Download pdf - 3Government Intervention & Allocative Efficiency

3

61THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)

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62 THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)

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So far we’ve looked at free or competitive markets, i.e. markets where market forces (supply and demand) are left alone to provide what consumers want and so achieve allocative efficiency. But for a variety of reasons the government may choose to intervene in a market.

This unit looks at ways that governments intervene in markets, and how this reduces the allocative efficiency of markets and creates deadweight loss.

I just want to be free ...

government intervention& allocative efficiency

1 how does the government intervene in international

trade markets ?what’s a sales tax and

how does it affect allocative efficiency?

3 what’s a subsidy and how does it affect

allocative efficiency?

unit overview

by the end of this unit, you should be able to answer these questions...


2

4 how do fixed prices (price ceilings) affect allocative efficiency?

3


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65THE MARKET AND ALLOCATIVE EFFICIENCY (3.1) 65THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)

get more protectionCountries trade with each other when domestic firms look to overseas markets to export their goods or services and so increase their profit, or consumers wish to import goods and services made overseas.

This is a logical extension of competitive or free markets within an economy. However international trade is also affected by international politics as firms try to give their domestic firms a competitive advantage or protect a country’s strategic interests.

This topic looks at how a government can intervene in international markets through the use of tariffs and quotas ... and how this impacts on allocative efficiency.

o describe international trade

o show market equilibrium in a two-country model

o illustrate trade between New Zealand and the world

o show changes to international trade

o describe international protectionism

o show the impact of tariffs on trade and allocative efficiency

o show the impact of quotas on trade and allocative efficiency

topic 3.1

international tra

de

- tariffs & quotas

by the end of this topic, you should be able to...

remember - try the exercises and then read the notes to learn what you don’t know ...

3

66 THE MARKET AND ALLOCATIVE EFFICIENCY - 3.1

The graphs below show the market for soap in New Zealand and Australia (ignoring exchange rates).

1. On the graphs show the equilibrium price and quantity in both countries.

2. Calculate the after-trade equilibrium price (note: both graphs are in NZ$). Show this on the graph.

3. Show local production (QP), local consumption(QC), imports (M) and exports (X) after trade.

4. Complete the table below:

Before Trade After Trade

Equilibrium price in New Zealand $ $

Equilibrium price in Australia $ $

Domestic production in New Zealand bars bars

Change in New Zealand domestic production bars

Domestic production in Australia bars bars

Change in Australian domestic production bars

Domestic consumption in New Zealand bars bars

Change in New Zealand domestic consumption bars

Who is better off from trade in New Zealand? consumers / producers

Who is better off from trade in Australia? consumers / producers

5. Based on you analysis above, should New Zealand trade with Australia? Why (not) ?

Yes No

____________________________________________________________________________________________

____________________________________________________________________________________________

Graph 1: NEW ZEALAND MARKET FOR SOAP$

8

6

4

2

Q (000’s bars)

4 8 12 16

SNZ

DNZ

Graph 2: AUSTRALIAN MARKET FOR SOAP$

8

6

4

2

Q (000’s bars)

4 8 12 16

SA

DA

Exer

cise

3.1

Inte

rnat

iona

l Tra

de

3


The graph below shows the early days of the New Zealand wine industry, when New Zealand firms were struggling to establish themselves in New Zealand and internationally against overseas companies.

1. The New Zealand government decides to impose a $10 tariff on imported wine. Show this on Graph 3. Label the new world price (WP2).

2. Identify the new quantity of imports, local production and local consumption.

3. Show the loss of consumer surplus resulting from imposing the tariff.


Before the Tariff After the Tariff

Domestic production litres Domestic production litres

Revenue earned by local firms $ Revenue earned by local firms $

Quantity imported litres Quantity imported litres

Value of imports $ Value of imports $

Domestic consumption litres Domestic consumption litres

Revenue from tariff $

5. Now that the industry is more mature, why is there less of an argument for the government to protect local producers from imports?

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

100

80

60

40

20

2 4 6 8

NZ$

10 12 14 16 18Q (millions of litres)

DNZ

WP

SNZ

Graph 3: NEW ZEALAND MARKET FOR WINE

Exer

cise

3.2

Impo

sing

a T

ariff

3


Imagine game consoles can be imported direct to New Zealand for an average price of New Zealand $300 (including transport costs, etc.).

1. On Graph 4, show the effects on the New Zealand market due to the world price (WP) for Game Consoles being lower than the equilibrium price in New Zealand.

2. Imagine the New Zealand government places a $100 tariff on all Game Consoles imported into New Zealand. Show this on Graph 4 (WP+ Tariff) and answer the questions below.

3. Use coloured pencils to shade the following areas (after the tariff is imposed):

The revenue of local producers.

The revenue to firms importing Game Consoles.

The total tariff paid to the government.

4. Calculate the following values (after the tariff is imposed):

a. Number of locally made Game Consoles ____________________

b. Total consumer spending $ ____________________

c. Revenue to local firms $ ____________________

d. Total tariff paid to government $ ____________________

e. Value of imports $ ____________________

f. Number of imported Game Consoles ____________________

5. On Graph 4, identify the deadweight loss (loss of allocative efficiency) resulting from the tariff being imposed.

Graph 4: NEW ZEALAND FOR GAME CONSOLESNZ$

1 200

1 000

800

600

400

200

SNZ

500

DNZ

1 000 1 500 2 000 2 500 3 000

Exer

cise

3.3

Impo

sing

a T

ariff

3


Again, imagine the same market for Game Consoles that are imported directly to New Zealand for an average price of New Zealand $300 (including transport costs, etc.).

1. On Graph 5, show the effects on the New Zealand market due to the world price (WP) for Game Consoles being lower than the equilibrium price in New Zealand.

2. Imagine the New Zealand government places a quota of 750 Game Consoles per year that may be imported into New Zealand. Show this on the graph above and answer the questions that follow.

3. Use coloured pencils to shade the following areas on Graph 5 (after the quota is imposed):

The revenue to local producers.

The revenue to firms importing Game Consoles.

4. Calculate the following values (after the quota is imposed):

a. Number of locally made Game Consoles ____________________

b. Total consumer spending $ ____________________

c. Revenue to local firms $ ____________________

d. Value of imports $ ____________________

e. Number of imported Game Consoles ____________________

Graph 5: NEW ZEALAND FOR PLAYSTATIONS

1 200

1 000

800

600

400

200

SNZ

Quantity of Playstations

500

DNZ

1 000 1 500 2 000 2 500 3 000

NZ$

Exer

cise

3.4

Impo

sing

a Q

uota

3


Show the world price of $15 on the graph below. Label this SWORLD.

2. Show the quantity of goods supplied locally (QSNZ), the quantity of goods demanded (QDNZ) and imports.

3. The New Zealand government imposes a tariff on pocket knives of $10 per knife. Show this and the resulting changes to imports on the graph.

4. Show the the following areas on the graph after the government has imposed the tariff:

• the new consumer surplus

• the extra increase in producer surplus

• the government revenue from the tariff

• the deadweight loss

5. Using the graph above as example, explain what ‘deadweight loss’ is.

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________


Before Trade After Trade (Before Quota)

After Trade (After Quota)

Total revenue for New Zealand producers $ $ $

Total expenditure by New Zealand consumers $ $ $

Consumer Surplus $ $ $

Producer Surplus $ $ $

Quantity Supplied by Local Producers

Quantity Demaned by Local Consumers

Graph 6: NEW ZEALAND MARKET FOR POCKET KNIVESNZ$

55

50

45

40

35

30

25

20

15

10

5

Q (000’s)2 4 6 8

DNZ

10 12 14 16 18 20 22 24 26 28

SNZ

Exer

cise

3.5

Impo

sing

a Q

uota

3


notesInternational TradeTrade is important to the economies of most countries in the world. It helps economies by increasing the size of the market available to domestic firms – this is especially relevant to firms in small economies such as New Zealand. It is also necessary if a country wants to import goods from overseas. To do this they need foreign currency, which the country earns by selling goods and services abroad (i.e. exporting).

Show Market Equilibrium in a Two-Country ModelTrade between two or more countries can occur when one country is able to produce more of a good or service than its own (domestic) consumers demand and it can produce the good or service more cheaply than producers in another country.

We can use supply and demand analysis to show how and why producers and consumers in different countries trade with each other. To simplify the analysis, we will ignore exchange rates and the cost of freight (transport). Figure 3.1 shows two countries trading with each other.

However it is not all good. In Albania, consumers bought 5 000 teapots per annum (QA) at $5 (PA) each before trade. After trade consumers only buy 3 000 teapots each year (Q1) at a price of $7 (PW). Teapot consumers in Albania are worse off.

In Bolivia, domestic producers sold 3 000 (PB) teapots annually for $9 (PB) before trade. After trade they only sell 2 000 (Q3) teapots for $7 (PW) each. Their annual revenue has fallen from $27 000 to $14 000.

Figure 3.1 ... Two-Country Model of International Trade

Before TradeIn Albania, teapots sell for $5, while in Boliva they sell for $9.

After Trade

Realising that they can sell teapots for a higher price in Bolivia, Albanian firms will export to Bolivia. This will cause the price in Bolivia to fall as Albanian firms sell their teapots below the market price.

At the same time, the price in Albania will rise. The opportunity cost of selling teapots in Albania (i.e. what firms can earn in Bolivia) rises due to trade. This will cause Albanian firms to raise the price of teapots in Albania to match the price they can earn in Bolivia.

The prices will rise in Albania (to PW) and fall in Bolivia (to PW) until they are equal and the quantity exported equals the quantity imported.

The graphs above show the quantity of exports (Q1 to Q2) and imports (Q3 to Q4) at the new price (PW).

ALBANIAN MARKET FOR TEAPOTS

PA

Q1

DAQ (000pa)

US$SA

PW

Q2

1413121110987654321

1 2 3 4 5 6 7 8 9 10QA

Domestic Sales

Exports

BOLIVIAN MARKET FOR TEAPOTS

PW

Q3

DB

Q (000pa)

US$

SB

PB

Q4

1413121110987654321

1 2 3 4 5 6 7 8 9 10QB

Domestic Production

Imports

3


Illustrate Trade Between New Zealand and the WorldThe section on the previous page shows two countries who share a double coincidence of wants, i.e. they both want to trade with each other at the same time. In reality, most New Zealand firms sell to a number of geographic markets (e.g. Japan, USA) throughout the world.

Figure 3.2 shows how we use supply and demand graphs to illustrate New Zealand importing a good from overseas.

Alternatively Figure 3.3 shows how we illustrate New Zealand exporting a good.

You will notice that in both Figures 3.3 and 3.4, the world price is shown as a horizontal line, i.e. perfectly price elastic.

When New Zealand is importing, the horizontal line represents world supply. New Zealand is too small to influence the price and so world supply is shown as purely elastic. Overseas’ suppliers can produce whatever New Zealand demands at the same marginal cost of production and therefore price.

When New Zealand exports, the horizontal line represents world demand. With so many overseas consumers and producers, New Zealand firms are tyipically price takers because they are so small by world standards and cannot influence world demand.

One exception to this is Fonterra which is a leading international trader of dairy products.

Figure 3.2 ... New Zealand as an Importer

Before TradeThe equilibrium price is $2 000 (PNZ) and quantity is 40 000 (QNZ).

After Trade

Overseas firms sell to New Zealand consumers at a lower price (PW) than PNZ.

Domestic consumers are better off because they are buying more computers at a lower price. Domestic producers are worse off because they are selling less computers at a lower price and so their revenue has fallen from $80 000 to $20 000 after trade.

MARKET FOR COMPUTERS

PW

QSNZ

DNZ

Q (000pa)

$

SNZ

PNZ

QDNZ

4 0003 5003 0002 5002 0001 5001 000

500

10 20 30 40 50 60 70 80QNZ

Domestic Production

Imports

World Supply

Figure 3.4 ... New Zealand Compared to the World Market

The New Zealand market is microscopic compared to a total world market. We represent less than 0.2% of world trade.

WORLD

PW

DWQ

$ SW

QW

NZ

DQ

$ S

Figure 3.3 ... New Zealand as an Exporter

Before Trade80 000 MT (QNZ) of timber is sold to local customers for $4/MT (PNZ).

After Trade

New Zealand producers can earn a higher price overseas than PNZ. Therefore, they will export timber overseas. This will result in the price in New Zealand rising (see Figure 9.5 for discussion of this) and local sales falling form QNZ to QDNZ

.

MARKET FOR TIMBER

PW

QDNZ

DNZ Q (000 MT pa)

$/MT

SNZ

PNZ

QSNZ

8

7

6

5

4

3

2

1

20 40 60 80 QNZ

Domestic Sales Exports

World Demand

100 120 140 160 180

3


Show Changes to International TradeBecause New Zealand is so small compared to overseas economies and firms, New Zealand firms are often (but not always) price takers when it comes to international trade. Figure 3.5 below shows how New Zealand markets respond to a change in international trade.

Show the Impact of Trade on Allocative EfficiencyAs we saw above, international trade can be good for consumers and producers. Consumers benefit from imports by being able to buy a wider range of goods and services at a cheaper price. Producers benefit from being able to sell their products overseas.These benefits can also be shown in terms of their impact on consumer and producer surplus, and therefore alloactive efficiency in a market. This is shown in Figures 3.6 and 3.7 below.

Figure 3.5 ... Changes to International Trade

If the world supply falls then prices will rise globally. In New Zealand, the price will rise, resulting in more locally produced goods (0 to Q2) and less imports (Q2 to Q3).

NEW ZEALAND MARKET

P1W

QNZ

Q

$

S1W

PW SW

SNZ

Q2 Q3Imports

Q1 Q4Imports

WORLD MARKET

$S1

W

PW1

SW

QWQ2 Q1

Figure 3.6 ... Imports and Allocative Efficiency

Before TradeBoth consumer and producer surplus are maximised.

After Trade

World supply is below the NZ market price, resulting in imports and a lower prices in the market. Consequently consumer surplus (the area between price paid and the demand curve) has grown.

However producer surplus for domestic producers has reduced as they now sell less at a lower price. .

This market is still allocatively efficient, as consumer and producer surplus are both maximised.


DNZ

Q (000pa)

$

SNZ

4 000

3 500

3 000

2 500

2 000

1 500

1 000

500

10 20 30 40 50 60 70 80


DNZ

Q (000pa)

$

SNZ

4 000

3 500

3 000

2 500

2 000

1 500

1 000

500

10 20 30 40 50 60 70 80

World Supply

Consumer Surplus

Producer Surplus

Consumer Surplus

ProducerSurplus

Imports

3


Describe International ProtectionismThe general trend in international trade is towards lowering government intervention, i.e. increasing the opportunities for free trade. Multi-lateral organisations such as the World Trade Organisation (WTO) and trade agreements such as Closer Economic Relations (CER), exist to promote greater trade between countries. However, a great deal of international protectionism exists.

International protectionism is when a government intervenes in international markets to reduce or hinder the overseas competition faced by local firms. Governments do this for a various reasons:

• New Industries New industries often have high start-up costs. A government may protect them long enough to establish themselves and then be able to compete internationally.

• Local Jobs Overseas competition may cause local firms to close down and lay off staff. Protecting local firms from overseas competition can preserve local jobs.

• Strategic Industries A particular industry may be one that a country does not want to rely on other countries for, e.g. energy production, food, military hardware.

• Unfair Trade Practices Overseas governments sometimes unfairly support their firms through subsidies or other means. Or large foreign firms may ‘dump’ their goods at ridiculously low prices to force domestic firms out of business (and then they raise the price). The government may try to protect local firms from such unfair trade practices.

The two types of international protectionism we will look at are tariffs and quotas.

Figure 3.7 ... Exports and Allocative Efficiency

Before TradeBoth consumer and producer surplus are maximised.

After Trade

Overseas demand leads to New Zealand firms exporting. This causes the price in the price of goods in New Zealand to rise as local producers can export at a higher price.

This increases the producer surplus, but reduces the consumer surplus.

This market is still allocatively efficient, as consumer and producer surplus are both maximised.

MARKET FOR MILK

DNZ

Q (m litres)

$

SNZ

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.50

10 20 30 40 50 60 70 80

MARKET FOR MILK

DNZ

Q (m litres)

$

SNZ

4.00

3.50

3.00

2.50

2.00

1.50

1.00

0.50

10 20 30 40 50 60 70 80

World Demand

Consumer Surplus

Producer Surplus

Consumer Surplus

ProducerSurplus

Exports

3


Show the Impact of Tariffs on Trade & Allocative EfficiencyA tariff is a tax on imported goods or services. It protects domestic firms from overseas competition by raising the price of imported products to local consumers. This means that local firms can sell more at a higher price – good for them but bad for consumers.

Figure 3.8 shows the impact of a tariff on international trade. The are several points to note about the changes shown:

• Identify the Tariff The tariff is shown by raising the world supply curve the amount of the tariffs. In Figure 3.8 the supply curve is raised by $20.

• Imports are Reduced The volume of imports (the horizontal distance between QSNZ and QDNZ) falls as the price rises and local firms increase their quantity supplied.

• Identify the Government Tax Revenue A tariff is a tax and so is paid to the government. The total revenue from the tariff is shown by the rectangle shown as the volume of imports multiplied by the value of the tariff.

• Deadweight Loss This is shown by the black triangles. Read the notes below Figure 3.8 to explain what deadweight loss is.

The tariff has helped protect local firms by increasing the market price. This is good for them as they now sell more goods at a higher price. However it is bad for local consumers as they buy less at a higher price.

This idea can also be illustrated by looking at the impact of the tariff on the producers’ surplus and consumers’ surplus for local firms and consumers. Though it doesn’t specifically show it, if you identify the consumer surplus before and after the tariff, you will see that it has decreased. Domestic consumers are worse off.

If you identify the producer surplus for local producers before and after the tariff, you will see that it has increased. Local firms are better off.

The reduction in consumer surplus is not all transferred to producers. Some also goes to the government as revenue from the tariff. However some of the lost consumer surplus goes to neither firms or the government. Where does it go? Nowhere. This surplus is lost from the market. This lost surplus is called ‘deadweight loss’.

Figure 3.8 ... Show a Tariff

A tariff is shown as a vertical increase in the world supply curve.

This pushes the market price up to $60 per teapot ($40 + $20 tariff).

As a result, imports fall from 6 000 (QSNZ– QDNZ

) to 2 000 (Q1

SNZ– Q1

DNZ). Importer’s Revenue falls

from $240 000 to $80 000.

At the same time local production rises from 2 000 (QSNZ

) to 4 000 (Q1SNZ

), and local firms revenue grows from $80 000 to $240 000.

Government revenue from the tariff (shaded area) is $40 000, i.e. the tariff ($20) multiplied by the new quantity of imports (2 000).

Tariff Revenue

1 2 3 4 5 6 7 8 9 10

MARKET FOR TEAPOTS

P1W

Q1DNZ

DNZ

Q (000 pa)

$SNZ

PW

QSNZ

100

90

80

70

60

50

40

30

20

10

SW

SW + TARIFF

$20 Tariff

Q1SNZ

QDNZ

Imports After Tariff

Imports Before Tariff

Deadweight Loss: The consumer or producer surplus lost due to intervention in a market and not gained by anyone else in exchange.

Deadweight Loss

3


Show the Impact of Quotas on Trade & Allocative EfficiencyA quota protects local firms by limiting the number of goods or service overseas firms can bring into a country. By restricting supply, the local market prices and local firms supply more. Figure 3.9 illustrates the impact of a subsidy on trade.

The world can supply teapots more cheaply and so lowers the market price to $40. However because there is a quota, importers can no longer bring in enough teapots to satisfy quantity demanded.

Because there is a shortage, consumers will bid up the price. As per the law of supply, firms will respond by increasing quantity supplied until supply equals demand at the new market price of $60 and quantity of 6 000 teapots.

A big difference between a tariff and a quota, is that quota’s do not earn the government revenue. The increased price goes directly to overseas firms (or importers) who have an import licence under the quota scheme

Like a tariff, a quota also creates deadweight loss. This is shown in Figure 3.9 as the black triangles Remember that, in this case, they show the consumer surplus that local consumers used to enjoy that is no longer a surplus for anyone in the market - consumers, producers or the government.

Figure 3.9 ... Show a Quota

This graph shows the government imposing a quota of 2 000 teapots.

At the original world price of $40, local firms will produce 2 000 teapots. Overseas firms then bring in 2 000 more under the quota.

At that level of output (Q2) and price (PW), a shortage exists. Consumers will start to bid up the price. Because no more imports are allowed, local firms begin to supply again (as per the law of supply). until quantity supplied equals quantity demanded. at the new market price of $60.

Revenue to Importers

P1W

PW

1 2 3 4 5 6 7 8 9 10

MARKET FOR TEAPOTS

Q2

DNZ

Q (000 pa)

$SNZ100

90

80

70

60

50

40

30

20

10

SW

SNZ + QUOTA

Q1

Domestic Production

Q3

Imports Domestic Production

Deadweight Loss

R.L.T. #6 ...isereviserevisereviserevisionrevi...

Have you made a mindmap of what you’ve learned yet?

The trick to mindmaps is not to create one perfect summary of what you’ve learned ... because learning is active. The best mindmaps are quickly drawn and then thrown away.

Focus on identifying the key (big) ideas and how they connect to each other. Learning the ‘structure’ of what you are studying will help you to remember (and understand) it.

LEARNING IS ACTIVE ... EXERCISE YOUR BRAIN ... MAKE CONNECTIONS ... YOUR MIND IS NOT A BUCKET

3

77THE MARKET AND ALLOCATIVE EFFICIENCY (3.1) 77THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)

topic 3.2sales ta

x

... plus a bit extra

Governments use sales taxes to generate tax revenue or to discourage the consumption of certain products such as tobacco.

This topic looks at what a sales tax is, how it works in a market, and how it affects allocative efficiency in a market.

o describe a sales tax

o show a sales tax

o show the effect of a sales tax on allocative efficiency

o show and compare the incidence of a sales tax on producers and consumers



77

R.L.T. #6 ...isereviserevisereviserevisionrevi...

Have you made a mindmap of what you’ve learned yet?

The trick to mindmaps is not to create one perfect summary of what you’ve learned ... because learning is active. The best mindmaps are quickly drawn and then thrown away.

Focus on identifying the key (big) ideas and how they connect to each other. Learning the ‘structure’ of what you are studying will help you to remember (and understand) it.


3


Show the impact of a sales tax on the following graphs.

1. Show the impact of a sales tax of $20 per bottle on on the market for perfume.

2. a) Show the consumer and producer surplus at market equilibrium in the market for petrol.

b) Calculate the value of ... consumer surplus $ __________________________

producer surplus $ __________________________

c) On the graph show the following:

• the impact on the market of imposing a sales tax of $2 per litre on petrol.

• deadweight loss resulting from the sales tax

• revenue to the government from the sales tax

• consumer surplus after the sales tax

• producer surplus after the sales tax

Exer

cise

3.8

Impo

sing

a S

ales

Tax

Price($/bottle)

Quantity (000 bottles)

80

70

60

50

40

30

20

10

10 20 30 40 50 60 70 80

Q1

P1

D

S

MARKET FOR PERFUME

Q1

Price($/litre)

Quantity (million litres)

8

7

6

5

4

3

2

1

2 4 6 8 10 12 14 16

P1

D

S

MARKET FOR PETROL

3


The market for wine is shown in the graph to the right.

1. Show equilibrium price and quantity on the graph.

2. Imagine the government imposes a sales tax of $30 on wine. Show this on the graph.

3. After the sales tax, how much do consumers pay for wine, and how much revenue do producers earn?

expenditure: $_____________________

revenue: $_____________________

4. Who bears the main brunt of the sales tax – consumers or producers?

___________________________________________________

5. Explain why the market price of wine did NOT rise by $30, i.e. the same amount as the (per litre) sales tax.

____________________________________________________________________________________________

____________________________________________________________________________________________

6. On the graph above, highlight the following areas (following the sales tax):

• consumer surplus

• producer surplus

• sales tax revenue

• deadweight loss

7. Explain the concept of deadweight loss. What is it? Why has it occurred?

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

8. Indicate the following areas by stating the letters given on the graph alongside.

a. Consumers’ surplus before tax. ___________

b. Total expenditure after tax. ___________

c. Total revenue after tax. ___________

d. Total tax revenue. ___________

e. Incidence of sales tax on producers. ___________

f. Producers’ surplus after tax. ___________

9. What letter represents the point of allocative efficiency before the sales tax?

___________

$

Q

a

D

S’

p

g

m

0

n

S

q

i

hk

b

c

d

e

f

MARKET FOR WINEPrice($/litre)

1 2 3 4 5 6 7 8 9

S

D

Q (000 litres)

10

20

30

40

50

60

70

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Imagine two markets . . . porcupines (they make great pets!) and African tangerines (not such good pets).

1. On the graphs below, identify market equilibrium, producers’ surplus and consumers’ surplus.

2. Show the impact of a sales tax on each of the graphs below. Identify the new producer and consumer surplus and the deadweight loss.

3. Show the incidence of the sales tax on producers and consumers in both markets.

4. With reference to the two markets, describe how the sensitivity of consumers to changes in price (i.e. price elasticity of demand) affects the impact of a sales tax on the quantity of goods sold.

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

MARKET FOR PORCUPINES

Price ($)

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MARKET FOR AFRICAN TANGERINES

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Sales tax of $15

MARKET FOR PORCUPINES

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MARKET FOR AFRICAN TANGERINES

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notesSales Tax

Describe a Sales TaxFrom time to time, governments impose a sales tax on a good or service. This may be done to generate tax revenue or to dissuade people from consuming a product. Sales taxes are referred to as indirect taxes as consumers pay for the tax . . . but pay it to producers who collect it and then pay it to the government.

The most common example of a sales tax in New Zealand is the Goods and Services Tax, i.e. GST. However there are many other indirect taxes in New Zealand.

Show the Effect of a Sales Tax A sales tax is a cost to producers and so affects the supply curve. A sales tax increases firms’ costs of production and therefore decreases supply, i.e. supply moves upwards by the amount of the sales tax.

Though the supply curve shifts up by the amount of the sales tax, typically the price will increase by a smaller amount. As the price rises for consumers they will consume less, i.e. QD falls. At the same time, producers are earning less per good, resulting in them choosing to produce less, i.e. QS falls. This idea is illustrated in Figure 3.11 where a sales tax of $1.50 per good only raises the market price by $1.00.

This means that producers have chosen to ‘absorb’ some (50c) of the sales tax in their selling price, and so they earn less revenue. The rest of the sales tax ($1.00) has been passed on to consumers through a higher market price.

Figure 3.10 ... Indirect Tax

Indirect taxes are paid by consumers but indirectly through producers who collect them on behalf of the government and then pay them to the government.

Consumers Producers Government

Figure 3.11 ... Imposition of Sales Tax

Imagine the government imposes a sales tax of $1.50 per unit.

This increasesfirms’ cost ofproduction, and the supply curveshifts up by the amount of the tax.

This causes the market price to rise, though not by the fullamount of the sales tax. Producers will absorb some of the sales tax into the price.

Aspricerises,themarketquantityfalls fromQ1 toQ2. At this quantity consumers pay P1 ($4), but firms only receive P3($2.50).

The difference goes to the government as tax revenue.

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Sales Tax: A tax that is added to the price of a good or service, and paid when the good or service is sold.

$1.50 Sales TaxP3

3


Show the Impact of a Sales Tax on Allocative Efficiency As a result of the sales tax, there will be a loss of allocative efficiency. Both consumers’ and producers’ surplus will decrease. Some of this surplus will go to the government as tax revenue, while some will be lost altogether – i.e. deadweight loss.

In Figure 3.12, the imposition of a sales tax ($1.50 per good) has caused the supply curve to shift upwards (S2). As are result, consumers lose some of their surplus because they are now buying less goods (Q2) for a higher price (P2). Producers lose some of their surplus as they are selling less goods (Q2) for a lower price (P3).

Some of this lost consumer and producer surplus goes to the government as sales tax revenue (30 x $1.50 = $45 ... in the graph above). But some is lost entirely from the system, i.e. consumers and producers lose it and no one else gets it, not even the government. This is shown in Figure 3.12. Its value, if you calculate it, is $7.50 (½ x $1.50 x 10).

Show and Compare the Incidence of a Sales Tax on Producers and Consumers (see “tips 4 teachers” re. elasticity ... page 106)

A government uses a sales tax for two main reasons - to raise tax revenue and modify the behaviour of producers and consumers.

GST is a good example of a sales tax that is used to raise tax revenue. It applies to most goods and services and is the same rate (15%) for all of them. The government then uses this revenue to fund other government activities such as education, health, etc.

Other sales taxes such as the excise duty on cigarettes are imposed to modify the behaviour of consumers and producers, i.e. get them to consume / produce less of the good.

To see how much a sales tax will affect consumers and producers we need to examine the graph more carefully and look at who pays most of the sales tax.

Producers could, in theory, absorb the entire sales tax into their existing sales price. This would reduce their profit but they wouldn’t lose any customers. Alternatively a firm could choose to pass the entire sales tax on to customers by raising the selling price by the full amount of the sales tax.

In practice firms usually do something in between, they pass on as much of the sales tax as possible to consumers by raising the price, but also pay some of the sales tax out of their own profits. The proportion of the sales tax paid by consumers and producers is call the ‘incidence’ on consumers or producers. This is shown graphically in Figure 3.13.

Figure 3.12 ... Sales Taxes and Deadweight Loss

The imposition of the sales tax will reduce producer and consumer surpluses.

Some of this lost surplus will go to the government as tax revenue.

The rest will be lost to the system and is called deadweight loss.

Deadweight Loss

Consumer Surplus - after the sales tax

Producer Surplus

Sales Tax Revenue

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How much of a sales tax that firms decide to pass on to consumers depends on the ‘price elasticity’ of demand and supply. We will study price elasticity more in another standard. For now all you need to know is that price elasticity refers to how sensitive consumers and producers are to a change in price, e.g. how much will quantity demanded change in response to a change in price?

If consumers are very ‘price elastic’, i.e. they are very sensitive to a change in price and likely to stop buying or buy less goods due to an increase in price, then firms will absorb most of the sales tax into the existing selling price. This situation is shown in Figure 3.14, where you will see that the incidence of the sales tax is greater on producers.

In figure 3.14, the sales tax has been effective from the government’s perspective because it has caused consumers to demand less goods and firms to produce less goods (Q2)

Figure 3.13 ... Incidence of a Sales Tax on Consumers and Producers

To show the incidence of the sales tax on consumers and producers,startwiththerectangleshowingthewholesalestax.

Then divide the rectangle by the original price. The area above the original price is the incidence of the sales tax on consumers. The area below the original price is the incidence of the tax on producers.

Inthisgraph,thesalestaxof$3perunithasresultedinapriceincrease of $2 per unit. Firms have chosen to only ‘pass on’ $2 of the sales tax to consumers. Firms will pay the other $1 of salestaxoutoftheirprofits.

In this market, the incidence of the sales tax is greater onconsumers.

Incidence of the Sales Tax on Producers

Incidence of the Sales Tax on Consumers

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Figure 3.14 ... Sales Tax in a Market with High Price Elasticity of Demand

The consumers in this market are very sensitive to changes in theprice,i.e.demandispriceelastic.Thismeansthatalargenumber (not all) customers will stop buying the good if the price rises.

Unwillingtolosetoomanycustomers,firmsinthismarketwillabsorbmostofthesalestaxintotheirprofitsratherthanpassit on to customers through a higher selling price.

Theresult isthat,asshowninthegraph,theincidenceofthesales tax falls mainly on producers.



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The alternative is a market where the demand for a good is price inelastic, i.e. consumers are less likely to change how much of a good or service they buy when the price changes.

The market for cigarettes is a good example of this. Because of the nicotine in cigarettes, smokers are largely addicted to smoking them. Therefore an increase in price is unlikely to cause many smokers to stop buying cigarettes. This situation is shown in figure 3.15 below.

In a market such as the one for cigarettes, the government must impose a large sales tax on the good to signficantly change the behaviour of consumers and producers.

Note:

The analysis above has only discussed the price elasticity of demand. In fact we also need to consider the price elasticity of supply when analysing the incidence of a sales tax on consumers and producers. The final impact of a sales tax on the selling price ... and therefore the behaviour of consumers (quantity demanded) and producers (quantity supplied) depends on the relative price elasticities of both demand and supply.

Figure 3.15 ... Sales Tax in a Market with Low Price Elasticity of Demand

The consumers in the market for cigarettes are not very sensitive tochanges in theprice, i.e.demand isprice inelastic. Only a few customers will stop buying the good if the price rises.

Inthissituation,firmswillpassonmostofthesalestaxtoconsumersthroughahighersellingprice,becausethey know that they won’t lose many customers by doing so.

Theresultisthat,asshowninthegraph,theincidenceof the sales tax falls mainly on consumers.



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MARKET FOR CIGARETTES

R.L.T. #7 ... i have a friend!

Learning is a social activity. Don’t do it alone. Create or join a FACEBOOK group where you can share questions ... answers ... current economic events ... etc.


3


... less a little bitGovernments sometimes intervene in markets to encourage the production, and therefore consumption of goods. To increase output, the government must subsidise firms.

This topic looks at what a subsidy is, how it works in a market, and how it affects allocative efficiency in a market.

o describe a subsidy

o show a subsidy

o show the effect of a subsidy on allocative efficiency

o show and compare the incidence of a subsidy on producers and consumers

THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)



topic 3.3subsidy

85

3


Show the impact of a subsidy on the following graphs.

1. Show the impact of a sales tax of $5 per bottle on on the market for computer games.

2. a) Show the consumer and producer surplus at market equilibrium in the market for biofuel.

b) Show the impact of a subsidy of $2 per litre on biofuel on the market.

c) Show the following:

• deadweight loss

• cost of the subsidy to the government

• consumer surplus after the subsidy

• producer surplus after the subsidy

c) Calculate the following:

• cost of the subsidy to the government $ _______________________

• revenue earned by firms BEFORE the subsidy $ _______________________

• revenue earned by firms AFTER the subsidy $ _______________________

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3


Some people think that Teddy bears improve social cohesion. Imagine the Australian Government decides to subsidise the production of teddy bears. The graph to the right shows the market for teddy bears in Australia, including the subsidy.

1. Use two coloured pencils to shade in the new producers’ surplus and consumers’ surplus.

2. Shade in the deadweight loss.

3. Use the figures from the graph to complete the following table:

4. How has the subsidy affected producer and consumer surplus?

producer surplus: ____________________________________________________________

consumer surplus: ___________________________________________________________

5. How much is the per unit subsidy on teddy bears? $ ________________

6. How much has the price of teddy bears fallen after the introduction of the subsidy? $ ________________

7. Why has the price of teddy bears not fallen by the full (per unit) amount of the subsidy?

____________________________________________________________________________________________

____________________________________________________________________________________________

8. What is the total cost of the subsidy to the government? $ _________________________

9. Calculate the incidence of the subsidy on consumers and producers.

incidence of subsidy on producers $ _________________________

incidence of subsidy on consumers $ _________________________

10. Explain why the incidence of the subsidy on consumers is different to the incidence on producers.

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

Before Subsidy After Subsidy

Total Revenue

Total Expenditure

Producers’ Surplus

Consumers’ Surplus

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The markets for broccoli is shown below.

1. Imagine that the government decides to increases consumption of broccoli by subsidising its production. Show the impact of a government subsidy on the market for broccoli.

2. On your graph, identify the following:

• new market price (PSUBSIDY)

• new quantity sold (QSUBSIDY)

• the incidence of the subsidy on consumers

• the incidence of the subsidy on producers

• the deadweight loss resulting from the subsidy

3. Describe how producers and consumers are affected differently by the subsidy:

____________________________________________________________________________________________

____________________________________________________________________________________________

4. Explain why the impact of the subsidy on consumers is different to the impact on producers.

____________________________________________________________________________________________

____________________________________________________________________________________________

____________________________________________________________________________________________

5. Explain why governments use subsidies in some markets ... AND ... why governments must consider the price elasticity of demand when considering the use of a subsidy.

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notesSubsidy

Describe a SubsidyA subsidy is the opposite of a sales tax. The government pays a subsidy to a firm to lower its costs of production and so encourage it to produce more.

A subsidy raises the price that firms earn, causing them to produce more of the good or service - i.e. quantity supplied rises. At the same time the subsidy lowers the price paid by consumers, encouraging them to buy more, i.e. quantity demanded rises.

Show a SubsidyBecause a subsidy lowers the costs of production to producers, the supply curve shifts down to the right. Figure 3.16 shows the impact of a subsidy of $1.50 per unit being imposed. The subsidy is shown by shifting the supply curve down by $1.50 at each quantity (SSUBSIDY).

In Figure 3.14 the subsidy of $1.50 per good results in market price falling by $1.00 from P1 to P2. As the price falls, the market quantity rises from Q1 to Q2. The market price does not change by the full ‘per unit’ amount of the subsidy. This is due to the interaction of supply and demand.

At Q2 consumers now pay $3.00 per good and firms earn $4.50. The difference between the price consumers pay and the revenue firms earn is the per unit subsidy. The total cost of the subsidy to the government is shown by the grey box in Figure 3.16. In this case the subsidy costs $60, i.e. $1.50 x 40 goods.

Show the Effect of a Subsidy on Allocative EfficiencyShowing the effect of a subsidy on allocative efficiency can be a bit confusing. Have a look at Figure 3.17 over the page. This shows the producer and consumer surplus AFTER a subsidy.

Before the subsidy, the consumer surplus would be the triangle below the demand curve down to the market price of $4.00. But now consumers pay a lower price, so the consumer surplus has increased down to the price of $3.00.

Producer surplus was the triangle above the supply curve and up to the market price of $4.00. Because firms now earn $4.50 per good, the producer surplus has grown to be the triangle from the supply curve up to the price firms earn, i.e. $4.50.

Figure 3.16 ... Showing a Subsidy

The subsidy causes supply to shift downwards,causing price paid by consumers to fall from P1 to P2.

QuantityDemandedwillriseasconsumerswillnowbuymoregoods(Q2) at a lower price (P1).

Quantity suppliedwill also rise, as firms nowearnmore (P3)andsosupplymore(Q2).

Note:

The subsidy per good is $1.50. This is shown as the vertical distance between the two supply curves.

The total cost of the subsidy to the government is $60. This is shown as the grey box shown on the graph.

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So with a subsidy, producer and consumer surplus overlap. How can this happen? How can both firms and consumers get the same surplus?

It can happen because the government pays for the extra surplus with the subsidy. But the problem is the cost of the subsidy to the government exceeds the increased producer and consumer surplus. Go back to Figure 3.16 and identify the area on the graph that represents the full cost of the subsidy. Now show this on the graph in Figure 3.17.

The part of the full cost of the subsidy that doesn’t go to either producers or consumers as a surplus is the deadweight loss that results from a subsidy. This is show by the black triangle in Figure 3.17.

Show and Compare the Incidence of a Subsidy on Producers & ConsumersIn the case of a subsidy, the ‘incidence’ on consumers and producers refers to the benefit each gets from a subsidy. For consumers, a subsidy increases the benefit they get over and above the price. For producers, the subsidy increases their profit.

The incidence of a subsidy on consumers’ and producers’ surpluses can be shown on a graph in the same way as we do for a sales tax . . . except that it is done in reverse. The area of the rectangle representing the subsidy, that is above the original price, is the incidence of the subsidy on producers. While the area below the original price is the incidence of the subsidy on consumers. This is shown graphically in Figure 3.18.

Figure 3.18 ... Incidence of a Subsidy on Consumers and Producers

The incidence of a subsidy on consumers is the area of the subsidy below the original price.

The incidence of a subsidy on producers is the area of the subsidy above the original price.

Incidence of the Subsidy on Producers

Incidence of the Subsidy on Consumers

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Figure 3.17 ... Subsidies and Deadweight Loss

A subsidy increases both producers’ and consumers’ surplus. This is hard to show these graphically as the new surpluses overlap.

Deadweight loss is the black triangle between thetwo supply curves. This is the part of the full cost of the subsidy that doesn’t go to either producers or consumers as a surplus.

Producer Surplus

Consumer Surplus

Deadweight Loss

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The effectiveness of a subsidy is also affected by the price elasticity of demand and supply. Figures 3.19 and 3.20 show how a subsidy will be more effective in increasing quantity demanded and supplied in a market with low price elasticity of demand.

Again ... remember that in practice we need to consider the relative price elasticity of demand and price elasticity of supply to determine the full effect of a subsidy.

Figure 3.19 ... Subsidy in a Market with Low Price Elasticity of Demand

The consumers in this market are very sensitive to changesintheprice,i.e.demandispriceelastic.Thismeans that a large number of new customers buy the good if the price falls.

Because they only need to raise the price by a small amounttoincreasesales,firmswillkeepmostofthesubsidy and only lower the price slightly.

Theresultisthat,asshowninthegraph,theincidenceof the sales tax falls mainly on producers.



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Figure 3.20 ... Subsidy in a Market with High Price Elasticity of Demand

The consumers in this market are not very sensitive to changesintheprice,i.e.demandispriceinelastic.Thismeans that very few new customers buy the good if the price falls.

Firms will need to pass on most of the subsidy to consumersby lowering theprice to geta significantincrease in the number of consumers buying this good.

Theresultisthat,asshowninthegraph,theincidenceof the sales tax falls mainly on consumers.



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R.L.T. #8 ... be question smartLearning is finding the asnwers to what you don’t know.

The intelligent place to find answers is by asking other people - your teacher, other students, parents, etc.

Make sure you ask SMART questions. DON’T ask “I don’t get this. Tell me the answer.” That’s a bucket question. DO ask “I understand this part ... can you please explain how this relates to what I already know?”


3


3

93THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)



topic 3.4fixed price

s

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we shall not be moved

The government sometimes imposes f ixed prices on markets to help consumers or producers.

This topic looks at how maximum and minimum prices work, and how the impact on allocative efficiency.

o describe fixed prices

o show a maximum price

o show the effect of a maximum price on allocative efficiency

o show a minimum price

o show the effect of a minimum price on allocative efficiency

3


Famous examples of a maximum price include the markets for rental accommodation in New York and Helsinki.

1. Show the current market price (P1) and quantity (Q1) for the Hitas appartments on the graph below.

2. Show a impact of the Helsinki City Council imposing a price ceiling of €40 in the market.

3. Following the imposition of the price ceiling, identify the following in the market:

• quantity demanded

• quantity supplied

• consumer surplus

• producer surplus

• deadweight loss

4. Explain why the maximum price resulted in discrimination against people such as the handicapped and elderly.

_________________________________________________________________________________________

_________________________________________________________________________________________

5. Explain how the maximum price for Hitas Appartments might affect the market for other appartments in Helsinki.

_________________________________________________________________________________________

_________________________________________________________________________________________

_________________________________________________________________________________________

According to professors Niko Määttänen and Ari Hyytinen, price ceilings on Helsinki City Hitas apartments are economically highly inefficient. They cause queuing, and discriminate against the handicapped, single parents, elderly, and others not able to queue for days. They cause inefficient allocation, as apartments are not bought by those willing to pay the most for them. And those who get an apartment are unwilling to leave it, even when their family or work situation changes, since they can’t sell it at what they feel the market price should be. These inefficiencies increase apartment shortage and raise the market price of other apartments.

http://en.wikipedia.org/wiki/Price_ceiling#Rent_control_in_New_York_City (accessed on 25/8/12)

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notesFixed PricesDescribe a Fixed PriceGovernments may intervene in a market by fixing the market price. This might be done by setting a minimum price (price floor) or maximum price (price ceiling).

Show a Maximum PriceTo help consumers from excessive prices (usually for important or essential goods such as housing) governments may limit the market price of a good or service. This is known as a maximum price or price ceiling.

Figure 3.21 shows the government imposing a maximum price of $150 on the market for rental properties. The problem is that while the intervention succeeds in lowering the price (P1 to P2), firms will respond by reducing the amount of rental housing they provide. This follows the law of supply which states that when price falls, so to will quantity supplied.

Show the Effect of a Maximum Price on Allocative EfficiencyA maximum price will create a shortage, which the market is unable to fix due to the government restricting price signals. Figure 3.22 shows the impact of this on the allocative efficiency in the market. Ideally consumer would increase by expanding down to the new maximum price. However the choice of firms not to supply more than Q2 means that there is deadweight loss as shown by the black triangle.

The part of the full cost of the subsidy that doesn’t go to either producers or consumers as a surplus is the deadweight loss that results from a subsidy. This is shown by the black triangle in Figure 3.22.

Figure 3.21 ... Showing a Maximum Price

The maximum price (or price ceiling) causes the market price to fall from P1 to P2.

ThiswillcausequantitydemandtorisetoQ3 as per the law of demand and more consumers demand rental housing at the lower price.

HoweverquantitysuppliedwillfalltoQ2 asfirmsarenotwillingtosupplyasmuchrental housing.

The net effect is that less rental housing is provided in the market - albeit at a lower price for those lucky enough to get some..

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Figure 3.22 ... Maximum Prices & Allocative Efficiency

Ideally the maximum price should increase consumer surplus down to the new market price of $150 and out to the quantitydemandedof40.

However firms’ choice to only supplyQ2 stops this happening.

The black triangle shows the producer and consumer surplus that used to exist in the market and is now lost due to the intervention,i.e.deadweightloss.

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3


Show a Minimum PriceA government may decide to support producers by guaranteeing a minimum price for their goods. The New Zealand government used to guarantee dairy farmers a minimum price for milk. If the market price fell below the minimum price, the government would pay the difference between the price paid by consumers and the minimum price - i.e. a subsidy.

Figure 3.23 shows the government imposing a minimum price of $5 per litre of milk. Firms will respond by increasing quantity supplied to Q2. However the law of demand means consumers will demand less (Q3).

Show the Effect of a Minimum Price on Allocative EfficiencyA minimum price will create a surplus in the market. In Figure 3.23 this is the horizontal distance between Q2 (quantity supplied) and Q3 (quantity demanded). Because the price signal is not able to work in this market due to the minimum price, the government must intervene further in the market to remove the surplus.

Therefore the government will have to subsidise production to lower the market price to consumers, while still ensuring firms earn the minimum price of $5 (see topic 3 to explain subsidies more fully).

Figure 3.24 shows how the government must subsidise the price of milk by $4 per litre to increase quantity demanded to Q2. This will increase consumer and producer surplus (which overlap), but result in deadweight loss associated with the subsidy. This is shown as the black triangle on the graph.

Figure 3.23 ... Showing a Minimum Price

Theminimumprice(orpricefloor)causesthe market price to rise from P1 to P2.

This will cause a surplus in the market as quantitysuppliedrises(Q2)andquantitydemandedfalls(Q3).

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Figure 3.24 ... Minimum Prices & Allocative Efficiency

Assuming that the government uses a subsidy to maintain a minimum price in amarket, thentherewillbedeadweightloss resulting from the subsidy.

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10 20 30 40 50 60 70 80Q1

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97THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)THE MARKET AND ALLOCATIVE EFFICIENCY (3.1)

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1. On Graph 3, identify the market price and quantity before the subsidy (P1, Q1) and after the subsidy (P2, Q2).

2. On Graph 1 above, show the following as a result of a $1 500 subsidy on installation of home insulation.

a. Shade the change in producer surplus with horizontal lines

b. Shade the change in consumer surplus with dots:

c. Shade the loss of allocative efficiency resulting from the payment of the subsidy with vertical lines:

To improve people’s health and reduce healthcare costs, the government has chosen to subsidise the installation of home insulation.

Graph 1: The Market for Home Insulation

Price

Quantity (home installations)

S

D

4 000

3 000

2 000

1 000

SSUBSIDY

200 400 600 800 1 000 1 200

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sion

3.1

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idy

This question checks that you can: show a subsidy and its effect on allocative efficiency show changes to allocative efficiency and deadweight loss explain how a subsidy affects different groups differently

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3. With reference to consumer and producer surplus, explain why producers benefit more from the subsidy on home insulation.

In your answer:

• explain the effect of the subsidy on producers of home insulation

• explain the effect of the subsidy on consumers of home insulation

• explain why the price of home insulation does not fall by $1 500 per installation

• explain the effect that elasticty has on the government’s goal of making home insulation more affordable for people wanting to install home insulation

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1. Rent is the price paid by tenants for rental accommodation. Describe what maximum rent (price) is. Your answer should refer to the purpose of a maximum rent in relation to the market equilibrium price.

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2. The current weekly rental is show in Graph 2 as P1. Assume that the Government sets a maximum rental of PF.

After the imposition of the maximum rent, show:

• the quantity of rental housing that the government and consumers would like at the maximum rent (QG)

• the quantity of rental housing that the market will provide at the maximum rent

• the deadweight loss resulting from the imposition of the maximum rent.

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imum

Pric

e

Soaring house prices are causing a the price of rental housing, i.e. rent, to soar. To help low-income families, the Government is considering imposing a maximum rent.

Graph 2: The Market for Rental Housing

Rent ($/week)

PF

Quantity

Maximum Rent

S

D

P1

QF

This question checks that you can: describe the government policy of imposing a maximum price show the impact of a maximum price on allocative efficiency evaluate the effectiveness of a maximum price

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4. Evaluation the effectiveness of the Government imposing a maximum rent.

In your answer:

• explain the effect of the maximum rent on suppliers of rental accommodation

• explain the effect of the maximum rent on consumers of rental accommodation

• explain the impact of the maximum rent on market forces in the market for rental accommodation, and equilibrium quantity

• evaluate the success of the Government’s policy with regard to it achieving its goals of helping low-income families.

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Graph 3 shows the New Zealand market for clothing with the tariffs on imported clothes in place (i.e. in 1987).

1. Using the New Zealand market for clothing as an example, explain the purpose of a tariff on imports.

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2. At PT (with high tariffs in place) on Graph 3 above, show:

a. the quantity of cosmetics produced in NZ (QP)

b. the quantity of cosmetics consumed in NZ (QC)

c. the level of imports of cosmetics (M).

3. Show the lowering of tariffs by adding a new supply curve (SW).

4. Show the impact of the lowering of tariffs by identifying on Graph 3:

a. the new price (PW)

b. the new quantity consumed (Qc1) and quantity produced by NZ (Qp1)

c. shading the loss in tariff revenue for the government from removing the tariff.

d. the deadweight loss that resulted from the higher tariffs and no longer exists at SW.

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3.3

Tariff

s

In 1987, tariffs on clothing ranged from 40-65%. By 1999 they were 12.5-19%. While beneficial to New Zealand consumers, the move was initially disastrous for local clothes manufacturers and

their employees - where the number of jobs nearly halved over the same period.

Graph 3: The New Zealand Market for Clothing

Price ($)

PT

Q

SW+TARIFF

S

D

P1

Q1

This question checks that you can: describe the government policy of imposing a tariff compare the impact of a tariff on different groups in a market explain the impact of a tariff on allocative efficiency evaluate the effectiveness of a tariff

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4. Evaluate the effectiveness of the government policy in the late 1980’s to lower tariffs on imported clothing. Your answer should include:

In your answer:

• explain how market forces respond to the lowering of tariffs on imported clothes

• compare and contrast the impact of the lower tariffs on New Zealand consumers and producers

• explain the impact of the lower tariff on allocative efficiency in the market

• evaluate the overall success of the Government’s policy with regard to to improving allocative efficiency in the market for clothing and in New Zealand generally

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idy

3



Assume the price of wine includes a sales tax of 7 per litre of wine. Graph 4 shows the supply of wine including the tax (STAX) and excluding the tax (S).

1. With the tax included (STAX), state:

a. the price consumers would pay per litre of wine $________________

b. the amount retailers will receive for themselves per litre if wine $________________

c. the reduction in wine sold in the market ________________ million litres

2. Fully explain the effect of the tax on wine by calculating:

a. the tax revenue received by the Government $________________ million

b. the change in total consumer spending on wine $________________ million

c. wine suppliers’ revenue if there was no sales tax (S) $________________ million

d. wine suppliers’ revenue with the sales tax (STAX) $________________ million

e. the change in Consumer Surplus due to the tax $________________ million

f. the value of the deadweight loss resulting from the sales tax $________________ million

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sion

3.4

Sale

s Ta

x

Price

($/

litre

)

Quantity(million litres)

Graph 4: Market for Wine

14128

14

24

22

18

16

S

2 4 106

28

An informal comparision of the price of wine in New Zealand and USA suggested that New Zealand consumers are paying considerably more for New Zealand wine that US

consumers due to the high level of sales taxes on wine in New Zealand.

This question checks that you can: describe the government policy of imposing a sales tax compare the impact of a sales tax on different groups in a market explain the impact of a sales tax on allocative efficiency

evaluate the effectiveness of a sales tax

20

30

STAX

D

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4. Explain the impact of the government imposing a sales tax on the allocative efficiency of the market for wine.

Your answer should clearly:

• describe how market forces cause the imposition of a sales tax to change the market equilibrium price and quantity.

• explain why the market price for wine does not increase by the full amount of the sales tax

• explain the impact of the sales tax on allocative efficiency (i.e. consumer and producer surplus) in the market for wine

• compare and contrast the different impact of the sales tax on groups in the market (including consumers, producers and government)

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s Ta

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Graph 5 shows the market for smartphone applications in New Zealand.

1. From Graph 5, identify the letter or letters that represent:

a. Consumer surplus before trade ____________________

b. Producer surplus after trade ____________________

c. The quantity imported after trade ____________________

d. The increase in allocative efficiency due to trade ____________________

2. Explain why the world supply curve (SW) is drawn as a horizontal line.

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3.5

Inte

rnat

iona

l Tra

de

Price ($)

Quantity

D

S

Graph 5: New Zealand Market for Smartphone App’s

SWP2

P1

dc

e

b

a

Q1 Q3Q2

Key

S = domestic supply

SW = world supply

D = domestic demand

The growth in smartphones has led to an increase of small computer applications (app’s) that are increasingly cheap to develop and market - both in New Zealand and internationally..

This question checks that you can: describe the impact of international trade on a market explain how market forces respond to international trade evaluate (compare and constrast) the impact of international trade on different groups in a market

3


Graph 6 shows the same market for smartphone applications in New Zealand.

3. On Graph 6, show the impact of an increase in domestic demand for smartphone app’s by:

a. showing the new demand curve (D2)

b. showing the increase in consumer surplus

c. showing the new quantity of imported smartphone applications

4. Explain how the market for smartphone app’s will respond to the increase in domestic demand.

Your answer should clearly:

• describe how market forces respond to the increase in domestic demand, and result in a new equilibrium quantity, but not price

• explain the impact of increased demand on consumer surplus

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Graph 6: New Zealand Market for Smartphone App’s

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P1

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Key

S = domestic supply

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UNIT 3 Supply & Demand Applications

Unit Content:Understanding

1 (poor)

2 3 (good)

3.1 International Trade • Show Market Equilibrium in a 2-Country Model

• Illustrate Trade Between New Zealand and the World

• Show Changes to International Trade

• Describe International Protectionism

• Show the Impact of Tariffs on Trade and Allocative Efficiency

• Show the Impact of Quotas on Trade and Allocative Efficiency

3.2 Sales Tax • Describe a Sales Tax

• Show the Effects of a Sales Tax

• Show the Impact of a Sales Tax on Allocative Efficiency

• Show and Compare the Incidence of a Sales Tax on Consumers and Producers

3.3 Subsidy • Describe a Subsidy

• Show the Effects of a Subsidy

• Show the Impact of a Subsidy on Allocative Efficiency

• Show and Compare the Incidence of a Subsidy on Consumers and Producers

3.4 Fixed Prices • Describe a Fixed Price

• Show a Maximum Price

• Show the Effect of a Maximum Price on Allocative Efficiency

• Show a Minimum Price

• Show the Effect of a Minimum Price on Allocative Efficiency

checklist:

I have ... done a mind-map of the main ideas (before and after I’ve done the work) tried (and marked) all of the exercises watched the online videos of this work read the notes and summarised the key ideas in the margins of the pages made (or downloaded from quizlet) flashcards of the key ideas and definitions

relevant current events and examples:

relevant events and examples for this unit are:

I didn’t really get the following parts of this unit ...

... and I’m going to ask ___________________ to help me with this

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tips 4 revisionYouTubeTo help you with the material in this workbook, you can access video resources on YouTube. There is a wide variety of economic resources that you can search for. There are specific videos that have been created to go along with this workbook. Many of these videos relate to the notes. However there are also videos that show you how to do the exercises in this workbook. To find these, go online to www.youtube.com and search the following keywords - dykesnz, economics.

quizletTo help you revise, make revision resources through the year. At the start of the year, create your own Quizlet (www.quizlet.com) account. As you finish each topic, create a set of flash cards for the definitions and concepts you must learn. Some sets have been created on Quizlet for you (keywords - dykesnz, economics).

how to studyToo many students do bucket study, i.e. they think their mind is a bucket and if they just read their notes again ... and again ... and again ... etc, they will fill their mind up with lots of facts, which they can then download during a test of exam.

YOUR MIND IS NOT A BUCKET.Revision does include some memorising or rote learning. But remember that you mind learns new stuff by forming patterns, so study in a way that supports this. There are three main types of revising:

• memorise In economics, and all of your courses, there will be some stuff that you do need to memorise. Definitions, key concepts, rules, formulae. The key to this is repetition. It’s better to spend 2 minutes every hour doing some memorising, that one half-hour block per day. To help you make some flashcards, or download some digital flashcards (e.g. from Quizlet) on to your phone. And then look at them between periods, or during ad breaks while watching tv.

• understand Most importantly you must understand the course and demonstrate this in a test or exam. Mind-maps are useful for this as they get you to work out how the different pieces of the course relate to each other, and help your brain form patterns. Mind-maps are also very good if you are a visual learner, as you will find it easier to remember a picture than lots of facts or definitions.

• practise The most effective way to revise is do past tests or exams. Use the exercises and revision activities in this book, or go to www.nzqa.govt.nz and download past exam questions and model answers. Check with your teacher about which ones to use as the standards changed in 2013. As you do the tests or exams, identify what you don’t know and go back to the notes to find the answers. Then redo the test and check your answers. Make sure you understand it correctly.

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tips 4 exam technique

scan ... plan ... doWhen you sit the exam or test, there’s a good strategy to use ... scan, plan and do

• scan Quickly read through the exam or test and identify what the exam is asking you about.

• plan take two minutes to write down on a blank piece of paper ideas that come into your mind. Focus on what you do know and don’t worry about what you don’t.

Once you’re under way, you’ll be surprised what comes back to you. As you do the test and ideas about questions pop into your mind - write them down on the piece of paper for you to use later.

• do Get started. If you don’t know the answers to something, make a note on your planning piece of paper and come back to it. Don’t waste time trying to remember. When you’ve finished the exam or test, go to your planning sheet and go back to the questions you left unanswered.

Finally ... go through actual test paper and make sure you’ve left nothing blank.

no white spaceIn NCEA it is important that you answer every question even if just part of it. Under the marking schedule, markers can find evidence of you meeting the standard ... including with merit and excellence ... anywhere in the exam.

So try to answer every question.

Don’t leave any question unanswered.

NO WHITE SPACE !!

no white space no white space

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nO wHite spAce

nO WhiTe SPaCEe

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tips 4 writing skillsTo do well in economics - this year, at university and as a professional economist, you must be able to write well.

As an economist, you write to persuade. You must write an argument, that through a series of ideas or evidence, leads the reader to understand your conclusion and why it is the correct or best conclusion.

StructureYour writing should have the following basic structure:

Introduction ... what is the question or issue that I am considering? ... what options / arguments / evidence will I consider? ... what is the conclusion I will make?

Analysis ... what are the key parts to my conclusion? ... what what are the arguments or evidence, for and against my conclusion?

Conclusion ... what is the question or issue? ... what options have you considered? ... evaluate the arguments or evidence - which do you think are the best? ... what is your preferred conclusion?

Paragraphs / S.E.X.Paragraphs are the building block of any writing. They help you to organise your work and the reader to follow your logic. If you can write good paragraphs, you will write good essays.

Every paragraph should have one point. Use the mnemonic S.E.X. when writing each essay

Statement ... state the key idea of this paragrah?

Explain ... unpack your key idea with more detail

eXample (evidence) ... back up your key idea with an example or evidence (data) - provide data, anecdotes or economic theory to support the key idea

A paragraph does not need to be long. It is far better to have more smaller paragraphs, than one large paragraph with lots of points. KEEP IT SIMPLE.

PlanAlways plan your writing. Start with a very high level plan and gradually build it up.

Your first plan may only state the topic, you main points and you conclusion.

Your second plan may add the arguments for and against within your main points, and/or some of the evidence (data) you will use.

Your third plan may include the ideas (paragraphs) within your main points.

Use your plan to check that you have answered the question ... that you have a definite conclusion ... that you have a range of ideas and/or evidence .... and that you have a logical structure for the reader to follow.

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tips 4 teachers

allocative efficiencyThere are two alternative definitions of allocative efficiency. At a economy-wide level we are interested in how the economy allocates a country’s scarce resources to the production of the most desired goods and services. It’s important that students have this overview.HOWEVER ... in the standard AS 3.1, allocative efficiency is defined in terms of maximising consumer and producer surplus, i.e. how does one single market achieve allocative efficiency.In exams and formal assessments, students should clearly refer to the maximisation of producer and consumer surplus in any definition or discussion of allocative efficiency.

steps: achieve ... merit ... excellenceThe graduation from achieved to achieved with excellence is as follows:

• achieve An answer shows or describes one change, e.g. shows a correct change in supply.

• achieve with merit An answer shows and explains two or more changes. It might include a change in supply and the resulting change in producer or consumer surplus; or a double shift of supply/demand curves; or a change in supply and price with a correct explanation.

• achieve with excellence An merit answer with some form of comparison or contrasting. For example the answer may identify and explain that a gain from international trade (e.g. exports) exceeds the lost consumer surplus; or that consumers and producers are both affected by a sales tax (compare), but the incidence on producers is greater (contrast).

elasticityThis standard requires students to analyse (compare, contrast, explain) the effect of a change or intervention in the market on different participants - i.e. consumers, producers and the government.In the case of sale taxes and subsidies, students may also be asked to analyse the incidence of a sales tax on consumers and producers - as well as changes to equilibrium price and quantity.To fully analyse the incidence of a sales tax or subsidy in different markets, students should be able to explain the impact of price elasticity of demand and/or suppy on the incidence of a sales tax or subsidy. You might refer to this ‘sensitivity to price’ if you want to teach it in more general terms. The material on sales taxes and subsidies in unit 3 also discusses how price elasticity affects the desired goals of government intervention, i.e. how will the price elasticity of demand (or supply) affect the ability of a sales to decrease quantity demanded and supplied, or a subsidy to increase quantity demanded and supplied.Technically elasticity is not part of this standard, it belongs to Achievement Standard 3.3. However an understanding of price elasticity of demand in this situation would be appropriate.

private goodsAchievement Standard 3.1 assumes all goods and services are private , i.e. they are rival (depletable) and excludable.

3


learning vs. contentThis workbook is designed to focus on HOW students learn as much as WHAT they learn. Designed for self-directed learning, teachers should take time in class to monitor and assist how students learn.

competitive marketAchievement Standard 3.1 assumes that all markets are competitive. This is relevant when explaining how a market responds to a change in supply of demand.A change in demand or supply will create a shortage or surplus. Consumers will respond to this by bidding up or down the price. If there is a shortage, consumers will bid up the price to get the good or service. If there is a surplus consumers will know this (i.e. perfect knowledge) and bid the price down.Firms will respond to this because they are price-takers in competitive markets.

long-answer questions in the examStudents should expect to have longer questions in the exam for this standard, typically with multiple points to cover. Students must be able to identify the main points of such a question (with guidance from the wording of the question) and write the full answer in a way that links the points together to create a coherent answer.After completing the question, encourage students to go back to the original question and tick off that they have answered each of the points in the question.

Grade Scale MarkingTwo key changes to the level 3 standards and their assessment are:

• single achievement criteria a single achievement criteria for each standard gives the examiner more freedom to select the context of a question.

• grade-scale marking all questions can now be marked for excellence ... and even if one question does not receive an excellence, it’s mark could contribute to an overall excellence in the exam (standard)

Grade scale marking means that every question in the exam is marked for a possible excellence (or merit/achieve/etc) as per the achievement criteria. Each question receives N, A, M, or E grade, along with a score. Possible grade scores for a question:

Not Achieved Achievement Merit Excellence N0 N1 N2 A3 A4 M5 M6 E7 E8

Note that even a ‘not achieved’ in a question can still earn a score - which counts towards the final grade for the overall exam (standard).Marking is “top down”, which requires the marker to initially look for evidence for Excellence, as described by the Excellence criterion in the standard. Only if this evidence is missing or deficient, do markers look for Merit evidence, and then down to Achievement. A student’s final grade for the exam is calculated by adding the scores of all the questions. The examiner will decide what overall score (i.e. the total of scores for each question) determines an achieved, merit or excellence. Hence even a ‘not achieved’ grade in one question can still be important.The key message for students is to attempt all questions. THERE ARE NO EXCELLENCE QUESTIONS. By attempting ALL questions, students may improve their score in a question which contributes to their final mark.

NO WHITE SPACE !!!!

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