Understanding Economics 4th edition by Mark Lovewell, …classwithmsmcrae.pbworks.com/w/file/fetch/54261635/lovewellch07.pdf · Understanding Economics 4th edition by Mark Lovewell,

Copyright © 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

Understanding Economics 4th edition

by Mark Lovewell, Khoa Nguyen and Brennan Thompson

Understanding Economics

4th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson

Chapter 7

Economic Welfare and Income Distribution



Learning Objectives

In this chapter you will: 1. learn about the concepts of consumer surplus and

deadweight loss, and come to appreciate how these concepts can further our understanding of the operation of markets

2. examine spillover costs and benefits and the ways that government addresses these issues

3. see how income is distributed among Canadian households, how this distribution is measured, and the factors underlying this distribution

4. consider the causes of poverty and the way poverty is measured

5. evaluate the effectiveness of government intervention to change the distribution of income


Marginal and Total Benefit

Both consumers and producers gain from market activity.

For consumers, these gains can be measured by marginal and total benefit.

Marginal benefit is the extra satisfaction, expressed in dollar terms, from consuming a certain unit of a product.

Total benefit is the total satisfaction, expressed in dollar terms, from consuming a product.


Consumer Surplus (a)

http://www.reffonomics.com/TRB/chapter4/consumersurplus.swf

Consumer surplus shows the extent to which consumers pay a lower price than the highest one they are willing to pay.

It is defined as the net benefit, expressed in dollar terms, from buying a product at its market price.

It is found, either for an individual or in an entire market, by subtracting total expenditure from total benefit.





Consumer Surplus (b) Figure 7.1, page 172

0 1 2 3 4

Quantity (pizzas per week)

Consumer’s Demand Curve for Pizzas

Consumer’s Demand

Schedule for Pizzas

Quantity

Demanded

(D)

(pizzas)

Total Benefit

($)

Price

($ per

pizza)

$14 1

12 2

10 3

Pri

ce

($

pe

r p

izza

)

4

8

12

16

D

A = $6

B = $30 14

26 (14 + 12)

36 (14 + 12 + 10)

A+B = Total Benefit

B = Total expenditure

10

14

• The consumer pays $10 for each of the 3 pizzas but gets

more marginal benefit from the first 2 pizzas.

• At 2 pizzas the $12 marginal benefit can be split into the

$10 market price and the $2 surplus for that pizza.

• The consumer’s total benefit from eating pizzas is area

AB, and the total expenditure is area B.

• The consumer surplus is area A.

Consumer Surplus (c) Figure 7.2, page 173

0 50 100

Quantity (thousands of pizzas per week)

Market Demand Curve for Pizzas

Market Demand Schedule

for Pizzas

Quantity Demanded

(D)

(thousands of

pizzas)

Price

($ per

pizza)

18 0

14 50

10 100 P

ric

e (

$ p

er

piz

za

)

4

8

12

16

D

2

6

10

14

A = $400,000

B = $1 million

A+B = Total Benefit

B = Total Expenditures 18

• When consumers in the pizza market are charged a price of

$10 they consume 100 000 pizzas

• Adding up consumers’ marginal benefits for all these pizzas

gives a total benefit in the market equal to area AB

• The consumers’ total expenditure on pizzas is area B

• Total consumer surplus in the market is found by subtracting

area B from area AB so it’s equal to area A


Producer Surplus (a)

http://www.reffonomics.com/TRB/chapter4/producersurplus1.swf

Producer surplus shows the extent to which producers receive a price different from the lowest one they are willing to accept.

It is defined as the difference between the price received from selling each unit of a product and the marginal cost of producing it.




Producer Surplus

At a market price of $10 producers in the pizza market supply 100 000 pizzas

Because market price and marginal cost are the same for the 100 000 pizza there is no producer surplus at this unit

For every previous pizza produced, price exceeds marginal cost giving a total producer surplus equal to area C

Subtract the area under the supply curve D from the total revenue shown by area CD



The Case of Perfect Competition

In a perfectly competitive market, the requirement of marginal-cost pricing is met.

Based on this requirement, equilibrium will occur where marginal benefit equals marginal cost, and both consumer surplus and producer surplus are maximized.

The Case of Perfect Competition Figure 7.4, page 175

4

14

12

10

8

6

16

50 100 150


0

Pri

ce

($

pe

r p

izza

)

D

18 S

Consumer Surplus

2

Producer Surplus

• If the pizza market is perfectly competitive, then at the equilibrium price of $10 and output of 100 000

pizzas the requirement of marginal-cost pricing is met while the consumer surplus and producer

surplus are both maximized

• At quantities below 100 000 pizzas, marginal benefit exceeds marginal cost

• At quantities above 100 000 pizzas marginal cost exceeds marginal benefit so that a reduction in

quantity will bring about greater economic welfare


When a Market Becomes

Uncompetitive

When a market becomes uncompetitive, for example due to government policy, price rises. The result is that a portion of the consumer surplus becomes producer surplus.

Also there is a net reduction in both the consumer surplus and producer surplus due to the reduction in market output. This net reduction is known as the deadweight loss.

When a Market Becomes Uncompetitive Figure 7.5, page 176

0

Deadweight

Loss

4

14

12

10

8

6

16

50 100 150


Pri

ce

($

pe

r p

izza

)

D

18

S

2

75

• If some pizza-makers are allowed to collude, they might restrict output to 75 000 pizzas raising

market price to $12

• Area E represents the transfer of consumer surplus into producer surplus which is gained by

the colluding pizza-makers

• Area FG represents the deadweight loss—combining a fall in both consumer surplus and

producer surplus—as a result of the lower output


7.2 Spillover Costs (a) http://www.reffonomics.com/TRB/chapter15/LightHouse1.swf

Spillover costs are the negative external effects of producing or consuming a product.

http://www.reffonomics.com/textbook2/microeconomics2/swiftfile/externalities/negativeexternality.swf

Adding these costs to private costs raises the supply curve.

The preferred outcome is at a lower quantity than in a perfectly competitive market.

Government intervention (e.g. an excise tax) can produce the preferred outcome.

http://www.reffonomics.com/TRB/chapter15/LightHouse1.swf

http://www.reffonomics.com/TRB/chapter15/LightHouse1.swf





Spillover Costs (b) Figure 7.6, Page 179

0 1 2 3 4 5 6 7

Millions of Litres

Market Demand Curve for Strawberries

Demand and Supply

Schedules for Gasoline

Quantity

Demanded

Quantity

Supplied

Price

($ per

litre)

6

5

4

3

2 P

ric

e (

$ p

er

litr

e)

0.50

1.00

1.50

2.00

2.50

(millions of litres)

8

a

b

Spillover

Costs,

Excise

Tax

D S0 S1

8

7

6

5

4

4

5

6

7

8

$2.50

2.00

1.50

1.00

0.05

(D) (S0) (S1)

• Without government intervention, equilibrium occurs at point b

• To account for spillover costs, the government may impose an excise tax

of $1/litre

• The supply curve shifts from So to S1 moving equilibrium to point a

Spillover Benefits (a)

Spillover benefits are the positive external effects of producing or consuming a product.

http://www.reffonomics.com/textbook2/microeconomics2/swiftfile/externalities/positiveexternality.swf

Adding these benefits to private benefits raises the demand curve.

The preferred outcome is at a higher quantity than occurs in a perfectly competitive market.

Government intervention (e.g. a consumer subsidy) can produce the preferred outcome.

Public good –a product whose benefits cannot be restricted to certain individuals (e.g. national defence)




Spillover Benefits (b) Figure 7.7, page 180

0 8 9 10 11 12 13

Thousands of Students

Demand and Supply Curves for an

Engineering Education Demand and Supply Schedules

for an Engineering Education

Enrollment

Demanded

Quantity

Supplied

Tuition

($ per

year)

10

11

12

13

14

Tu

itio

n (

$ p

er

ye

ar)

1000

2000

3000

4000

5000

(thousands of students)

14

a

b

6000

Spillover

Benefits,

Student

Subsidy

S D0 D1

8

9

10

11

12

$6000

5000

4000

3000

2000

12

11

10

9

8

(S0) (S1) (S)

• Without government intervention in the market for engineering

education, equilibrium occurs at point a

• If spillover benefits are determined to be $2000 per student,

government can create a subsidy for students pursuing a career in

engineering

• The demand curve shifts from Do to D1 and the new equilibrium is at

point b with $2000 of each student’s tuition paid


Canadian Distribution of Income

Canada’s distribution of income can be shown using the Lorenz curve.

This curve is a graph showing the cumulative distribution of income for households categorized into five groups based on their income levels.


Income Distribution in Selected Years Figure 7.8, page 182

Lowest 20% Second 20% Third 20% Fourth 20% Highest 20%

Average of total

1951

4 11 18 23 43

1961

4 12 18 25 41

1971

4 11 18 25 43

1981

5 11 18 25 42

1991

5 10 17 25 44

2004

4 10 16 24 47

Average Income (2004)

$12 900 26 900 47 500 72 300 142 700

61 000

Percentage of Total Pre-Tax Income Received by Each Fifth of Households

http://www40.statcan.gc.ca/l01/cst01/famil106a-eng.htm

http://www40.statcan.gc.ca/l01/cst01/famil105a-

eng.htm?sdi=income

http://www40.statcan.gc.ca/l01/cst01/famil21a-

eng.htm?sdi=average%20income




http://www40.statcan.gc.ca/l01/cst01/famil105a-eng.htm?sdi=income



http://www40.statcan.gc.ca/l01/cst01/famil21a-eng.htm?sdi=average income



The Lorenz Curve (page 183)

A graph showing the cumulative distribution of income among a country’s households

http://www.reffonomics.com/TRB/chapter19/LorenzCurveLesson5.swf

http://www.econedlink.org/lessons/index.php?lid=885&type=educator

http://www.youtube.com/watch?v=AQWN_DqcHG4&safety_mode=true&persist_safety_mode=1&safe=active

http://visualeconomics.creditloan.com/income-distribution-by-country/





















Interpreting the Lorenz Curve

In using the Lorenz curve as a distribution measure, it is useful to compare it with curves for two hypothetical economies:

For an economy of perfect equality, where all have identical incomes, the Lorenz curve would be a 45-degree line emanating from the origin.

For an economy of perfect inequality, where one household receives all of the economy’s income, the Lorenz curve would follow the horizontal and vertical axes of the graph.


The Gini Coefficient

The Gini coefficient provides a single numerical measure of income distribution.

It is defined as the area between a Lorenz curve and the 45-degree line of perfect equality, divided by the entire triangular area under the 45-degree line.

The coefficient varies from 0 to 1, with 0 representing perfect equality and 1 representing perfect inequality.


Wage Determinants (a)

There are seven main wage determinants:

labour productivity

education

experience

job conditions

regional disparities

market power

discrimination


Labour Productivity

In any given market, labour productivity determines the wage of that worker.

Labour productivity is defined as output per worker in a given time.

It is the most important determinant of wages.

The output of each worker varies because of such factors as the worker’s ability to do the job and the state of technology

With more capable workers or a technological innovation, labour productivity rises, pushing up the prevailing wage


Distribution of Earnings (2004) Figure 7.10, page 185

Earnings

Under $5000 $5000 - $9999 $10 000 - $14 999 $15 000 - $19 999 $20 000 - $24 999 $25 000 - $29 999 $30 000 - $34 999 $35 000 - $39 999 $40 000 - $44 999 $45 000 - $49 999 $50 000 - $49 999 $60 000 and over

Percentage of All Earners

15.7 11.2 8.9 7.3 7.1 6.9 6.3 5.8 5.2 4.2 6.5 15.0

100.0


Education

In general, the more education a worker needs to perform a job, the higher the pay

usually adds to a worker’s pay but has opportunity costs as well

serves two main purposes (consumption and investment in human capital)

A student will undertake an educational program if its benefits (both monetary and nonmonetary) exceed its opportunity costs.


Education and Average Family Income

(2004) Figure 7.11, page 185

Education

University Degree Post-secondary diploma Some post-secondary High school graduate Some high school 0 to 8 years of school

Average Incomes (Managerial)

$80 300 53 100 44 300 55 900 36 400 31 600

Experience

On-the-job experience increases a worker’s productivity, pushing up the wage rate

In many industries, workers gain certain privileges the longer they work for a single employer

Seniority rights: the workplace privileges provided to workers who have the longest experience with their employer


Experience

Older workers are often paid higher wages and can apply first for promotions and overtime work, allowing them to earn higher incomes than their younger colleagues

The positive effect of workplace experience on earnings is one of the main reasons average incomes rise with age during the first part of a person’s working life



Age and Average Income (2000) Figure 7.12, page 187

Job Conditions

Working conditions can make one job less appealing than the other

In order to attract workers to less-appealing occupations, employers must offer higher wages


Regional Disparities

In Canada, workers in the same occupation earn different incomes, depending on the region they live in

In a perfectly functioning labour market, workers in a single occupation would move from one part of the country to another until wage disparities in this occupation were eliminated

Labour trends tend to be immobile—why?



Market Power

As a rule, earnings in labour markets that are unionized tend to be higher than in non-unionized markets

Professional groups (doctors and Lawyers) can play a similar role in providing their members with market power

There are two main types of labour unions:

Industrial unions include all workers in a certain industry.

Craft unions include workers in a particular occupation and restrict who can be members.


Job Discrimination

Job discrimination relates to hiring, wage, and promotion decisions based on criteria other than a worker’s credentials or performance.

Job discrimination can be direct, in which case employees are paid different amounts for substantially the same work.

Job discrimination can also be indirect, involving a discriminatory division of jobs.


Reasons for Income Inequality (Other

Incomes)

There are three main reasons for income inequality in addition to wage determinants:

Risk-taking--entrepreneurs

Ability—professional athletes

Wealth—ownership of financial assets such as stocks and bonds or real assets such as land and buildings

Wealth is more unequally distributed than income.


Distribution of Wealth in Selected

Countries Figure 7.13, page 189

Sweden (1975)

Canada (1984)

France (1986)

US (1986)

0

10

20

30

40

50

60

70

80

90

Top 1% Top 5% Top 20%

Share

of

Wealth H

eld

by

Top W

ealth H

old

ers

(%

)

Assignment

Page 190 7.3 Practice Questions 1 and 2


7.4 Poverty

http://www.cbc.ca/news/canada/story/2011/09/28/poverty-report.html

One of the main reasons behind the economic goal of income equity is the desire to minimize poverty

Poverty is a situation in which a person’s income is inadequate to provide the necessities of life such as food, clothing and shelter








The Poverty Line

The poverty line is the income level below which a household is classified as poor.

In Canada, the average family spends 44% of its household after-tax income on food, clothing and shelter

The Poverty Line

Statistics Canada defines as poor any household that spends more than 64% of its after-tax income on food, clothing, and shelter.

In dollar terms, the poverty line (also known as the low-income cut-off—LICO) depends on the number of household members and the size of the community they live in.


The Poverty Line

People in rural areas or small towns can generally live more cheaply than those in urban centres



The Poverty Line for Various

Households (2004) Figure 7.14, page 191

1 person 2 persons 3 persons 4 persons 5 persons 6 persons 7 or more persons

500 000 and over

$16 853 20 512 25 542 31 865 36 285 40 241 44 107

100 000 to 499 999

$14 253 17 347 21 601 26 948 30 686 34 032 37 378

30 000 to 99 999

$14 075 17 131 21 332 26 613 30 032 33 610 36 931

Less than 30 000

$12 617 15 357 19 121 23 856 27 165 30 127 23 089

$11 025 13 418 16 709 20 844 23 736 26 324 28 912

Urban Areas (categorized by size)

Rural Areas

Size of Household Unit


The Incidence of Poverty

Using Stats Canada’s LICO poverty line an estimated 3.5 million Canadians lived in poverty in 2004

870,000 were children under the age of 18


The Incidence of Poverty (b) Figure 7.15, page 192

All persons

Gender Males Females Age Under 18 Between 18 and 64 65 and over

Persons in economic families Males in economic families Females in economic families Elderly persons in economic families Persons under 18 in female lone-parent families Persons under 18 in two-parent families

Unattached individuals Males Females Elderly males Elderly females

Percentage of Households Below the Poverty Line in 2004

11.2 10.6 11.7 12.8 11.7 5.6

8.1 7.5 8.6 1.6 40.0 8.1

29.6 28.7 30.5 11.6 17.0

Gender Household Type and Age

Poverty rates are higher among unattached individuals than among those who are part of an economic family

Unattached females are more likely to be poor than unattached males

Single-parent families are more likely to be poorer than two-parent families


Employment

While poverty is more common among the unemployed, a notably high proportion of the employed are poor as well

For nonelderly unattached individuals classified as poor a large portion are employed for at least part of the year

This group is known as the “working poor”

They are often found in primary industries like fishing where wages are low and seasonal employment is common


Region

Historically poor households tend to be concentrated in certain regions particularly the Atlantic provinces and parts of Quebec

Poverty exists throughout Canada e.g. over a third of Canada’s poor live in Ontario


Debates over the Measurement of

Poverty

In recent years there has been considerable criticism of the use of Statistics Canada’s LICO measure

The federal government has recently introduced an alternative measure of poverty known as the Market Basket Measure (MBM) which is based on an absolute definition of those items considered as necessities


7.4 Debates over the

Measurement of Poverty

A household making an income lower than the amount needed to buy these items is then considered poor using the MBM measure

International Labour Organization (ILO) stats

http://www.ilo.org/global/topics/economic-and-social-development/poverty/lang--en/index.htm

http://www.globalissues.org/article/4/poverty-around-the-world#WorldBanksPovertyEstimatesRevised


http://www.ilo.org/global/topics/economic-and-social-development/lang--en/index.htm










http://www.globalissues.org/article/4/poverty-around-the-world









7.5 The Canadian Welfare Society

A welfare society is one in which the government plays a major role in attempting to ensure the economic well-being of its citizens.

Transfer payments and personal income taxes are the most important elements of Canada’s welfare society.


Transfer Payments and Income

Equity

Transfer payments are now usually based on the principle of means testing rather than universality.

Universality —benefits apply to all individuals no matter what their incomes

Advantage: treating everyone in the same way

Drawback: expense—in order to provide substantial help to those who needed it most a large sum of money was paid to all recipients


Equity

Means Testing —transfer payments vary according to a recipient’s income

Advantage: benefits can be directed to those who need them most so poor households receive the highest payments

Drawback: governments may use means testing to limit spending by narrowing qualifications



Equity

Transfer payments are greatest as a percent of income for the poorest fifth of households, but the second-poorest fifth of households receives the largest share of these payments.



Transfer Payments and Income Equity (b) Figure 7.16, page 195


Average of Total

Average Transfer Payments Received (2004)

$7 000 9 300 8 000 6 500 4 800

7 100

Transfer Payments as a Percent of Total Income

(2004)

54.5% 31.4 16.9 9.0 3.4

11.7

Share Received of Total Transfer

Payments (2004)

19.7% 26.1 22.5 18.3 13.5

Impact on Income Distribution

Government transfer payments to individual households from all three levels of government are an average of between 10 and 20% of households’ income

Payments to unattached individuals represent a larger proportion, as a rule, than for families



Principles of Taxation

There are two main principles of taxation:

benefits received (e.g. gasoline taxes for roadwork)

ability to pay (e.g. personal income tax)

Benefits Received

Suggests that taxes should be geared to the benefits each taxpayer gains from government activity

In this case government services are paid for in the same ways that products are bought and sold in the private sector

The guiding philosophy behind some taxes e.g. proceeds from gas taxes are often earmarked for road construction and maintenance


Ability to Pay

The philosophy more closely tied to the goal of income equity

According to this principle, taxes should vary in the proportion of a taxpayer’s financial resources

It is difficult to measure ability to pay



Taxes and Income

progressive taxes: increase as a proportion of income as income rises

Well-off tax payers are taxed more in both $ terms and % terms

http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html#federal

http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/t4032/jn10/menu-eng.html

http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html












Proportional Taxes

proportional taxes: stay constant as a proportion of income as income rises

While taxpayers with different incomes pay proportionately the same tax, the well-off taxpayer pays a higher $ amount

E.g. Income $10 000 taxed at 6% pays $600

$20 000 taxed at 6% pays $1 200


Regressive Taxes

regressive taxes: decrease as a proportion of income as income rises

Taxpayers with low incomes pay proportionately more of their incomes for the tax than do well-off taxpayers even though the well-off taxpayer may pay more as a $ amount

http://www.reffonomics.com/TRB/chapter23/FiscalPolicy/typesoftaxesinteractive3b.swf






Taxes and Income Equity

Sales and excise taxes tend to be regressive (unless combined with a system of tax credits) since the poor spend a higher proportion of their incomes on consumption items than do the rich who are most likely to save part of their incomes

Property taxes are often regressive, largely because the poor devote a higher proportion of their incomes to housing than the rich do


Corporate income taxes are difficult to classify as either progressive or regressive

To the extent that these taxes these taxes reduce the income of shareholders—a rich group of Canadian society—they are progressive

Corporations that have considerable market power may succeed in passing on the burden of tax to consumers in the form of higher prices for their product—in this case the corporate tax is regressive



Personal income taxes are progressive, with the proportion of income paid in tax rising significantly with a household’s income level

Post-tax incomes in Canada are much more equally distributed than they would otherwise be



Personal Income Taxes and Income

Equity (2004) Figure 7.17, page 197


Average of Total

Average Personal Income Taxes

Paid

$ 700 2 700

6 300 11 900 31 900

10 700

Personal Income Taxes as a Percent of Total Income

5.4% 9.1 13.3 16.4 22.4

17.5

Share Paid of Total Personal

Income Taxes

1.2% 5.0 12.0 22.3 59.5


The Doomsday Prophet

Thomas Malthus formulated a theory of population based on two principles:

food increases in an algebraic progression (1,2,3…)

population increases in a geometric progression (1,2,4…)

He predicted that over time population growth would outstrip growth in the food supply with disastrous effects


A Malthusian Time Chart page 203

Year Food Population

A Malthusian Time Chart

1 1 1

25 2 2

50 3 4

75 4 8

100 5

16

125 6

32

150 7

64

175 8

128

200 9

256

225 10

512


The Role of Labour Unions (a)

(Online Learning Center)

Unions represent members’ interests through collective bargaining. Both unions and employers make collective agreements which bind both parties for a given period.

When agreement is impossible, mediation or arbitration can be used to bring about a settlement.


The Role of Labour Unions (b)


If no settlement is reached, union members can work to rule, or stage a strike.

Employers may use a lockout to bring about a settlement.


Reaping the Rewards


David Ricardo developed a theory of rent based on varying grades of land.

According to his theory, a rise in the demand for wheat increases wheat prices and increases rent as poorer land is brought into cultivation.

He predicted that higher wheat prices would lead to higher money wages and lower profits.


Ricardo’s Theory of Rent Figure A

$ 5

10

C 0 A B D

Grade of Land

Land Rents per Hectare

W

age (

$ p

er

year)

100

200

300

400

Land Rents per Hectare

Wheat

Price

($)

(when production costs are $100 per hectare)

Grade A

(50 kg

output)

Grade B

(40 kg

output)

Grade C

(20 kg

output)

Grade D

(10 kg

output)

150

[($5 x 50) – $100]

400

[($5 x 50) - $100]

100

300

0

100

not

cultivated

0

$150

$400

$100

$300

$100

$0 $0

Understanding Economics

4th edition

by Mark Lovewell, Khoa Nguyen and Brennan Thompson

Chapter 7

The End


Documents

Understanding Economics 4th edition by Mark Lovewell, …classwithmsmcrae.pbworks.com/w/file/fetch/54261635/lovewellch07.pdf · Understanding Economics 4th edition by Mark Lovewell,