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IB Economics Study Guides Assessment Outline -‐ SL EXTERNAL ASSESSMENT (3 hours) 80%
Monday May 2, 2016 Paper 1 (1 hour and 30 minutes) 40% An extended response paper (50 marks) Assessment objectives 1, 2, 3, 4 Section A Syllabus content: section 1—microeconomics Students answer one question from a choice of two. (25 marks) Section B Syllabus content: section 2—macroeconomics Students answer one question from a choice of two. (25 marks)
Tuesday May 3, 2016 Paper 2 (1 hour and 30 minutes) 40% A data response paper (40 marks) Assessment objectives 1, 2, 3, 4 Section A Syllabus content: section 3—international economics Students answer one question from a choice of two. (20 marks) Section B Syllabus content: section 4—development economics Students answer one question from a choice of two. (20 marks)
Completed March 2015 INTERNAL ASSESSMENT (20 teaching hours) 20% This component is internally assessed by the teacher and externally moderated by the IB at the end of the course. Students produce a portfolio of three commentaries, based on different sections of the syllabus and on published extracts from the news media. Maximum 750 words x 3 (45 marks)
Basic Definitions Social Science and Economics Social Science is defined as a branch of science that studies the society and human behavior in it, including anthropology, communication studies, criminology, economics, geography, history, political science, psychology, social studies, and sociology. Economics is the branch of social science that deals with the production and distribution and consumption of goods and services and their management. It is the study of how scarce resources are allocated to fulfil unlimited wants. Microeconomics and Macroeconomics Economics is usually divided into two main branches: Microeconomics, which examines the economic behaviour of individual actors such as businesses, households, and individuals, with a view to understand decision making in the face of scarcity and the allocation consequences of these decisions. Macroeconomics, which examines an economy as a whole with a view to understanding the interaction between economic aggregates such as national income, employment and inflation. Economic growth is the increase of per capita gross domestic product (GDP) or other measure of aggregate income. It is often measured as the rate of change in GDP. Economic growth refers only to the quantity of goods and services produced. Economic development typically involves improvements in a variety of indicators such as literacy rates, life expectancy, and poverty rates. It is a measure of welfare in the economy. Human Development Index (HDI) is one of the most commonly used development measure. Sustainable development is a pattern of resource use that aims to meet human needs while preserving the environment so that these needs can be met not only in the present, but also for future generations. Economic development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Free Goods and Economics Goods Free goods are what is needed by the society and is available without limits. The free good is a term used in economics to describe a good that is not scarce. A free good is available in as great a quantity as desired with zero opportunity cost to society. Economics goods are consumable item that is useful to people but scarce in relation to its demand, so that human effort is required to obtain it.
Economic Definition of the Four Factors of Production Economic resources are the goods or services available to individuals and businesses used to produce valuable consumer products. The classic economic resources include land, labor and capital. Entrepreneurship is also considered an economic resource because individuals are responsible for creating businesses and moving economic resources in the business environment. These economic resources are also called the factors of production. The factors of production describe the function that each resource performs in the business environment. Land Land is the economic resource encompassing natural resources found within a nations economy. This resource includes timber, land, fisheries, farms and other similar natural resources. Land is usually a limited resource for many economies. Although some natural resources, such as timber, food and animals, are renewable, the physical land is usually a fixed resource. Nations must carefully use their land resource by creating a mix of natural and industrial uses. Using land for industrial purposes allows nations to improve the production processes for turning natural resources into consumer goods. Labor Labor represents the human capital available to transform raw or national resources into consumer goods. Human capital includes all able-‐bodied individuals capable of working in the nations economy and providing various services to other individuals or businesses. This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services. Human capital can also be improved through training or educating workers to complete technical functions or business tasks when working with other economic resources. Capital Capital has two economic definitions as a factor of production. Capital can represent the monetary resources companies use to purchase natural resources, land and other capital goods. Monetary resources flow through a nation’s economy as individuals buy and sell resources to individuals and businesses. Capital also represents the major physical assets individuals and companies use when producing goods or services. These assets include buildings, production facilities, equipment, vehicles and other similar items. Individuals may create their own capital production resources, purchase them from another individual or business or lease them for a specific amount of time from individuals or other businesses. Entrepreneurship Entrepreneurship is considered a factor of production because economic resources can exist in an economy and not be transformed into consumer goods. Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk involved with transforming economic resources into consumer products. Entrepreneurship is also considered a factor of production since someone must complete the managerial functions of gathering, allocating and distributing economic resources or consumer products to individuals and other businesses in the economy.
Three Basic Economic Questions As an entrepreneur and as an economic agent, there are three basic economic questions you should ask when deciding how to use scarce resources:
• What to produce? • How to produce? • For whom to produce?
What to Produce? In a true command economy, what to produce is determined by a central economic authority. In a true free market, what to produce is determined by individual choices. However, most nations fall somewhere between a true command economy and a true free market and production is determined by a mixture of central planning and individual choices. For example, in the United States, while the production of some foodstuff is determined by supply and demand, others, such as sugar and milk, are subsidized by the government. All businesses must decide what to produce given limited resources. While a society must decide how much food and shelter to produce to satisfy the population, a business must decide how much of each goods or services to produce. Because of scarcity, by producing A, you must forgo the production of B, thus incurring an opportunity cost. You choose to produce, hopefully, the product or service that brings the highest benefits relative to costs. However, as the organization gets bigger and more complicated and as the number of choices increases, so will the difficulty in answering this question. How to Produce? There are many ways to produce a good or service of equal quality. As an entrepreneur, it is important to have a clear understanding of all your alternatives. Should the business produce all the goods and services it sells by itself or will it bring in outside contractors? Should the production take place domestically or should it be outsourced to another country? Should the production be labor intensive or capital intensive? For Whom to Produce? All goods and services are produced for somebody to consume. In a free market, who gets what is determined by who is able to afford what at a price determined by supply and demand. As an entrepreneur, this question should be addressed in the same line of thought as "what to produce?" Who are your customers? Will your targeted customers be able to afford the product? Are there enough of them to support your business?
4 Factors Examples Papa Johns Pizza Land: Retail Locations/Kitchens/Stores Labor: Hourly and Salaried Workers, per diem delivery drivers. Capital: Ovens, Boxes, Utensils (pans, spatulas, etc.), Point of Sales equipment, Ingredients, etc. Entrepreneur: Papa John Schnatter, Founder CEO Coca-‐Cola Softdrinks Land: Factories, Bottling Plants, Floor Space at the Retail Market Labor: Hourly and Salaried Workers Capital: Ingredients, Bottling Supplies (Aluminum & Plastic), Packaging, Delivery Vehicles, etc. Entrepreneur: John Pemberton, Founder. Today; CEO and Board of Directors
3 Basic Questions Examples What to produce: Automobiles; SUVs, sports cars, sedans, coupes? How to Produce: Factory, USA or Overseas? Union or Non-‐Union For Whom to Produce: How expensive do you make the vehicle? Chevrolet, Buick or Cadillac What to produce: TAG Heuer; Timepieces How to Produce: Factory and handmade, Switzerland For Whom to Produce: sports, casual and dress watches and customers What to produce: New Era Hats How to Produce: Factory, USA or Overseas? Union or Non-‐Union For Whom to Produce: MLB Hats, NFL Hats, NBA Hats, NHL Hats, Casual Hats, Comic Hats
Section 1: Microeconomics 1.1 Competitive markets: demand and supply (some topics HL only) 1.2 Elasticity 1.3 Government intervention (some topics HL extension, plus one topic HL only) 1.4 Market failure (some topics HL only) 1.5 Theory of the firm and market structures (HL only) The purpose of this section is to identify and explain the importance of markets and the role played by demand and supply. The roles played by consumers, producers and the government in different market structures are highlighted. The failures of a market system are identified and possible solutions are examined. The concepts learned here have links with other areas of the economics syllabus; for example, elasticity has many applications in different areas of international trade and development. What is Market Market is a place where buyers and sellers meet. In economics, the concept of a market is any structure that allows buyers and sellers to exchange any type of goods, services and information. The exchange of goods or services for money is a transaction. Features of a market Market participants consist of all the buyers and sellers of a good who influence its price. There are two roles in markets, buyers and sellers. The market facilitates trade and enables the distribution and allocation of resources in a society. Markets allow any tradable item to be evaluated and priced. A market emerges spontaneously or is constructed deliberately by human interaction in order to facilitate the exchange of goods and services What is demand? Demand is defined as want or willingness of consumers to buy goods and services. In economics willingness to buy goods and services should be accompanied by the ability to buy (purchasing power) and is referred to as effective demand. Law of demand The law of demand is an economic law that states that consumers buy more of a good when its price decreases and less when its price increases, ceteris paribus.
It states that when price increases, the amount demanded will fall and when prices fall, the amount demanded will rise.
Rationale of the law of demand There are two reasons for a fall in demand when the prices increase. Income effect: People feel poorer. As the price of a good rises the purchasing power of people to buy that good will fall. This is known as income effect. Substitution effect: Some people might shift to cheaper alternatives/substitutes once the price of a good rise, thus leading to a fall in demand for that good.
Straight line (linear) demand curve A straight line demand curve will have a different elasticity at each point on it. The price elasticity of demand can also be measured at any point on the demand curve. If the demand curve is linear (straight line), it has a unitary elasticity at the midpoint. The total revenue is maximum at this point. Any point above the midpoint has elasticity greater than 1, (Ed > 1). Here, price reduction leads to an increase in the total revenue (expenditure). Below the midpoint elasticity is less than 1. (Ed < 1). Price reduction leads to reduction in the total revenue of the firm. Now the question arises, why does a straight line demand curve have different elasticity at each point? The value of PED falls as price falls. The reason is that low priced products have a more inelastic demand than high priced products, because consumers are not that price sensitive when the product is inexpensive, Similarly the value of PED is higher when the prices increase because consumers are more sensitive to price change when the good is expensive. A mathematical explanation can be given as follows. As we seen in diagram below
Movement along the demand Curve: Extension of demand Extension of demand is the increase in demand due to the fall in price, all other factors remaining constant. Contraction of demand Contraction of demand is the fall in demand due to the rise in price, all other factors remaining constant.
Shift in the demand curve Usually demand curves are drawn based on the assumption except for price all other factors remain the same. But there might be instances when demand may be affected by factors other than price. This will result in the change in demand although the price will remain the same. This change in demand may cause the demand curve to SHIFT inwards or outwards. Shift of demand curve OUTWARDS shows an increase in demand at the same price level. It is known as INCREASE IN DEMAND. Shift of demand curve INWARDS shows that less is demanded at the same price level. It is known as a FALL IN DEMAND.
Factors affecting demand Change in people’s income: More the people earn the more they will spend and thus the demand will rise. A fall in income will see a fall in demand. Changes in population: An increase in population will result in a rise in demand and vice versa. Change in fashion and taste: Commodities or which the fashion is out are less in demand as compared to commodities which are in fashion. In the same way, change in taste of people affects the demand of a commodity. Changes in Income Tax: An increase in income tax will see a fall in demand as people will have less money left in their pockets to spend whereas a decrease in income tax will result in increase of demand for products and services because people now have more disposable income. Change in prices of Substitute goods: Substitute goods or services are those which can replace the want of another good or service. For example margarine is a substitute for butter. Thus a rise in butter prices will see a rise in demand for margarine and vice versa. Change in price of Complementary goods: Complementary goods or services are demanded along with other goods and services or jointly demanded with other goods or services. Demand for cars is affected the change in price of petrol. Same way, demand for DVD players will rise if the prices of DVDs’ fall. Advertising: A successful advertising campaign may affect the demand for a product or service.
Climate: Changes in climate affects the demand for certain goods and services. Interest rates: A fall in Interest rate will see a rise in demand for goods and services. What is Supply? Supply refers to the amount of goods and services firms or producers are willing and able to sell in the market at a possible price, at a particular point of time. Law of Supply It states that when the price of a commodity rises, the supply for it also increases. The higher the price for the good or service the more it will be supplied in the market. The reason behind it is that more and more suppliers will be interested in supplying those good or service whose prices are rising.
Movement along the Supply Curve Extension of supply It refers to the increase in supply of a commodity with the rise in price, other factors remaining unchanged. Contraction of supply It refers to the fall in supply of a commodity when its prices fall, other factors remaining unchanged.
Shift in Supply Curve When factors other than price affect the supply it results in the shift of supply curve. The supply curve may move inward or outward. A shift of supply curve outwards to the right will mean an increase in supply at the same price level. When the supply curve moves inwards to the left it means that less is being supplied at the same price level.
Factors affecting Supply Price of the commodity: A rise in price will result in more of the commodity being supplied to the market and vice versa. Prices of other commodities: For example if it is more profitable to produce LCD TVs then producers will produce more LCD TVs as compared to PLASMA TVs. Thus the supply curve for PLASMA TVs will shift inwards i.e. a fall in supply. Change in cost of production: Increase in the cost of any factor of production may result in the decrease in supply as reduced profits might see producers less willing to produce that commodity. Technological advancement: Improvement in technology results in lowering of cost of production and more profits for the producer and thus more supply of that commodity. Climate: Climate and weather conditions affect the supply of commodities especially agricultural goods. Equilibrium Equilibrium is a point of balance or a point of rest. A more complex definition is Equilibrium is a state in market where economic forces are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. It is the point at which quantity demanded and quantity supplied is equal. Market equilibrium, for example, refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the equilibrium price. In the graph below the point at which the demand curve meets the supply curve is the equilibrium price.
Equilibrium is ‘self righting’ It means that if we try to move away from the equilibrium situation it will revert back to its original position, if there is no external disturbance. Figure below explains the concept.
In this diagram the equilibrium price is P* and the quantity supplied Qe. However, the prices have been increased to P2. As the price has increased it will lead to more suppliers entering the market and supply increasing to Qs. At the same time, a increase in price to P1 will lead to a fall in demand (as per the law of demand) i.e. Qd. This will create an excess supply situation. Now the suppliers will find it difficult to sell their goods and they will have to reduce their price to attract more consumers. This will go on till the price again reaches its initial level i.e. P*. Hence the situation is self righting if the prices are raised without any external reason. Similarly, in the figure below
We can see that the prices have been artificially reduced from P* to P1. This leads to a fall in supply from Q* to Qs (as per law of supply). As the prices fall from P* to P1, people can afford to buy more of that good and demand increase from Q* to Qd. Again an excess demand situation is created. In order to get the most out of this situation the suppliers will start increasing their price. On the other hand demand will start falling as the prices increase. This will all continue till the prices settle at equilibrium price i.e. Pe. Hence we can say that equilibrium is ‘self-‐righting’ Movement to a new equilibrium The equilibrium price remains unchanged till the demand and supply curves retain their position. The moment there is a shift in any of the components, a new equilibrium will be formed.
Effect of change in Demand and Supply Demand Supply Equilibrium price Equilibrium quantity Increase Unchanged Rise Rise Decrease Unchanged Fall Fall Unchanged Increase Rise Rise Unchanged Decrease Rise Fall
Affect of Change in Demand on equilibrium
If there is a shift in demand, it will lead to a movement along the supply curve and a new equilibrium point will be achieved. In figure 1, There is equilibrium at point E, where the price is Pe and quantity supplied is Qe. There is a shift in demand from D1 to D2. At price Pe, it will lead to a 'excess demand' situation (F). In order to cope with excess demand the suppliers will start increasing the price and more will be supplied. On the other hand as the prices increase, demand will start to fall. This phenomenon will continue till a new equilibrium stage is reached at point G. Now the Price will be P1 and quantity supplied at that point will be Qe1. Hence it has resulted in an increase in price and quantity demanded. The opposite will happen if there is a shift of demand curve to the left. The price and quantity demand will fall.
Affect of Change in Supply on equilibrium
In figure 2, the equilibrium point is E with Pe as the equilibrium price and Qe as the quantity demanded. Now there is a rightward shift in supply curve to S2 i.e. supply increases. This will lead to a excess supply. Producers will find it difficult to find consumers and will have to reduce their prices to clear their inventories. As the prices fall, more people will be interested in buying the product. This will continue till equilibrium is achieved at G. There will a price fall from Pe to Pe1 and Qe to Qe1. The result is lower equilibrium price and lower equilibrium quantity. Price Elasticity of demand The responsiveness of quantity demanded, or how much quantity demanded changes, given a change in the price of goods or service is known as the price elasticity of demand.
Price Elasticity of demand (PED)= % change in quantity demanded % Change in price
Negative sign The mathematical value which is derived from the calculation is negative. A negative value indicates an inverse relationship between price and the quantity demanded. However, the negative sign is ignored.
Range of PED The value of PED might range from 0 to ? Lets take a look at various types of PED. Perfectly Inelastic demand In this case the PED =0 That means, any change in price will not have any effect on the demand of the product. Or in other words, the percentage change in demand will be equal to zero. It is hypothetical situation and does not exist in real world. Perfectly elastic demand In this case the PED =? The demand changes infinitely at a particular price. Any change in price will lead to fall of demand to zero. It is hypothetical situation and does not exist in real world. However Normal goods have value of PED between 0 and ?. These can be classified as Inelastic demand When a product has a PED less than 1 and greater than 0, it is said to be have an inelastic demand. The percentage change in demand is less than the percentage change in price of the product.
Demand for a product is said to be ELASTIC if the percentage change is demand is more than the percentage change in price. The value of PED is more than 1.
When there is a smaller percentage change in quantity demanded as compared to the percentage change in its price, the product is said to price INELASTIC. The value of PED is less than 1.
Applications of Price Elasticity of Demand Examine the role of PED for firms in making decisions regarding price changes and their effect on total revenue. Firms give a lot of importance to PED while setting prices for their products. A firm will be more willing to increase the price of a product, which has a more inelastic demand because it will lead to an overall increase in their revenue. With an increase in price of the product, the demand will not fall in the same proportion and this end up in more revenue for the firm. On the other hand a firm seeking to increase its revenue and having elastic demand for its product should not increase its prices because it will lead to a fall in their revenue. As the price increase there will be a more than proportionate fall in sales, thus pulling down the overall revenue of the firm.
Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high. The PED for primary commodities is relatively low due to the fact that they have very few substitutes whereas manufactured products have a relatively high PED because of the existence of many substitutes. For example, the PED for cow leather (primary commodity) is relatively lower than a genuine cow leather shoe (manufactured product). The reason being there is no or very few substitutes for leather as a raw material for producing shoes. However, leather shoe may have many substitutes in the form of sheep leather and other types of artificial leather shoes available in the market. Examine the significance of PED for government in relation to indirect taxes. PED hold a lot of significance for government while deciding indirect taxes on goods and services. Government uses taxes to reduce the use of demerit goods in the economy. For example they might increase taxes on cigarettes. Cigarettes are habit forming or ‘addictive’ and have inelastic demand, thus, even a high increase in indirect taxes will not lead to a fall in the consumption of
cigarette smoking. Thus overall revenue of government will increase without drastically harming the cigarette manufacturing industry and employment. Moreover, it might lead to some fall in cigarette consumption due to increased prices. Cross price elasticity of demand (XED) Cross elasticity of demand is the effect on the change in demand of one good as a result of a change in price of related to another product. In economics, it is denoted by the symbol XED. The formula for cross elasticity of demand is
Cross elasticity of demand = % change in quantity demanded of good X % Change in price of good Y
In XED it is important to have the positive/negative sign in front of the value. If the value of XED is positive, this means that the two goods being considered are substitute goods. Close substitutes have high positive value. Example: butter and margarine. If two goods are complements, an increase in the price of one will lead to a reduction in the demand for the other—the XED is negative. Very close complements have a lower negative value. If two goods are unrelated, a change in the price of one will not affect the demand for the other—the XED is zero. The Income Elasticity of Demand (YED) measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income.
Income elasticity of demand= % change in quantity demanded % Change in Income
Normal goods: an increase in income leads to an increase in consumption, demand shifts to the right. Thus YED is positive for normal goods. Inferior goods: Income elasticity is actually negative for inferior goods, the demand curve shifts left as income rises. As income rises, the proportion spent on cheap goods will reduce as now they can afford to buy more expensive goods. For example demand for cheap/generic electronic goods will fall as people income rises and they will switch to expensive branded electronic goods.
Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods. Basic or necessity goods have a low income elasticity i.e., 0 < ? < 1. Quantity demanded will not increase much as income increases (income elasticity for food = 0.2) Luxury goods have high income elasticity i.e. ? > 1. Quantity demanded rises faster than income. For restaurant meals income elasticity is higher than for food, because of the additional restaurant service.
In different types of economies, the demand for goods and services are determined by the income elasticity. As economies grow, firms will want to avoid producing inferior goods. The reason being as income increases more and more people will switch from inferior goods to superior goods.
Price Elasticity of Supply = % change in quantity Supplied % Change in price
Elasticity = 0: if the supply curve is vertical, and there is no response to prices. Elasticity = ?: if the supply curve is horizontal. Supply is price elastic if the price elasticity of supply is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. Supply is Price Elastic when the percentage change in quantity supplied is more than the percentage change in Price of the commodity. PES is more than 1.
Supply is Price Inelastic when the percentage change in quantity supplied is less than the percentage change in Price of the comoditity. PES is less than 1.
Types of Price elasticity of Supply Unitary Price Elasticity of Supply
Perfectly price elasticity of supply
Infinite price elasticity of Supply
Price Elasticity of Supply Price elasticity of supply is a measure of the responsiveness of quantity to a change in price. In other words, it the percentage change in supply as compared to the percentage change in price of a commodity. Factors affecting Price Elasticity of Supply Time: In the short run firms will only be able to increase input of labor to increase supply of commodities may not be able to increase the supply in response to the price change but the supply change will be little because other factors of production may not be increased in the same proportion and may limit the supply. However, in the long run a firm will increase the input of all factors of production and thus the supply becomes more price elastic. Availability of resources: If the economy already using most of its scarce resources then firms will find it difficult to employ more and so output will not be able to rise. The supply of most of goods and services will therefore be price inelastic. Number of producers: More producers mean that the output can be increased more easily. Thus supply is more elastic. Ease of storing stocks: If goods can be stocked with ease and have a long shelf life, the supply will be elastic, otherwise inelastic. For example perishable goods such as fresh flowers, vegetables have comparatively inelastic supply because it is difficult to store them for longer periods. Increase in cost of production as compared to output: In cases where there is a significant increase in cost of production when output is increased, supply is inelastic. This is because
suppliers will have to have to do a significant investment in order to increase the output. It will take time and some suppliers may be hesitant in doing so. Improvement in Technology: In industries where there is a rapid improvement in technology, the PES of such goods will be more elastic as compared to industries where there is not much improvement in technology. Stock of finished goods: In industries where there are high inventories/stocks of finished goods, the suppliers can easily supply more as the price rises. Thus, the PES for these goods will be elastic. Consumer Surplus Consumer surplus measures the difference between total benefit of consuming a given quantity of output and the total expenditures consumers pay to obtain that quantity.
the shaded area OCDE; total expenditures are given by the rectangle OBDE. The difference, shown by the triangle BCD, is consumer surplus.
Producer Surplus Producer surplus can be defined as The difference between the amount that a producer of a good receives and the minimum amount that he or she would be willing to accept for the good. The difference, or surplus amount, is the benefit that the producer receives for selling the good in the market. Producers' surplus exists when actual price exceeds the minimum price sellers will accept.
Here, total revenue is given by the rectangle OBDE, and total costs are given by the area OADE. The difference, shown by the triangle ABD is producer surplus.
Community Surplus is the welfare of society and it is made up of a consumer surplus plus a producer surplus. It exists when it is impossible to make someone better off without making someone else worse off.
When the consumer surplus is equal to producer surplus It exists when the market is in equilibrium, with no external influences and no external effects. Market is said to be socially efficient and community surplus is at its maximum.
Allocative Efficiency Allocative efficiency is when resources are allocated in the most efficient way from society's point of view. In other words the market is said to be socially efficient. Allocative efficiency exisists where Community Surplus (consumer surplus and producer surplus) is maximized. At equilibrium where demand is equal to suppy, community surplus is maximised.
Indirect taxes An indirect tax is a tax collected by an intermediary i.e. seller, from the person who bears the ultimate economic burden of the tax i.e. consumer. It is imposed on expenditure. In simple terms, it is a tax which is imposed on goods and services sold. It is usually added to the cost of the good or service and charged from the ultimate consumer. The seller will then file a return to the government on all the taxes he has collected from the consumer. Examples are sales tax and excise duty
Reasons for imposing taxes The main reasons for government imposing taxes can be
• To generate Government revenues: excise duties on beers, wines and spirits are price inelastic in demand, so tax price increases by levying specific alcohol and tobacco taxes raise consumer expenditures as a whole on these categories and therefore taxation revenues;
• To discourage consumption: Government might use taxes to discourage consumption of certain demerit goods such as cigarettes.
• To alter the pattern of consumption: Government might use direct taxes a a mean to alter the consumption patter of its population. Certain goods can be made more price attractive through lower taxes while goods which have high marginal social cost can be made expensive through taxation.
Distinction between specific and ad valorem taxes
• Specific tax is a flat rate of tax whereas ad valorem tax is a percentage tax. • Ad valorem literally the term means “according to value.” It is imposed on the basis of the
monetary value of the taxed item. • A specific tax is when specific amount is imposed upon a good, for example $10 on each
mobile phone sold; whereas ad valorem tax is expressed as a percentage of the selling price e.g. 12% of the sales.
• The amount of specific tax changes in the same proportion as the quantity sold increase, whereas, in ad valorem the tax collected is more at higher prices then at lower prices.
Consequences of imposing indirect tax Imposition of tax results in three economic observations.
• Incidence: Incidence of tax means the party who actually pays the tax. • Government revenue: the amount of tax government will receive as revenue • Resource allocation: the amount of fall in quantity demanded and produced created by
the tax.
Incidence or tax burden When a tax imposed on a good or service increases the price by the amount of the tax, the burden of the tax falls on consumers. If instead it lowers wages or lowers prices for some of the other factors of production used in the production of the good or service taxed, the burden of the tax falls on owners of these factors.
If the tax does not change the product’s price or factor prices, the burden falls on the owner of the firm—the owner of capital. If prices adjust by a fraction of the tax, the burden is shared. The incidence of tax will be shared between the consumers and producers, depending on the price elasticity of demand (PED) for that product (which we will discuss later). If we assume that the burden is equally shared by both the consumers and the producers then the size of square CYZPe is equal to PeZXP1. This means the incidence of tax is equally distributed by both the consumer and producer.
Government revenue Putting taxes on goods and services generates revenue for the government. Figure below shows the shaded region as tax revenue for government i.e. CYXP1. The implication will be a fall in output from Qe to Q1 and thus the consumption and production of the commodity will fall.
Tax incidence and price elasticity of demand and supply Incidence of indirect taxes on consumers and firms differs, depending on the price elasticity of demand and on the price elasticity of supply. Let’s study individual cases. Scenario 1: When PED is greater than PES Where PED is greater than PES, it implies that consumers are more sensitive to price changes as compared to suppliers. Thus the incidence of tax will be more on the suppliers because if too much burden of tax is passed on to the consumers then the demand will fall drastically. Therefore, this time the price paid by buyers barely rises; sellers bear most of the burden of the tax.
Scenario 2: When PES is greater than PED When the supply curve is relatively elastic, the bulk of the tax burden is borne by buyers. This is because PED as compared to PES is elastic, which means; consumers are not that price sensitive and will not reduce their consumption even if the prices rise. Because the PES is elastic, suppliers will stop the supply if the cost of production goes up. Therefore, buyers end up getting higher burden of tax.
Scenario 3 : PED is equal to PES In this case both the producer and consumer will share equal burden of tax. What are subsidies? A subsidy is a form of financial assistance paid by the government to a business or economic sector. Why subsidies are given? Subsidies might be given to
• Lower the cost of necessary goods which might affects a major part of population. Example, subsidies given to essential food items and oil (in India).
• Guarantee the supply of merit goods, which the government thinks consumers should consume.
• Help domestic firms become more competitive in the international market, also known as protectionism.
Effect of subsidy Subsidy reduces the cost of production. Thus the supply curve for the product shifts vertically downwards by the amount of subsidy provided.
Impact of subsidies on Producers Subsidies are monetary benefits provided to the producer by the Government on account of production of certain commodity. Subsidies lead to increase in producer revenue. Due to subsidy the supply curve (S-‐subsidy) will shift vertically downwards by the amount of subsidy. This reduces the cost of production and more is now being supplied at every price. Through the diagram, we can see, initially the market was at equilibrium with Qe being supplied & demanded at Price (Pe).
• Government provides subsidy WZ per unit. • Producers lower their prices to P1 Increase output till a new equilibrium is reached at Q1 • The producer will however not pass all the subsidy benefit to the consumer. • Initial producer revenue was OPeXQe which now increases to ODWQ1.
Impact of subsidies on Consumers Consumers will now consume more of the product due to lower prices. Consumers pay less as the prices fall from Pe to P1, however, they end up consuming more from Qe to Q1. It is difficult to say by how much the consumer expenditure will increase or fall as it will depend on their relative saving and extra expenditure.
Impact of subsidies on Government Government will end up paying a subsidy of P1DWZ. Obviously, this will involve an opportunity cost. Government will have to forego investments in other sectors of the economy in order to provide subsidy. At the end of the day, the burden usually lies on the taxpayer.
Subsidies and Elasticities The impact of subsidies on consumers will depend on the relative price elasticity of demand and price elasticity of supply. Scenario 1: When PED is elastic relative to PES The consumers do not benefit from a great fall but, because their demand is relative elastic, they increase their consumption by a significant amount.
Scenario 2: When PED is inelastic relative to PES Consumption of the product is increased and so is the revenue of the producer. The consumer benefit from a relatively large price fall, but their demand is relative inelastic, their consumption does not increase by a great amount.
GOVERNMENT INTERVENTION IN MARKET PRICES Maximum Price or PRICE CEILINGS In some markets, governments intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price. A price ceiling occurs when the government puts a legal limit on how high the price of a product can be. In order for a price ceiling to be effective, it must be set below the natural market equilibrium. It is also known as maximum price. Rent control is an example of a price ceiling, a maximum allowable price. With a price ceiling, the government forbids a price above the maximum. A price ceiling that is set below the equilibrium price creates a shortage that will persist.
For the price that the ceiling is set at, there is more demand (Q2) than there is at the equilibrium price. There is also less supply (Q1) than there is at the equilibrium price, thus there is more quantity demanded than quantity supplied i.e. shortage. Impact of Price ceiling Inefficiency: Inefficiency occurs since at the price ceiling quantity supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal to the deadweight welfare loss. Existence of black market: Due to demand exceeding the supply, there will be buyers who will be willing to purchase the good at a higher price. This will lead to existence of black market. How can government correct this situation? Subsidies may be offered to the firms to encourage the production of such goods. However it involves an opportunity cost to the government as they might have to divert funds from other activities. Government may also consider the option of producing the goods by themselves.
Government may also release previously stored inventory of such goods to ensure that there is no shortage in the market, however, it might not be possible for all the goods, for example, perishable goods. All these options will lead to the shift of supply curve to the right and thus forming a new equilibrium at Pmax
Minimum Prices or Price Floor A minimum allowable price set above the equilibrium price is a price floor. With a price floor, the government forbids a price below the minimum Price Floors are minimum prices set by the government for certain commodities and services that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance.
Government might set Minimum prices • To raise incomes for producers such a farmers and protect them from frequent fluctuations in the commodity market.
• To protect workers and ensure that they get a enough wages to sustain a reasonable standard of living. Examples of price floors • In many countries governments assist farmers by setting price floors in agricultural markets. • Setting Minimum wages for certain occupations is also an example of price floors. Consequences of a price floor As seen from the diagram. The equilibrium price for a particular good is Pe and the Quantity demanded is Qe.
The government thinks that it is too low for that good thus they set up a minimum price for a good Pmin. This will lead to a fall in demand to Q1 and increase in supply to Q2, thus creating excess supply or surplus. Government can eliminate the surplus by buying the excess supply at the minimum price. This will result in the shifting of demand curve to the right, thus creating a new equilibrium at Pmin. The Government may store it or sell it abroad. However, both these options have consequences. Buying the surplus and storing it will cost an opportunity cost for the government as they have to divert funds from other important areas and exporting it other countries may be considered as dumping. What is Market Failure? In a market where there is equilibrium, the resources are allocated in the best possible manner and there is 'allocative efficiency'. Allocative efficiency is when situation where Marginal cost is equal to Marginal revenue.
However, this is not possible in the real world. Market failure exists when the resources are not allocated efficiently. Community surplus is not maximized and thus there is market failure. From a community's point of view, producer surplus is not equal to consumer surplus.
Market failure is thus caused by
• Abuse of monopoly power • Lack of public goods • Under provision of merit goods • Overprovision of demerit goods • Environmental degradation • Inequality in distribution of wealth • Immobility of factors of production • Problems of information • Short termism
Externalities Externalities are a loss or gain in the welfare of one party resulting from an activity of another party, without there being any compensation for the losing party. This activity can be due to consumption or production of a good or service. If the third party suffers due to this activity then it is known as negative externality. When the third party gains from this activity is it known as positive externality. Marginal Private Benefit is the benefit which is derived by private individuals in the consumption of a good or service. Marginal Private Cost is the cost of producing, specifically marginal costs, which are incurred by private individual while producing a good or service.
Marginal Social Cost is the total cost to society as a whole for producing one further unit, or taking one further action, in an economy. This total cost of producing one extra unit of something is not simply the direct cost borne by the producer, but also must include the costs to the external environment and other stakeholders. The market demand and supply curves therefore reflect the MPB and MPC accruing to buyers and sellers. When there is no externality then the intersection MPB (demand) curve and MPC (supply) curve determine the equilibrium price. The price and quantity reflected at this point are ‘socially optimum’ level of production or consumption and the market is said to have allocative efficiency. i.e. MPC=MPB. At this point the consumer surplus is equal to the producer surplus. However, this is usually not the case in real world. The production or consumption of goods and services do produce externalities and thus the concept of Marginal social benefits and Marginal social costs comes into being. MSB=MPB+Externality MSC=MPC+Externality Types of Externalities Externalities can result either from consumption activities or from production activities There are four types of Externalities
1. Negative externality of Production 2. Negative externality of Consumption 3. Positive externality of Production 4. Positive externality of Consumption
Negative Production Externalities Negative production externalities are the side-‐effects of production activities. As a result an individual or firm making a decision does not have to pay the full cost of the decision. Pollution created by firms due to production activities is an example of negative production externality. In an unregulated market, producers don't take responsibility for external costs that exist-‐-‐these are passed on to society. Thus producers have lower marginal costs than they would otherwise have and the supply curve is effectively shifted down (to the right) of the supply curve that society faces. Because the supply curve is increased, more of the product is bought than the efficient amount-‐-‐that is, too much of the product is produced and sold. Since marginal benefit is not equal to marginal cost, a deadweight welfare loss results.
The diagram illustrates negative production externality. The supply curve given by MPC reflects the firm’s private costs of production and the marginal social cost curve given by MSC represents the full cost of production to society. The vertical difference between MPC and MSC represents negative externality. Therefore for each level of output, Q1, social costs given by MSC are greater than the firm’s private costs by the amount of externality. The optimal production quantity is Q*, but the negative externality results in production of Q1. The deadweight welfare loss is shown in blue. Corrective Negative Production externalities In order to correct negative externality of production and to bring down the production to the optimal level, government can intervene through the following options: Legislation and regulations Government can pass legislations to prevent or reduce the effects of production externalities. These legislations will lower the quantity of goods produced and bring it closer to the optimal quantity Q* by shifting the MPC curve upward towards the MSC curve. It might include legislations to
• Limit the emission of pollutants by setting limits to the extent of pollutants produced by a firm.
• Limit the production to a certain level. • Force polluting units to install technologies which reduce emissions.
Putting Taxes Government may impose a tax on the firm either on per unit of production or per unit of pollutants emitted. These will lead to a shift of MPC curve upwards towards the MSC curve and thus reducing output and bringing it closer to socially optimal level i.e. Q*. The diagram below shows the impact of taxes
Tradable permits Tradable permits are a cost-‐efficient, market-‐driven approach to reducing greenhouse gas emissions. A government must start by deciding how many tons of a particular gas may be emitted each year. It then divides this quantity up into a number of tradable emissions entitlements -‐ measured, perhaps, in CO2-‐equivalent tons -‐ and allocates them to individual firms. This gives each firm a quota of greenhouse gases that it can emit over a specified interval of time. Then the market takes over. Those polluters that can reduce their emissions relatively cheaply may find it profitable to do so and to sell their emissions permits to other firms. Those that find it expensive to cut emissions may find it attractive to buy extra permits. Trading would continue until all profitable trading opportunities had been exhausted. Tradable permits will result in firms to lower the quantity of goods produced so that it equals Q* and to raise the price of the goods.
Negative Consumption externalities Negative consumption externalities occur due to consumption of certain goods and services. Example, smoking. By smoking in public places, the consumer is creating negative externalities, in the form of passive smoking, for non-‐smokers. Other examples include using fossil fuels that pollute atmosphere, playing loud music and disturbing neighbors, discarding garbage in public places.
In negative consumption externality, the MPB is not reflecting social benefit and thus MSB lies below MPB. The vertical difference between MPB and MSB is the negative externality. The optimal level of consumption is where MSB=MSC i.e. Q*. However the negative externality is being ignored and thus there is an over consumption of the goods at Q1. Correcting negative consumption externalities Advertising: Government can using persuasive advertising/awareness campaigns to alert the consumers and influence them reduce their consumption. This will lead to a shift of MPB curve to the left thus reducing the gap between socially optimal level of consumption Q* and Q1. Legislations and regulations: Government can also pass legislations or impose fines on certain activities which create nuisance for the societies. Many countries already have banned smoking in public places. Imposing indirect taxes: By putting taxes on the production of goods that cause negative consumption externalities, government can reduce the supply. By putting taxes, the supply curve(MSC) will shift upwards to MSC+tax. This will reduce the gap between Q* and Q1. Positive Production externalities These are positive externalities created due to production of certain goods and services. Examples include, when firms train their employees which result in better manpower or invest in research and development and succeed in developing new technologies which benefits the society.
Due to the fact that positive externality is produced, the MSC lies below the MPC. The diagram below illustrates positive production externalities. As we can see that the social optimal level of production of these goods should be Q* , however there is under-‐allocation of resources and thus there is output is at Q1.
Corrective positive production externalities Subsidies can be provided to firms, which produce these goods. The effect will be the lowering of MPC and thus the MPC will more downward to MSC. This will increase the output to a level Q2 near to the socially optimal level Q*. The price will also fall from P1 to P2.
Positive consumption externalities Positive consumption externalities occur when there is a positive externality created by the consumption of certain goods. Examples include consumption of education and health care. Both these will lead to more productive workforce and hence high rate of economic growth for the society.
As the diagram illustrates, the MSB lies above the MPB and the difference between the two consists of positive externality. The socially optimal level is where MSB=MSC i.e Q*, however, due to under-‐allocation of resources the output/consumption is at Q1. Corrective Positive consumption externalities Subsidies By giving subsidies to the producers of the good with the positive externality will result in increasing supply and shifting the supply curve downwards. This will lead to MSC curve shifting to MSC+subsidy which means high output/consumption at socially optimal level Q* and at lower prices from P1 to P*.
Advertising Through positive advertising government can persuade consumers to increase their consumption and thus lead to a shift of MPB to the right i.e. increase in demand. If the MPB curve shifts enough, it will coincide with MSB and Q* will be produced and consumed.
