ECO1000EconomicsSemester One, 2004

Lecture Five

Cancellation of Workshops Due to small numbers, the workshops on

Monday 11-1 and Monday 12-2 have been cancelled effective immediately.

Students are requested to choose: Tuesday 10-12 (T124) if possible. If this is not appropriate, please see the course

leader.

Class test 1 Reminder (internals incl. Wide Bay students) April 7 (Next Week) Test open from 5 pm-8pm 25 questions Based on lectures & all

workshop activities Make sure you have

Graph paper (to help you work out the correct answers)

Rulers and pens Calculator Text Book etc

How to Access the Test (internals) The instructions are as follows… (students at the lecture were shown

the online procedures) Please note: students who have not

payed their guild fees or non-deferred HECS may not be able to access the test. An alternative can be arranged if this occurs.

In Case of Technical Difficulties… Note the problem Contact the CMA administrator If a solution is not forthcoming, contact

your lecturer the next morning There will be an electronic record of all those

who tried to, or actually accessed the test You must be on this list to qualify for further

consideration

Outline or Plan of Today’s Lecture Material Covered:

Module Two, Part Three

Reading: Text Chapter Six, Hakes and Parry Chapter Six

Topics: Markets and Government Policy

Purpose or Objectives of This Lecture

You will learn about: The effects of government policies

(ceilings and floors) on prices The effect of taxes on the price of a good

and quantity sold The burden of taxes on consumers or

producers

Relevant Economic Principles 6. Markets are usually a good way to

organise economic activity 7. Governments Can Sometimes

Improve Market Outcomes

A Starting PointFree Markets

Defining ‘free’ (unregulated) markets There is freedom of production &

consumption Most economic activity is done by the

private sector There should be competition amongst

buyers and sellers But private contracts have legal

backing

The Benefits of Free Markets Are: (according to classical theory) Individual freedom Efficiency in production

because competition leads to innovation

Allocative efficiency resources used in most efficient way the best way to shift goods & services

around Higher average standards of living

‘Creative Destruction’ Technological innovation increases

efficiency Productivity increases Labour is replaced by capital

(some) labour shifts to ‘new’ industries ‘New’ industries became a greater

proportion of the national economy

Reasons Why Governments Might Limit Market Freedom

To achieve equity or greater equality To protect the economically weak To protect or nurture a socially

desirable industry To gain votes To prevent or limit externalities Ensure social or economic stability

Government Intervention Aimed

at Producers

Assistance for Producers Tariffs on imported goods Mandated monopolies Preferred purchasing agreements Subsidies

Subsidising Producers Grant (lump sum payment)

eg for start-up capital Tariff (tax on imported/competing

product) Tax deductions on expenditure Subsidised infrastructure & research Payment per unit produced

The Effect of a Subsidy

Price

Quantity

S0

P0

Q0

D0

P1

Q1

S1

Points to Note A subsidy/unit effectively lowers the cost

of production The supply curve shifts to the right Both consumers and producers benefit Classical economics’ criticism:

Taxpayers pay Insulates producers from market signals

Price Floor (minimum price)

Price

Quantity

S0

P0

Q0

D0

P1

Q1

P1 is the minimum price allowed. The price cannot fall below that.

NB a floor price set below equilibrium will have no effect

Points to Note The minimum price can be set legally or by

having a marketing body that stockpiles At the higher price, consumers only want Q1, so

the quantity sold tends to decrease this would be less so if it was an inelastic

good Criticism

consumers buy less than they otherwise would

it sends the wrong market signal to producers

Surplus Production

Price

Quantity

S0

P0

Q0

D0

P1

Q1

Producers get the ‘signal’ to produce Q2, while consumers only want Q1

Q2

Surplus production

Surplus = Q2 - Q1

Government Intervention Aimed

at Consumers

Assistance for Consumers Product standard and safety laws ‘Truth in advertising’ laws Civil courts Australian Competition & Consumer

Council looks for anti-competitive behaviour standards and trade practices

Price Ceiling (maximum price)

Price

Quantity

S0

P0

Q0

D0

P1

Q1

P1 is the maximum price allowed. The price cannot rise above that.

NB a ceiling price set above equilibrium will have no effect

A Shortage in Production

Price

Quantity

S0

P0

Q0

D0

P1

Q1

Consumers want Q2 but producers get the ‘signal’ to produce Q1 so there will be an excess of demand (shortage).

Q2

Shortage

Shortage = Q2 – Q1

Criticisms of Intervention The problem of ‘rent-seeking’ by producers Lack of competition

Higher prices for consumers Collusion by small number of producers Inefficient allocation of resources Reduces pressure for innovation

Protection locks out developing countries

Market Deregulation Governments respond to the

classical criticisms

Microeconomic Reform Reduce tariffs Remove ‘non-tariff’ barriers Reduce direct & indirect subsidies Privatisation of govt enterprises Deregulate financial markets Competition ‘watchdogs’ & rules

Deregulation (removing a price floor)

Price

Quantity

S0

P1

Q1

D0

P0

Q0

If P0 is removed then the the ‘new’ price is P1 and the ‘new’ quantity is Q1

A Case Study of Labour Markets

Characteristics of labour markets Households supply labour The quantity is in hrs/wk, month or

year Firms demand labour The price is the wage rate/hr/mth/yr In the absence of regulation, the

wage rate is set by market signals the conjunction of supply and demand

Labour Market Intervention Maintain employment in certain regions Stop exploitation of ‘powerless’ workers Standard working conditions easier to

enforce Use minimum wages to boost household

income A form of income redistribution

Profits to wages

Some Possible Government Policies Subsidise/assist industry

to stimulate employment demand Increase value through education

etc supply side policies

Wage/training subsidies Minimum wage laws

Minimum Wage Policy

Price

Quantity

SL0

W0

QL0

DL0

W1

QL1

Unemployment (according to the classical view)

Price

Quantity

SL0

W0

QL0

DL0

W1

QL1

Workers want to supply QL2 hours while firms only want to emplyQL1 hours.

QL2

Unemployment?

No. of unemployed = QL2 – QL1

The Argument for Labour Market Deregulation…

Business wants to pay less in wages Government wants more people to be

employed BUT…LOWER WAGES DO NOT

ALWAYS LEAD TO LOWER UNEMPLOYMENT (this is discussed more in a later lecture)

Taxation and Markets

TaxationFOR AGAINST

Needed for government services

Income redistribution

Possible instrument of economic management

Disincentive for working hard

Disincentive for investment

Tax revenue ‘wasted’ by governments

A Tax

Price

Quantity

S0

P0

Q0

Increases price, reduces quantity sold

D0

Ptax

Qt

S1

Tax paid ($/unit)

P2

= Ptax- P2

A Tax

Price

Quantity

S0

P0

Q0

D0

Pt

Qt

S1

Total tax paid = (Pt- P2) x Qt

P2

The Distribution of the Tax Burden When a tax is imposed:

consumers pay more than they did, because of the higher price

producers receive less than they did because the reduction in quantity demanded effectively shifts them down the (S0) supply curve

Therefore, both consumers and producers ‘contribute’ to tax revenue

A Tax

Price

Quantity

S0

P0

Q0

D0

Pt

Qt

Stax

Consumer share of tax

P2

Producer share of tax

Points to note Consumers pay Pt − P0 more for the

good They pay total tax of (Pt − P0) x Qt

Producers receive P0 − P2 less for the good

They pay total tax of (P0 − P2) x Qt

Producer revenue is now P2 x Qt

A Tax Question If the equilibrium price was

$20/unit. A $6/unit tax is imposed and the

government receives $12,000/wk in tax revenue.

Producers revenue is now $36,000. What is the new price (with tax) of the unit?

What We Know

Price

Quantity

S0

20

Q0

D0

Pt

Qt

St

Govt. revenue = $12,000

P2

Producer revenue = $36,000

Tax/unit = $6 = Pt - P2

Govt revenue = Qt x $6 = $12,000/wk therefore Qt = 2000 units/wk

Producer revenue = $36,000 = Qt x P2

therefore 36,000 = 2000 x P2

therefore P2 = $18

Pt = P2 + tax rate

Pt = 18 + 6 = $24/unit = new price

Tax and Elasticity

Price

Quantity

S0

Q0

D0

Pt

Qt

Stax

Consumer contribution

P2

Producer contribution P0

Tax and Elasticity The more inelastic the good, the

more likely it is that consumers will ‘pay’ the greatest share of the tax burden.

The quantity does not fall as much so the producers are somewhat insulated from the effect.

Tax on an Elastic Good

Producer’s share of tax

Consumer’s share of tax

When demand is more elastic than supply, producers pay more of the tax

D

S0

St

Conclusions Whilst markets are usually a good

way to organise activity, governments do intervene.

Government policies may be aimed at assisting producers, consumers or both.

Government policies have an impact on prices and quantities.

In Light of the Objectives of the Lecture…

We now know: There are arguments for and against

government intervention in free markets When governments intervene, its policies

affect prices and quantities We can illustrate these effects and

determine, for example, who pays more of the particular tax.

Next Week Next Week’s Lecture:

Material Covered: Module Three Reading: Chapters Seven and Eight of Text

and Chapters Seven and Eight of Hakes and Parry

Topics: Macroeconomics Remember: Next Week’s Lecture is on

Thursday at 10.00 am in L209.

THE END