Adam Smith Theorem. Lecture 4(ii) Announcements. Lecture. 0. Link between efficiency and the market allocation.

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1 Lecture (ii) Announcements Experiment Thur am pm pm Friday pm (Only participate once!) Midterm Mon Oct, pm-pm Covers Lec(i) through Lec(ii) Deadline to register for the makeup without penalty is Mon Oct, pm. Question and Answer Sessions Wed Oct : -:pm (Anderson ) :-pm (Blegen ) Lecture. Link between efficiency and the market allocation. Adam Smith Theorem. Equilibrium with taxes. Who bears the burden of the tax?. Efficiency and Taxes Thur, Oct : :-pm (Anderson )

2 Last class determined rules for efficiency in Econland Name Res. Price Cost Name D S D S D S D S D S D S D S D S D S D S General Principle : Efficient Allocation of Consumption General Principle. Efficient Allocation of Production General Principle : Efficient Quantity In any efficient allocation, the quantity is where the marginal valuation of the last unit consumed equals the marginal cost of the last unit produced. Principles,, and imply that in an efficient allocation for the widget industry in Econ land: Q = S, S, S, S, S produce D, D, D, D, D consume

3 Dollars Quantity Q efficient Q efficient =, Social Surplus equals: ++++ = All of this should look familiar. Let s link this to the market Marginal Cost Marginal reservation price Market Allocation: P Dollars Q market Quantity Q =, S, S, S, S, S produce, D, D, D, D, D consume Market Allocation is Pareto Efficient! S D

4 Big Idea Assume. Market structure is perfectly competitive (not monopoly or oligopoly). No externalities (my action hurts or benefits others, but I don t take into account. Like pollution.) Then the unregulated market (laissez-faire) allocation is Pareto efficient. (It maximizes the size of the social pie.) First Welfare Theorem Adam Smith was on to this. Wealth of Nations, Every individual... neither intends to promote the public interest, nor knows how much he is promoting it (but) by directing thatt industry (to) its greatest value e, he is led by an invisible hand to prom mote an end whichh was no part of his intention.

5 The First Welfare Theorem also sometimes called: Adam Smith Theorem or Invisible Hand Theorem Now while the market maximizes the size of the pie (under the assumptions given above), you might not like the way it is divided up. Market delivers on efficiency. Not necessarily on equity. Next lectures: Study government interventions into the market. Use Econland to examine how government policy affects efficiency. We look at the size of the pie and the distribution of the pie. We look at: Taxes and Subsidies Cap and Trade Price Ceilings and Price Floors (rent control, minimum wage)

6 Taxes Big Picture: We will see how taxes distort decision making in Econland With taxes we won t be getting socially efficient quantity (But remember, no externalities here) But government gets revenue and it might do something useful with it.

7 Taxes Tax is a wedge between price consumer pays and price producer receives P D = tax + P S To find equilibrium under tax, find quantity where distance between demand and supply equals the tax. Taxes in Econland Equilibrium when tax = \$ \$ S D Q Tax = \$. Pick up and put on graph so top hits Demand (at point pd) and bottom hits Supply (at point ps)

8 Econland Effects of \$ Widget Tax \$ S D Q Equilibrium with tax of,, and?

9 Effects of tax on Price and Quantity Great question: Are we always on the left side of the free market quantity with a tax? Q P S P D No Tax \$ tax Change What about a \$ widget subsidy P D = P S + tax P S = P D + subsidy

10 Subsidy in Econland Equilibrium when subsidy = \$ \$ S D Q Subsidy = \$. Pick up and put on graph so top hits Supply (at point p S ) and bottom hits Demand (at point p D ) Great question: In Econland, after the \$ tax, P D = +\$, P S = \$. Do buyers and sellers always split the tax /? Burden of the tax depends on the elasticity of supply and demand.

11 Suppose supply is perfectly elastic: S D Q \$ Suppose supply is perfectly inelastic S D Q \$

12 The less elastic the side of the market you are on, the more you pay of the tax! Let s look at retail gas prices and gas taxes across countries from homework. Key point: the world oil market is global. Since any one country tends to be small, its own demand has a small impact on world market. If Spain doubles its demand, it won t impact the global market This means the market for oil in Spain looks like \$ S D Q Theory implies a gas tax in Spain gets passed on to consumers, Euro for Euro.

13 Tax P S P D Plot Tax and P D How does the theory do? Gas Price (\$ per gallon) US Gass Taxes and Gas Prices y =.x +. Canada Spain Japan Ger..... Gas Tax (\$ per gallon)

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

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

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

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

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

19 Change in Government Surplus GS = Q tax = = Allocation with tax not Pareto Efficient. Deadweight loss.

20 Diagnosis of the Source of Inefficiency. Problem: Breakdown of General Principle, Efficient Quantity where Marginal Reservation Price (MRP) equal to Marginal Cost (MC). Q = is too small (Tax puts wedge between MRP and MC) (But note General Principle and continue to hold. Get efficient allocation of consumption and production.)