (Parties other than the buyers and sellers) 

Negative externality (spillover cost):  When production or consumption of a commodity inflicts costs on the third party without compensation.   Ex: pollution by manufactures.    When this happens the costs of production (the cost of the disposal of pollutants) is passed on to the consumer. This means that the company is not paying the full cost of production. This means the supply curve will be further out (right) than if they had to cover the costs. 

  
The tax corrects the overallocation of the scarce resource

In order to correct negative externalities the government should:

1) impose a tax equal to the externality. This would bring about equilibrium. The supply curve will shift up equal to the amount of the tax. This is an attempt by the government to make the company pay for the externality.

2) use legislation to make the firm correct the externality. This will cause the supply curve to shift up.

 Social Costs (also called external costs): are the costs that fall on someone else.

  Positive externality  (also called positive spillover): production or consumption of a good or service may provide a benefit to the third party.  ex: immunizations, education...

Social Benefits (also called external benefits): are the benefits that fall on someone else.

    
With a positive externality the product is being underproduced.

When this happens the demand for the product is actually understated.  More people would actually demand the product. This is corrected by:

1) providing incentives to partake in that good or service.

2) provide incentives for the companies to increase supply.

Positive Externality can be corrected with a subsidy to consumer.

Positive Externality can be corrected by giving subsidy to producers in order to get them to produce more.

      Total Cost = Private Cost + Social Cost

      Total Benefit = Private Benefit + Social Benefit

Coase Theorem: says that the government does not have to get involved in externality if:
            1) property ownership is clearly defined
            2) number of people is small
             3) bargaining costs are negligible

 Sometimes large numbers of people are involved:  If this is the case often you will see:
            1) Direct controls: legislation
            2) Specific taxes: this tax is charged to those companies that cause negative externalities.   The reason being, to provide money for cleanup.
            3) A market for externality rights.  In this case the government determines how much externalities society (nature) can tolerate.  It then sells these.  Like everything else, there will be a demand curve.

            One thing you have to look at is that as you force externalities out of society you are increasing the cost of doing business.  Soon with diminishing marginal returns setting in the point will come where the MC of reducing externalities exceeds the MB.  At that point the company will go out of business and society loses.

Micro Unit 5 Lesson 3: Chapter 31

We know that the market demand for goods comes from the horizontal summation of all of the individual demand curves. However for a public good this is difficult to do.

Because the government can not deny access to its services the demand curve for its goods and services will be nonexistent or understated. People will not fess up to the demand for the good if they know they will get it for free anyway.

This makes a derivation of a demand curve for public goods difficult. You have to get people to say what they would pay rather than do without.

However, if you do derive a demand and supply curve you can get the equilibrium point.

Benefit-Cost Analysis:
Deciding whether to employ resources and quantity of resources to employ form a project or program (for the production of a good or service) by comparing the marginal benefits with the marginal costs.

When the public sector utilizes a good or service it represents a decline in production in the private sector. This means you have to look and see if the benefit to the public sector outweighs the loss to the private sector. You can then look at degrees of benefit v. degrees of costs.      

In this flood control plan the total benefits outweigh the total costs in all areas. This is reflected in column 6 (net benefit) This means the project should be undertaken.

To determine the size of the project you have to look at marginal costs and marginal benefits. You want to pursue the project as long as Marginal Benefit is equal or greater than Marginal Cost. Once the are equal you quit pursuing them. As always if they can not be equal you would want Marginal Benefit to be greater than Marginal Cost.

You can see from the table that Marginal Benefit is closest to Marginal Cost under medium reservoir plan.   Notice that at this point you have the largest net benefit.

One major problem you will have is that you can not truly measure the costs and benefits associated with a project. The externalities are too great in number and width.
         Ex. Building of the outer loop. They can estimate the actual cost of doing this. Buying the property, building the roads, maintaining the roads. Connecting the roads to other roads....    However, it does not take into account the costs of the additional pollution, the increase need for police and ambulances to cover the area.

Privatization: when the government turns over a previously public run project to a private company.  Stone Mountain Park is now privatized.

Unit 5, Lesson 3

Marginal analysis is essential to microeconomic decision making. Discuss how marginal analysis is used in each of the following cases.

a. To derive the supply curve for a perfectly competitive firm

b. To identify the least cost combination of capital and labor used to produce a given level of output

c. To regulate an industry that produces a product that generates negative externalities.

Unit 5, Lesson 4
Government Revenue and Spending

       Economic Impact of Taxes:

1. Resource Allocation:  When businesses are taxed it is an increased cost of doing business for them.  
       This shifts the supply curve to the                  .   This will increase prices.   This causes people to buy less (quantity demanded), which in turn cause business to hire less factors of production.  (Circular flow diagram) 

2. Behavior Adjustment:  People's actions can be influenced by taxes. The quantity demanded  decreases when price increases.  
        Lower taxes lead to more money in people’s pockets, which will translate to more savings.

      3. Productivity and Growth- -high taxes can reduce people's incentive to increase production.  (Why should I work harder, the government will just take it anyway.)

    Criteria for Taxes to be effective:

 Equity- fairness.  
        Tax Loopholes: exceptions or oversights in the tax laws that allow some people and business to avoid paying certain taxes.    Many feel these are unfair because it allows some people to not pay part of their taxes.

Simplicity- average people should be able to interpret and apply each tax.  People are more willing to pay it if they understand it. 
           Accountants and tax lawyers make billions each year because people cannot understand the tax code and therefore pay professionals to figure it out.
           It is estimated that complying with the IRS tax codes increases the cost of goods and services in the US by 20%.

Efficiency- should be easy to administer and should make revenue for government.
        Income taxes: employer withholds a portion of person’s paycheck and sends it to the government.  At the end of the year they notify the person as to how much was withheld.

Tax Burden:

1) Benefits- Received Principle: households and businesses should purchase the goods and services of government basically the same manner in which other commodities are bought. This means that those that benefit should pay the tax burden.

Problems:
   1) How do you determine who benefits? Things like highways and parks are easy to handle but what about things like education (does society benefit from your education? It will. What about my education? Yes, I teach others. What about your parents?) , national defense, police protection.....

   2) How do you handle redistribution income? You can not ask a person on welfare to foot their own bill.

2) Ability to Pay Principle: tax burden should be tied directly to ones ability to pay, based on wealth.

The logic behind this is that each dollar received by an individual actually provides less and less satisfaction so that person is not hurt as much by the larger tax burden.

The problem with this is how do you determine how much more satisfaction one gets.

Another problem is that it leads to the desire to not work as hard to earn the extra income because the government will just take it anyway. (Roman Republic)

Tax types

1) Progressive: average rate increases as income increases. (The marginal rate will also increase as income rises.) Such a tax claims not only a larger absolute amount, but also a larger fraction or percentage of income as income increase.

2) Regressive Tax: average rate declines as income increases. This takes a smaller proportion of income as income increases. Ex: 15% if income is less than 10,000 and 10% if it is more than 10,000

3) Proportional Tax: Average rate remains the same regardless of the size of income. Ex: Income tax set at 25%. Everyone pays 25% of their income no matter how much you make.

            Identify what type of tax each of the following is.

Federal Personal Income Tax  ________________.

Sales Taxes: (4%) in Gwinnett ________________

Corporate Income Tax _________________

Property Taxes _________________

Micro Unit 5 Lesson 4 day 2

Not all taxes work the way they are supposed to work. Sometimes the ones that are supposed to pay the tax do not.

Tax incidence: income lost as a result of the taxes after tax shifting.

Tax shifting: transfer of taxes to another group.

Given a supply and demand curve with a market price of $12 and a quantity of 100.

Now lets go in and put a government tax of $2 on this product.   This will cause the supply curve to shift back the equivalent of $2.  (Notice the distance between the lines at any quantity will be $2.   THIS IS VERY IMPORTANT. 

We all know that businesses do not absorb all of the taxes imposed. They attempt to pass this on to their customers.   

In this example we see that the new price will be $13 and the new quantity will be 80.     

Of the 13 collected, $2.00 goes to the government. 

This means that the company only keeps $11 whereas before they would have gotten $12. 

The company actually ended up paying $1 of the $2 tax.

Yet, they are only paying 1/2 of the tax. The other .50 is passed on to the consumer in the form of higher prices.

Given supply, the more inelastic the demand for the product the larger the portion of the tax shift forwarded to consumer.

                                         
                   
                      Elastic Demand                                                                 Inelastic Demand

The area between P and Pe is the increased price charged to the consumer and the area between P and Pa is the increase price charged to the producer.

Look at the difference in the two. Notice the change in quantity. WHY IS THIS SO? 

This is why taxes on gas, alcohol, and cigarettes work so well. They have very inelastic demand.

Given Demand, the more inelastic the supply. The larger the proportion of the tax borne by the producers.

                                                     

                          elastic supply                                                                               inelastic supply
 

Deadweight Loss (also called Efficiency loss ):
 loss sacrificed by society because consumption and production of the taxed products are reduced below their allocative efficient levels. (In other words the market has been upset by the tax and this leads to a loss of efficiency.)

Since more of the product is demanded this means that the MB exceeds the MC. Yet the tax causes less to be produced.

The more elastic the S and D curves the more the deadweight loss. This makes sense because a change in price will have a greater change in quantity if they are elastic.

You can calculate the deadweight loss:

Use the formula (base x height)/2. In so doing the base is the change in price and the height is the change in the quantity.

The Lorenz Curve 

The Lorenz curve is designed to show the distribution of money income graphically. 

 Criticisms of the Lorenz Curve:

1. Curve represents distribution of money from land, labor, capital, and entrepre.   It does not take into account transfer payments.  Money taken from the rich and given to the poor would change this curve. 

2. Does not take into account family size or number of wage earners. 

3. Does not account for age differences.  Middle age earners are at the top of their income class. 

4. Curve reflects before taxes. 

The Gini Coefficient 

Why does income inequality exist?

1. Innate abilities and attributes
2. Work and leisure
3. Education and training
4. Risk taking: ex: pay off for starting own company, pay off for taking dangerous job….
5. Luck:
6. Wage discrimination