Lecture 4(ii) Announcements. Lecture. Can still do experiment 2 Thur 10pm or Fri 11:30am. 1. Gordon Gekko on the First Welfare Theorem

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1 Lecture (ii) Announcements Can still do experiment Thur pm or Fri :am Midterm Mon Oct, pm-pm (If you have conflict, document this with headgrader at Lecture. Gordon Gekko on the First Welfare Theorem. Who bears the burden of the tax?. Efficiency and Taxes Question and Answer Sessions new week in Blegen Wed Oct, -: and :- Thur. Oct, :-pm Large Lectures (Lec and Lec ) No class Fri, Oct.

2 Gordon Gekko on the First Welfare Theorem (FWT) (From movie Wall Street, sequel out now.) Is Gekko s statement, Greed is good, a correct statement of the FWT? No! (His economics professor should have made a bigger fuss in class when it was taught so Gekko could remember it.) First, the statement leaves out the key assumptions () No monopoly () No externalities Next, what about greed? OK, that is in the FWT, though selfinterest is a more flattering way to put it. Next, what about good? FTW doesn t say good. It says that under the assumptions, self-interest and the workings of the free-market deliver Pareto efficiency. FTW doesn t say anything about equity.

3 A word about the recent financial debacle. The real world Gordon Gekkos played a big role in it. Obviously what happened did not maximize the social pie. Houses built that should not have been built (like S making a widget for D) Financial system almost collapsed. Did the First Welfare Theorem get it wrong Not necessarily Remember a key assumption is no externalities. Can argue that there is a kind of externality in the banking system where problems a few banks can bring down the rest, systemic risk Not an example of the free market at work, as government was in there effectively subsidizing bad loans. ( Too big to fail policy means big banks get bailed out when they make mistakes. A Heads I win, Tails You Lose situation (where I is Citibank and you is taxpayers). In such a system, banks have an incentive to make crazy loans.

4 Taxes in Econland Equilibrium when tax = $ $ S D Q Q P S P D Effects of $ Widget Tax No Tax P D = P S + tax $ tax Change

5 Great question: Are we always on the left side of the market quantity with a tax? What about a $ widget subsidy P S = P D + subsidy Taxes in Econland Equilibrium when subsidy = $ $ S D Q

6 Great question: In Econland, after the $ tax, P D = $, P S = $. Do buyers and sellers always split the tax /? Burden of the tax depends on the elasticity of supply and demand. Suppose supply is perfectly elastic: $ S D Q

7 Suppose supply is perfectly inelastic $ S D Q The less elastic the side of the market you are on, the more you pay of the tax! Let s look at retail gas prices and gas taxes across countries from homework. Key point: the world oil market is global. Since any one country tends to be small, its own demand has a small impact on world market. If Spain doubles its demand, it won t impact the global market

8 This means the market for oil in Spain looks like $ S D Q Theory implies a gas tax in Spain gets passed on to consumers, Euro for Euro. How does the theory do? Gas Price ($ per gallon) US Gass Taxes and Gas Prices y =.x +. Canada Spain Japan Ger..... Gas Tax ($ per gallon)

9 Let s get back to Econland and the $ tax. Let s do a welfare analysis of the effects of the tax

10 Effect of $ Tax in Econland Surplus Calculations Consumer Surplus at P D = No $ Tax Change Tax Q - P S - P D CS PS Gov t Surplus TS

11 $ tax in Econland. P D increases from $ to $ Consumer Surplus at P D =

12 Change in Consumer Surplus CS (P D from to )

13 Effect of $ Tax in Econland Surplus Calculations No $ Tax Change Tax Q - P S - P D CS.. PS.. Gov t Surplus TS CS and PS (P D from to ) (P S from to

14 Change in Government Surplus GS = Q tax = = Deadweight loss. Effect of $ Tax in Econland Surplus Calculations No $ Tax Change Tax Q - P S - P D CS.. - PS.. - Gov t Surplus TS -