Understanding Economics 4th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Understanding Economics 4 th 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/cons umersurplus.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.
Price ($ per pizza) Consumer Surplus (b) Figure 7.1, page 172 Price ($ per pizza) Consumer s Demand Schedule for Pizzas Quantity Demanded (D) (pizzas) $14 1 12 2 10 3 Total Benefit ($) 14 26 (14 + 12) 36 (14 + 12 + 10) 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. Consumer s Demand Curve for Pizzas 0 1 2 3 4 Quantity (pizzas per week) The consumer surplus is area A. 16 14 12 10 8 4 A = $6 B = $30 A+B = Total Benefit B = Total expenditure D
Price ($ per pizza) Consumer Surplus (c) Figure 7.2, page 173 Market Demand Schedule for Pizzas Price ($ per pizza) Quantity Demanded (D) (thousands of pizzas) 18 0 14 50 10 100 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 Market Demand Curve for Pizzas 18 16 14 12 10 8 6 4 2 A = $400,000 B = $1 million A+B = Total Benefit B = Total Expenditures 0 50 100 Quantity (thousands of pizzas per week) D
Producer Surplus (a) http://www.reffonomics.com/trb/chapter4/pro ducersurplus1.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 $10 producers in the pizza market supply 100 000 pizzas Because market price and marginal cost are the same for the 100 000 pizza there is no producer surplus at this unit For every previous pizza produced, price exceeds marginal cost giving a total producer surplus equal to area C Subtract the area under the supply curve D from the total revenue shown by area CD
The Case of Perfect Competition In a perfectly competitive market, the requirement of marginal-cost pricing is met. Based on this requirement, equilibrium will occur where marginal benefit equals marginal cost, and both consumer surplus and producer surplus are maximized.
Price ($ per pizza) The Case of Perfect Competition Figure 7.4, page 175 18 S 16 14 12 10 8 6 Consumer Surplus Producer Surplus 4 2 D 0 50 100 150 Quantity (thousands of pizzas per week) If the pizza market is perfectly competitive, then at the equilibrium price of $10 and output of 100 000 pizzas the requirement of marginal-cost pricing is met while the consumer surplus and producer surplus are both maximized At quantities below 100 000 pizzas, marginal benefit exceeds marginal cost At quantities above 100 000 pizzas marginal cost exceeds marginal benefit so that a reduction in quantity will bring about greater economic welfare
When a Market Becomes Uncompetitive When a market becomes uncompetitive, for example due to government policy, price rises. The result is that a portion of the consumer surplus becomes producer surplus. Also there is a net reduction in both the consumer surplus and producer surplus due to the reduction in market output. This net reduction is known as the deadweight loss.
Price ($ per pizza) When a Market Becomes Uncompetitive Figure 7.5, page 176 18 S 16 14 12 10 8 6 Deadweight Loss 4 2 D 0 50 75 100 150 Quantity (thousands of pizzas per week) If some pizza-makers are allowed to collude, they might restrict output to 75 000 pizzas raising market price to $12 Area E represents the transfer of consumer surplus into producer surplus which is gained by the colluding pizza-makers Area FG represents the deadweight loss combining a fall in both consumer surplus and producer surplus as a result of the lower output
7.2 Spillover Costs (a) http://www.reffonomics.com/trb/chapter15/lighthouse1.swf Spillover costs are the negative external effects of producing or consuming a product. http://www.reffonomics.com/textbook2/microeconomics2/swiftfile/externalities/negati veexternality.swf Adding these costs to private costs raises the supply curve. The preferred outcome is at a lower quantity than in a perfectly competitive market. Government intervention (e.g. an excise tax) can produce the preferred outcome.
Price ($ per litre) Spillover Costs (b) Figure 7.6, Page 179 Demand and Supply Schedules for Gasoline Price ($ per litre) Quantity Demanded Quantity Supplied (D) (S 0 ) (S 1 ) (millions of litres) Market Demand Curve for Strawberries 2.50 2.00 1.50 D S 0 S 1 a b Spillover Costs, Excise Tax $2.50 2.00 1.50 1.00 0.05 4 5 6 7 8 8 7 6 5 4 6 5 4 3 2 1.00 0.50 0 1 2 3 4 5 6 7 8 Without government intervention, equilibrium occurs at point b To account for spillover costs, the government may impose an excise tax of $1/litre The supply curve shifts from So to S1 moving equilibrium to point a Millions of Litres
Spillover Benefits (a) Spillover benefits are the positive external effects of producing or consuming a product. http://www.reffonomics.com/textbook2/microeconomics2/swiftfile/exte rnalities/positiveexternality.swf Adding these benefits to private benefits raises the demand curve. The preferred outcome is at a higher quantity than occurs in a perfectly competitive market. Government intervention (e.g. a consumer subsidy) can produce the preferred outcome. Public good a product whose benefits cannot be restricted to certain individuals (e.g. national defence)
Tuition ($ per year) Spillover Benefits (b) Figure 7.7, page 180 Demand and Supply Schedules for an Engineering Education Tuition ($ per year) $6000 5000 4000 3000 2000 Enrollment Demanded Quantity Supplied (S 0 ) (S 1 ) (S) (thousands of students) 8 9 10 11 12 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 10 11 12 13 14 Demand and Supply Curves for an Engineering Education 6000 5000 4000 3000 2000 1000 The demand curve shifts from Do to D1 and the new equilibrium is at point b with $2000 of each student s tuition paid 12 11 10 9 8 0 8 9 10 11 12 13 a Thousands of Students b Spillover Benefits, Student Subsidy S D 0 D 1 14
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 Percentage of Total Pre-Tax Income Received by Each Fifth of Households 1951 1961 1971 1981 1991 2004 Average Income (2004) Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% 4 11 18 23 43 4 12 18 25 41 4 11 18 25 43 5 11 18 25 42 5 10 17 25 44 4 10 16 24 47 $12 900 26 900 47 500 72 300 142 700 Average of total 61 000 http://www40.statcan.gc.ca/l01/cst01/famil106a-eng.htm http://www40.statcan.gc.ca/l01/cst01/famil105aeng.htm?sdi=income http://www40.statcan.gc.ca/l01/cst01/famil21aeng.htm?sdi=average%20income
The Lorenz Curve (page 183) A graph showing the cumulative distribution of income among a country s households http://www.reffonomics.com/trb/chapter19/lorenzcu rvelesson5.swf http://www.econedlink.org/lessons/index.php?lid=885 &type=educator http://www.youtube.com/watch?v=aqwn_dqchg4&s afety_mode=true&persist_safety_mode=1&safe=activ e http://visualeconomics.creditloan.com/incomedistribution-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 Average Incomes (Managerial) University Degree Post-secondary diploma Some post-secondary High school graduate Some high school 0 to 8 years of school $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 lessappealing 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 nonunionized 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 Share of Wealth Held by Top Wealth Holders (%) 90 80 70 60 50 40 30 20 Sweden (1975) Canada (1984) France (1986) US (1986) 10 0 Top 1% Top 5% Top 20%
Assignment Page 190 7.3 Practice Questions 1 and 2
7.4 Poverty http://www.cbc.ca/news/canada/story/201 1/09/28/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 Size of Household Unit Urban Areas (categorized by size) Rural Areas 500 000 and over 100 000 to 499 999 30 000 to 99 999 Less than 30 000 1 person 2 persons 3 persons 4 persons 5 persons 6 persons 7 or more persons $16 853 20 512 25 542 31 865 36 285 40 241 44 107 $14 253 17 347 21 601 26 948 30 686 34 032 37 378 $14 075 17 131 21 332 26 613 30 032 33 610 36 931 $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
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 Percentage of Households Below the Poverty Line in 2004 11.2 10.6 11.7 12.8 11.7 5.6 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 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-andsocial-development/poverty/lang--en/index.htm http://www.globalissues.org/article/4/povertyaround-theworld#worldbankspovertyestimatesrevised
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 wellbeing 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
Transfer Payments and Income 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
Transfer Payments and Income 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 Transfer Payments Received (2004) Transfer Payments as a Percent of Total Income (2004) Share Received of Total Transfer Payments (2004) Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% $7 000 9 300 8 000 6 500 4 800 54.5% 31.4 16.9 9.0 3.4 19.7% 26.1 22.5 18.3 13.5 Average of Total 7 100 11.7
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/txrtseng.html#federal http://www.craarc.gc.ca/tx/bsnss/tpcs/pyrll/t4032/jn10/menueng.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/fisca lpolicy/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
Taxes and Income Equity 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
Taxes and Income Equity 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 Personal Income Taxes Paid Personal Income Taxes as a Percent of Total Income Share Paid of Total Personal Income Taxes Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% $ 700 2 700 6 300 11 900 31 900 5.4% 9.1 13.3 16.4 22.4 1.2% 5.0 12.0 22.3 59.5 Average of Total 10 700 17.5
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 A Malthusian Time Chart Year Food Population 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) (Online Learning Center) 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 (Online Learning Center) 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.
Wage ($ per year) Ricardo s Theory of Rent Figure A Land Rents per Hectare (when production costs are $100 per hectare) Land Rents per Hectare Wheat Price ($) Grade A (50 kg output) Grade B (40 kg output) Grade C (20 kg output) Grade D (10 kg output) 400 $400 $ 5 150 [($5 x 50) $100] 100 0 not cultivated 300 $300 10 400 [($5 x 50) - $100] 300 100 0 200 $150 100 $100 $100 $0 $0 0 A B C D Grade of Land
Understanding Economics 4 th edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 7 The End