Embedded Economies. No Net Flow of Goods. Embedded Economies - Econ. of NA - RIT - Dr. Jeffrey Burnette

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1 Embedded Economies Embedded Economies - Econ. of NA - RIT - Dr. Jeffrey Burnette Embedded Economy - a sovereign economy contained within a larger economy. An embedded economy is different from that surrounding it. However, it is still largely governed by policies and activities of its encompassing economy. For any market, there are three possible relationships between an embedded and its surrounding economy: There is no net flow of goods between the two economies, The embedded economy is a net importer or The embedded economy is a net exporter. No Net Flow of Goods In the above case the equilibrium prices in both markets would be the same in both markets. This results in no change in consumer surplus, producer surplus or social welfare as a result of embedding the smaller economy. All of these measures of agent welfare would be the same if these economies were completely separated from one another and there no interaction is allowed. 1

2 Embedded Economy is a Net Importer The embedded economy is a net importer for a market when the price of the surrounding economy is less than what would clear the embedded market. This lower price results in consumers in the embedded economy purchasing additional units of this good or service because they are able to travel to the surrounding economy to procure the product. Firms are worse off and this is illustrated by the smaller producer surplus. However, the amount that producers are worse off is smaller than the benefit obtained by consumers. Consequently, there is a net increase in social welfare for the embedded economy. Embedded Economy is a Net Exporter The embedded economy is a net exporter for a market when the price of the surrounding economy is greater than what would clear the embedded market. This higher price results in firms within the embedded economy producing additional units of this good or service because they are able to sell them to consumers from the surrounding economy. Consumers are worse off and this is illustrated by the smaller consumer surplus. However, the amount that households are worse off is smaller than the benefit obtained by firms. Consequently, there is a net increase in social welfare for the embedded economy. 2

3 Effect of Tax by Surrounding Economy When the surrounding economy imposes a tax on its product the price consumers pay will increase. Since the encompassing economy is larger, the price in the embedded economy is that which clears the surrounding economy. In all cases the price paid for consumers in the embedded economy increases. No Net Flow of Goods In the graph below, the loss to consumer surplus caused by the higher price for households is surpassed by the increase in producer surplus because firms produce additional units of the product and receive a higher price for its sale. This results in an overall increase in social welfare for the embedded economy and in the embedded economy becoming an net exporter of the good to the surrounding economy. 3

4 Embedded Economy is a Net Importer When the embedded economy is a net importer in the market, the loss to consumer surplus caused by the higher price for households is greater than the increase to producer surplus. This results in an overall decrease in social welfare (or dead-weight loss) and net imports for the embedded economy. This makes sense because embedded consumers are primarily obtaining the product from the outside economy and are much better off doing so because the cost of producing these units by embedded firms is larger than the price of the product in the outside market. 4

5 Embedded Economy is a Net Exporter When the embedded economy is a net exporter in the market, the gain to producer surplus from the higher price for firms is greater than the decrease to consumer surplus. This results in an overall increase in social welfare and net exports for the embedded economy. Again, this is because embedded firms are more efficient at producing the product than the outside economy. As a consequence, embedded firms are much better off producing these units and the extra benefit obtained by embedded households from consuming these fewer units is less than the price firms receive from producing it for outside consumers. 5

6 Effect of Subsidy by Embedded Economy When the surrounding economy pays out a subsidy to its firms for producing goods and services firms will produce additional units but the embedded consumers will not benefit from a lower price. Again, price is determined in the larger encompassing economy. In all cases the embedded economy suffers a dead-weight loss. No Net Flow of Goods In the situation below, the embedded economy turns into a net exporter of the good or service and there is an increase in the producer surplus. However, since the consumer does not receive a lower price, the firm is the sole beneficiary from any subsidy. Furthermore, the extra benefit to the firm from the subsidy is less than the pay out by the embedded government. The end result is a dead-weight loss for the embedded economy from this policy. 6

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8 Embedded Economy is a Net Importer 8

9 When the embedded economy is a net importer, there is a decrease in the level of imports and it may even turn into a net exporter of the good or service. As a consequence, there is an increase in the producer surplus and again the firm is the sole beneficiary from any subsidy. As in earlier cases, the extra benefit to the firm from the subsidy is less than the pay out by the embedded government and there is a dead-weight loss for the embedded economy. Embedded Economy is a Net Exporter When the embedded economy is a net exporter, there is an increase in the level of exports and an increase in the producer surplus. Again, the firm is the sole beneficiary from any subsidy, the extra benefit to the firm from the subsidy is less than the pay out by the embedded government and there is a dead-weight loss for the embedded economy. Special Cases Change in Profits for Individual Firm As you would expect, firms in the embedded economy benefit from the surrounding economy imposing a tax. Hence, the propensity for Native Nations to sell cigarettes and gasoline; 9

10 two goods that are heavily taxed. The individual firm will produce additional units and sell its product for a higher price. This result could have been inferred from our earlier analysis concerning the relationship between taxes and the producer surplus. Impact of Minimum Wage in Surrounding Economy When the surrounding economy imposes a price floor, or Minimum wage, the embedded economy looses. The wage rate is too high for the embedded economy to achieve equilibrium and it becomes a net exporter. In the case of the labor market, workers who wish to remain on the reservation will find it hard to find a job and the level of unemployment will be significant. We do not need a minimum wage in the encompassing economy to achieve this result. This is still likely to happen when the prevailing wage in the outside market is higher than that in the embedded economy. This result mirrors what we see in the Native Labor market in that the model predicts high unemployment rates and highly educated individuals leaving to participate in the surrounding labor market. 10