This post is 3rd in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).
Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)
Part 3: Markets and Welfare
Chapter 7: Consumers, Producers, and the Efficiency of Markets
- Welfare economics: The study of how the allocation of resources affects economic well-being. This is a normative analysis (i.e. what should be).
7.1 Consumer Surplus
- Willingness to pay: The maximum amount that a buyer will pay for a good.
- Consumer surplus: The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.
- “The area below the demand curve and above the price measures the consumer surplus in a market.”
- In most markets, consumer surplus is a good proxy for economic well-being.
7.2 Producer Surplus
- Cost: The value of everything a seller must give up to produce a good. Example: For a house painter this includes the cost for equipment and materials (paint brushes) and the cost of time.
- Producer surplus: The amount a seller is paid for a good minus the seller’s cost of providing it.
- “The area below the price and above the supply curve measures the producer surplus in a market.”
7.3 Market Efficiency
- Consumer surplus and producer surplus are basic metrics used by economists to study the welfare of buyers and sellers in a market. They help answer the question: “Is the allocation of resources determined by free markets desirable?”
Total surplus: The sum of consumer and producer surplus for a given market.
- Consumer surplus = Value to buyers - Amount paid to buyers
- Producer surplus = Amount received by sellers - Cost to sellers
- Total surplus = Value to buyers - Cost to sellers
- Efficiency: The property of a resource allocation of maximizing the total surplus received by all members of society.
Efficiency in examples:
- An allocation is inefficient if a good is not being produced by the sellers with lowest cost. Solution: raise total surplus by moving production of the good from high cost sellers to lower cost sellers.
- An allocation is inefficient if a good is not being consumed by the buyers who value it most highly. Solution: raise total surplus by moving consumption of the good from a buyer with a low valuation to a buyer with a high valuation.
- Equality: The property of distributing economic prosperity uniformly among the members of society.
Three insights about market outcomes:
- “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 lowest cost.”
- “Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.”
- The equilibrium outcome is an efficient allocation of resources.
- Laissez faire: French phrase that is used as shorthand for the policy to “let the people do as they will” or to “let the market decide.”
7.4 Conclusion: Market Efficiency and Market Failure
- Market efficiency depends on several assumptions. If these assumptions are not true, the market may not function efficiently as it should under ideal circumstances.
Two key assumptions:
Markets are perfectly competitive.
- In real economies, competition is sometimes imperfect. In some markets a single buyer or single seller may have control of market prices.
- Market power: The ability to influence prices.
- Market power can be inefficient if it prevents the price and quantity from reaching the same equilibrium that free market supply and demand would arrive at.
The assumption that only buyers and sellers care about the market outcome.
- Decisions of market participants sometimes affect those who do not directly participate in the market.
- Pollution is a classic example of this phenomenon.
- Externalities: the side-effects exhibited or created by a market.
- Buyers and sellers often ignore these side effects when considering the buyer’s value and the seller’s costs.
- “Equilibrium in a market can be inefficient from the standpoint of society as a whole.”
- Market failure: The inability of some unregulated markets to allocate resources efficiently.
- Public policy is one potential remedy for failed markets (to increase economic efficiency).
Chapter 8: Application: The Costs of Taxation
8.1 The Deadweight Loss of Taxation
- “The impact of a tax on a market outcome is the same whether the tax is levied on buyers or sellers of a good.”
When a tax is enacted:
- The price paid by buyers rises.
- The price received by sellers falls.
- The elasticities of supply and demand determine the allocation of the tax burden between buyers and sellers.
- The size of the market for the good will shrink.
- On a supply and demand curve, a tax creates a tax wedge between the price buyers pay and the price sellers receive.
- Tax wedge illustrated on a demand/supply curve:
Using welfare economics to measure the gains/losses from a tax on a good:
- Buyers benefit in a market is measured by consumer surplus (the amount buyers are willing to pay for the good minus the amount they actually pay for it).
- Sellers benefit in a market is measured by producer surplus (the amount sellers receive for the good minus their costs).
- Public benefit (as mediated by the government) is the total tax revenue. Total tax = Tax * Quantity of good sold.
- The public benefit is collected by the government but the actual benefit should accrue to the public on whom the revenue is spent.
A tax causes the following:
- Reduced buyer surplus.
- Reduced seller surplus.
- Improved benefit to the government.
- “The losses to buys and sellers from a tax exceed the revenue raised by the government.”
- “The fall in total surplus that results when a tax (or some other policy) distorts a market outcome is called a deadweight loss.”
- Remember: Absent any tax, the equilibrium of supply and demand will maximize the total surplus of buyers and sellers in a market.
- Gives buyers an incentive to consume less.
- Gives sellers and incentive to produce less.
- The affected market will shrink.
- Distorted incentives cause markets to allocate resources differently.
Example of deadweight loss:
Scenario: Mike cleans Mei’s house weekly for $100.
- The opportunity cost of Mike’s time is $80.
- The value of a clean house to Mei is $120.
- The total surplus in this scenario is $40.
The government decides to levy a $50 tax for cleaning services:
- There is no price that Mei can pay Mike that will leave both of them better off.
- Mei is willing to pay $120. However, at that price Mike is left with $70 after paying the tax which is less than his $80 opportunity cost. For Mike to receive his opportunity cost of $80, Mei would need to pay $130.
- Mike and Mei cancel their transaction. Mike loses the income and Mei no longer has a clean house.
- Mike and Mei are worse off because they have, combined, lost a $40 surplus.
- The government collects no revenue from Mike and Mei.
- The $40 is deadweight loss: A loss to the buyers and sellers in a market that is not offset by an increase in government revenue.
- “Taxes cause deadweight losses because they prevent buyers and sellers form realizing some of the gains from trade.”
8.2 The Determinants of the Deadweight Loss
- Price elasticities of supply and demand affect the size of the deadweight loss.
- When supply is relatively inelastic the deadweight loss is small. As the supply becomes more elastic the deadweight loss grows.
- Illustration of supply elasticity and size of deadweight loss:
- When demand is relatively inelastic the deadweight loss is small. As the demand becomes more elastic, the deadweight loss grows.
- Illustration of demand elasticity and size of deadweight loss:
Taxes induce buyers and sellers to change their behaviors:
- Higher prices for buyers result in reduced consumption.
- Higher costs for sellers result in reduced production.
- The market shrinks below optimal quantity.
- The greater the elasticities of supply and demand (sensitivity to price change), the greater the deadweight loss from a tax.
Case study: The Deadweight Loss Debate.
Political policy question: How big should the government be?
Deadweight loss provides a framework for understanding the cost of any government program.
- If losses are large, there is a strong argument for smaller government.
- If losses are small, there is a strong argument in favor of the program or policy.
Determining the size of the deadweight loss is the heart of the debate.
For example: Labor taxes are debated because economists have different ideas about the elasticity of the labor supply. Economists who believe that labor taxes do not cause high distortions believe labor is elastic.
8.3 Deadweight Loss and Tax Revenue as Taxes Vary
- “Taxes rarely stay the same for long periods of time. Policymakers…are always considering raising one tax or lowering another.”
- Example of different size tax and their corresponding deadweight loss. Tax revenue is represented in green. Deadweight loss is the grey wedge:
As a tax increases:
- The deadweight loss grows larger.
- The tax revenue first grows larger (middle diagram) and then falls (rightmost diagram). This relationship is called the Laffer curve.
- Tax revenue falls because the size of the market has been affected.
- Laffer Curve: The relationship of tax revenue to the size of a tax. Tax revenue assumes the shape of a bell curve as the tax increases.
Case study: The Laffer Curve and Supply-Side Economics
In 1974 economist Arthur Laffer suggested to a group of journalists that reducing tax rates might increase tax revenue.
Lower taxes would create greater incentives.
Ronald Reagan made cutting taxes part of his platform during his run for president in 1980. Influenced by Laffer’s (and others) ideas, he argued that incomes would rise so much that tax revenue would increase.
These ideas became known as supply-side economics.
Economists disagree about:
- Where a tax sits on the Laffer Curve (is the tax on the high end? Is it on the low end?)
- The size of the relevant elasticities (the greater the elasticity the more taxes distort behavior).
Cannot look only at tax rates when considering gains and loses from tax changes. The underlying changes in behavior must also be considered.
- When a government imposes a tax on a market, society as a whole loses some of the benefits of market efficiency.
- Taxes transfer resources from market participants to the government, alter market incentives and distort market outcomes.
Chapter 9: Application: International Trade
9.1 The Determinants of Trade
The textile market as a case study for international trade:
- Textiles are made in many countries across the world.
- Textiles comprise a large global market for trade.
- Governments have actively enacted policies to protect domestic textile production.
- Mankiw considers the case of the hypothetical “Isolandian textile market” which is isolated from global trade. There is no import or export of textiles in Isolandia.
- “When an economy cannot trade in world markets, the price adjusts to balance domestic supply and demand.”
Questions to ask when evaluating a trade policy:
- If free trade becomes policy, what happens to the price and quantity of the good sold in the domestic textile market?
- Who will gain and who will lose from free trade in textiles? (And do the benefits outweigh the costs?)
- Should a tariff (a tax on imports) be part of the trade policy?
World price: The price of a good that prevails in the world market for that good.
- If the world price is lower than the domestic price, a nation will import the good.
- If the world price is higher than the domestic price, a nation will export the good.
- Comparing the world price to the domestic price reveals if there is a comparative advantage.
- The domestic price reflects the opportunity cost for one unit of the good or service.
- “Trade among nations is ultimately based on comparative advantage.”
- “Trade is beneficial because it allows each nation to specialize in doing what it does best.”
9.2 The Winners and Losers from Trade
Consider the size of the economic actor in the equation: Can it influence the overall market?
- In the example of Isolandia, a small nation, its small economy cannot significantly impact the global economy.
- Price takers: An economic actor that must accept the prevailing world price for imports or exports.
- Price makers: Economic actors capable of influencing the market price and enjoying pricing power.
When a country becomes an exporter of a good:
- Domestic price will rise to equal the world price.
- Domestic producers of the good are better off.
- Domestic consumers of the good are worse off.
When a country become an importer of a good:
- Domestic price will fall to equal the world price.
- Domestic producers of the good are worse off.
- Domestic consumers of the good are better off.
- In both the export/import scenarios the overall impact of trade is increased well-being in that the gains of the winners exceeds the losses of the losers.
- The reality is that while trade expands the economic pie, not all participants will benefit equally.
- “Whenever a policy creates winners and losers, the stage is set for a political battle.”
- Tariff: A tax on goods produced abroad and sold domestically.
Effects of a tariff:
- Tariffs reduce the quantity of imports and move the domestic market closer to its equilibrium without trade.
- Like other taxes, tariffs result in deadweight loss.
- Import quotas are another method for governments to restrict trade. An import quota places an artificial limit on the quantity of an imported good. The key difference is that a tariff raises revenue for a government. A quota creates a surplus for those who obtain the license to import.
Additional economic benefits of international trade:
- Increased variety of goods (e.g. German beer is different from American beer).
- Lower costs through economies of scale. For example: a firm in a small country cannot take advantage of economies of scale if it can only operate in a small domestic market. Free trade gives firms access to large, global markets.
- Increased competition. Free trade fosters competition which allows the free market to work its magic.
- Enhanced flow of ideas. Trade is a tremendous force for knowledge transfer and universal advancement. For instance, a poor nation can purchase high-tech components from a more developed nation to learn about the technology (rather than start from scratch).
9.3 The Arguments for Restricting Trade
The Jobs Argument
- Advocates say: Free trade will impact or eliminate domestic jobs.
- Counterargument: Free trade creates jobs for laborers willing to move into domestic industries where there is a comparative advantage.
- Advocates counter: “Everything can be produced more cheaply abroad.”
- Counterargument: Even if a country is better than another at everything, there are still goods and services in which a country has a comparative advantage.
The National-Security Argument
- Advocates say: Specific industries are vital to national security. For instance, domestic steel is necessary for the production of guns and tanks.–
- Counterargument: There may be situations where this policy is appropriate but this line of reasoning is used as a matter of convenience by producers at the expense of consumers at times where there is no security threat.
- Companies and industries have a strong incentive to obtain protection from foreign competition.
- Imports can be beneficial since, to use the guns and tanks example, they result in lower cost to the buyer (in this case the military).
The Infant-Industry Argument
- Advocates say: Temporary trade restrictions are necessary to get started. After a period of protection, a mature and stable industry will then compete with foreign firms.
- Counterargument: Requires government to pick winners and losers. Once an industry is protected from competition it is very difficult to remove “temporary” policies.
The Unfair-Competition Argument
- Advocates say: Free trade is only desirable when all participants (countries) play by the same rules. If a foreign government provides subsidies to an industry another nation might want to protect its domestic industry in response.
- Counterargument: The imports will benefit the population (and this gain exceeds the losses of domestic producers). Moreover, the foreign nation is subsidizing the production, a burden which impacts the exporting nation’s taxpayers (not the importing nation).
The Protection-as-a-Bargaining-Chip Argument
- Advocates say: Use threat of a trade restriction to negotiate for removal of other trade restrictions.
- Counterargument: Bargaining may not work. If it doesn’t, a nation is faced with two bad choices: carry out its threat and implement the restriction (which reduces its own welfare) or back down from the threat (which reduces its international prestige).
Case study: Trade Agreements and The World Trade Organization
- Unilateral approach: Situation where a country removes trade restrictions on its own.
- Multilateral approach: Bargaining with trading partners to reduce or eliminate trade restrictions.
Examples of multilateral trade agreements:
- North American Free Trade Agreement (NAFTA)
- General Agreement on Tariffs and Trade (GATT)
- World Trade Organization (WTO): Established in 1995 and headquartered in Geneva, Switzerland. Main function is to administer trade agreements, act as a forum for negotiations and handle disputes among member nations.
- Economists and the public often disagree about free trade. Economists overwhelmingly support free trade. The public can be ignorant and skeptical about free trade.
- Reality is that Americans would not enjoy their current high standard of living without free trade.