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Consumers, Producers, and

the Efficiency of Markets Premium PowerPoint

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N. Gregory Mankiw

Macroeconomics Principles of

Sixth Edition

In this chapter,

look for the answers to these questions:

• What is consumer surplus? How is it related to the demand curve?

• What is producer surplus? How is it related to the supply curve?

• Do markets produce a desirable allocation of resources? Or could the market outcome be

improved upon?

Welfare Economics

▪ Recall, the allocation of resources refers to:

▪ how much of each good is produced

▪ which producers produce it

▪ which consumers consume it

▪ Welfare economics studies how the allocation

of resources affects economic well-being.

▪ First, we look at the well-being of consumers.

Willingness to Pay (WTP)

A buyer’s willingness to pay for a good is the

maximum amount the buyer will pay for that good.

WTP measures how much the buyer values the good.

name WTP

Anthony $250

Chad 175

Flea 300

John 125

Example:

4 buyers’ WTP

for an iPod

WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod, and

what is quantity demanded?

A: Anthony & Flea will buy an iPod,

Chad & John will not.

Hence, Qd = 2

when P = $200.

name WTP

Anthony $250

Chad 175

Flea 300

John 125

WTP and the Demand Curve

Derive the

demand

schedule:

4 John, Chad,

Anthony, Flea 0 – 125

3 Chad, Anthony,

Flea 126 – 175

2 Anthony, Flea 176 – 250

1 Flea 251 – 300

0 nobody $301 & up

Qd who buys P (price

of iPod)

name WTP

Anthony $250

Chad 175

Flea 300

John 125

WTP and the Demand Curve

P Qd

$301 & up 0

251 – 300 1

176 – 250 2

126 – 175 3

0 – 125 4

About the Staircase Shape…

This D curve looks like a staircase with 4 steps – one per buyer.

If there were a huge # of buyers,

as in a competitive market,

there would be a huge #

of very tiny steps,

and it would look

more like a smooth

curve.

WTP and the Demand Curve

At any Q,

the height of

the D curve is

the WTP of the

marginal buyer,

the buyer who

would leave the

market if P were

any higher.

Flea’s WTP

Anthony’s WTP

Chad’s WTP John’s

WTP

Consumer Surplus (CS)

Consumer surplus is the amount a buyer is willing

to pay minus the amount the buyer actually pays:

CS = WTP – P

name WTP

Anthony $250

Chad 175

Flea 300

John 125

Suppose P = $260.

Flea’s CS = $300 – 260 = $40.

The others get no CS because

they do not buy an iPod at this

price.

Total CS = $40.

CS and the Demand Curve P

Flea’s WTP P = $260

Flea’s CS =

$300 – 260 = $40

Total CS = $40

CS and the Demand Curve P

Flea’s WTP

Anthony’s WTP

Instead, suppose

P = $220

Flea’s CS =

$300 – 220 = $80

Anthony’s CS =

$250 – 220 = $30

Total CS = $110

CS and the Demand Curve P

The lesson:

Total CS equals

the area under

the demand curve

above the price,

from 0 to Q.

CS with Lots of Buyers & a Smooth D Curve

The demand for shoes

1000s of pairs

of shoes

Price

per pair

At Q = 5(thousand),

the marginal buyer

is willing to pay $50

for pair of shoes.

Suppose P = $30.

Then his consumer

surplus = $20.

CS with Lots of Buyers & a Smooth D Curve

The demand for shoes

CS is the area b/w

P and the D curve,

from 0 to Q.

Recall: area of

a triangle equals

½ x base x height

Height =

$60 – 30 = $30.

So,

CS = ½ x 15 x $30

= $225.

How a Higher Price Reduces CS

If P rises to $40,

CS = ½ x 10 x $20

= $100.

Two reasons for the

fall in CS.

1. Fall in CS

due to buyers

leaving market

2. Fall in CS due to

remaining buyers

paying higher P

demand curve

A. Find marginal

buyer’s WTP at

Q = 10.

B. Find CS for

P = $30.

Suppose P falls to $20. How much will CS

increase due to…

C. buyers entering

the market

D. existing buyers

paying lower price

ACTIVE LEARNING 1 Consumer surplus

ACTIVE LEARNING 1 Answers

demand curve

A. At Q = 10, marginal buyer’s WTP is $30.

B. CS = ½ x 10 x $10

= $50

P falls to $20.

C. CS for the

additional buyers

= ½ x 10 x $10 = $50

D. Increase in CS

on initial 10 units

= 10 x $10 = $100

Cost and the Supply Curve

name cost

Jack $10

Janet 20

Chrissy 35

A seller will produce and sell

the good/service only if the

price exceeds his or her cost.

Hence, cost is a measure of

willingness to sell.

▪ Cost is the value of everything a seller must give

up to produce a good (i.e., opportunity cost).

▪ Includes cost of all resources used to produce

good, including value of the seller’s time.

▪ Example: Costs of 3 sellers in the lawn-cutting

business.

Cost and the Supply Curve

3 35 & up

2 20 – 34

1 10 – 19

0 $0 – 9

Qs P Derive the supply schedule

from the cost data:

name cost

Jack $10

Janet 20

Chrissy 35

Cost and the Supply Curve

P Qs

$0 – 9 0

10 – 19 1

20 – 34 2

35 & up 3

Cost and the Supply Curve

At each Q,

the height of

the S curve

is the cost of the

marginal seller,

the seller who

would leave

the market if

the price were

any lower.

Chrissy’s

cost

Janet’s

cost

Jack’s cost

Producer Surplus

Producer surplus (PS):

the amount a seller

is paid for a good

minus the seller’s cost

PS = P – cost

Producer Surplus and the S Curve

PS = P – cost

Suppose P = $25.

Jack’s PS = $15

Janet’s PS = $5

Chrissy’s PS = $0

Total PS = $20

Janet’s

cost

Jack’s cost

Total PS equals the

area above the supply

curve under the price,

from 0 to Q.

Chrissy’s

cost

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

1000s of pairs

of shoes

Price

per pair

Suppose P = $40.

At Q = 15(thousand),

the marginal seller’s

cost is $30,

and her producer

surplus is $10.

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

PS is the area b/w

P and the S curve, from 0 to Q.

The height of this

triangle is

$40 – 15 = $25.

So,

PS = ½ x b x h

= ½ x 25 x $25

= $312.50

How a Lower Price Reduces PS

If P falls to $30,

PS = ½ x 15 x $15

= $112.50

Two reasons for

the fall in PS.

1. Fall in PS

due to sellers

leaving market

2. Fall in PS due to

remaining sellers

getting lower P

ACTIVE LEARNING 2 Producer surplus

supply curve

A. Find marginal

seller’s cost

at Q = 10.

B. Find total PS for

P = $20.

Suppose P rises to $30. Find the increase

in PS due to:

C. selling 5

additional units

D. getting a higher price

on the initial 10 units

ACTIVE LEARNING 2 Answers

supply curve

A. At Q = 10, marginal cost = $20

B. PS = ½ x 10 x $20

= $100

P rises to $30.

C. PS on

additional units

= ½ x 5 x $10 = $25

D. Increase in PS

on initial 10 units

= 10 x $10 = $100

CS, PS, and Total Surplus

CS = (value to buyers) – (amount paid by buyers)

= buyers’ gains from participating in the market

PS = (amount received by sellers) – (cost to sellers)

= sellers’ gains from participating in the market

Total surplus = CS + PS

= total gains from trade in a market

= (value to buyers) – (cost to sellers)

The Market’s Allocation of Resources

▪ In a market economy, the allocation of resources

is decentralized, determined by the interactions

of many self-interested buyers and sellers.

▪ Is the market’s allocation of resources desirable?

Or would a different allocation of resources make

society better off?

▪ To answer this, we use total surplus as a measure

of society’s well-being, and we consider whether

the market’s allocation is efficient.

(Policymakers also care about equality, though our

focus here is on efficiency.)

Efficiency

An allocation of resources is efficient if it maximizes

total surplus. Efficiency means:

▪ The goods are consumed by the buyers who

value them most highly.

▪ The goods are produced by the producers with the

lowest costs.

▪ Raising or lowering the quantity of a good

would not increase total surplus.

= (value to buyers) – (cost to sellers) Total

surplus

Evaluating the Market Equilibrium

Market eq’m:

P = $30

Q = 15,000

Total surplus

= CS + PS

Is the market eq’m

efficient?

Which Buyers Consume the Good?

Every buyer

whose WTP is

≥ $30 will buy.

Every buyer

whose WTP is

< $30 will not.

So, the buyers

who value the

good most highly

are the ones who

consume it.

Which Sellers Produce the Good?

Every seller whose

cost is ≤ $30 will

produce the good.

Every seller whose

cost is > $30 will

not.

So, the sellers with

the lowest cost

produce the good.

Does Eq’m Q Maximize Total Surplus?

At Q = 20,

cost of producing

the marginal unit

is $35

value to consumers

of the marginal unit

is only $20

Hence, can increase

total surplus

by reducing Q.

This is true at any Q

greater than 15.

Does Eq’m Q Maximize Total Surplus?

At Q = 10,

cost of producing

the marginal unit

is $25

value to consumers

of the marginal unit

is $40

Hence, can increase

total surplus

by increasing Q.

This is true at any Q

less than 15.

Does Eq’m Q Maximize Total Surplus?

The market

eq’m quantity

maximizes

total surplus:

At any other

quantity,

can increase

total surplus by

moving toward

the market eq’m

quantity.

Adam Smith and the Invisible Hand

―Man has almost constant occasion

for the help of his brethren, and it is

vain for him to expect it from their

benevolence only.

Adam Smith,

1723-1790

Passages from The Wealth of Nations, 1776

He will be more

likely to prevail if he can interest their

self-love in his favor, and show them

that it is for their own advantage to do

for him what he requires of them…

It is not from the benevolence of the

butcher, the brewer, or the baker that

we expect our dinner, but from their

regard to their own interest….

Adam Smith and the Invisible Hand

―Every individual…neither intends to

promote the public interest, nor knows

how much he is promoting it….

Adam Smith,

1723-1790

Passages from The Wealth of Nations, 1776

He intends only his own gain, and he is

in this, as in many other cases, led by

an invisible hand to promote an end

which was no part of his intention.

Nor is it always the worse for the society

that it was no part of it. By pursuing his

own interest he frequently promotes

that of the society more effectually than

when he really intends to promote it.‖

an invisible hand

The Free Market vs. Govt Intervention

▪ The market equilibrium is efficient. No other

outcome achieves higher total surplus.

▪ Govt cannot raise total surplus by changing the

market’s allocation of resources.

▪ Laissez faire (French for ―allow them to do‖):

the notion that govt should not interfere with the

market.

The Free Market vs. Central Planning

▪ Suppose resources were allocated not by the

market, but by a central planner who cares about

society’s well-being.

▪ To allocate resources efficiently and maximize total

surplus, the planner would need to know every

seller’s cost and every buyer’s WTP for every good

in the entire economy.

▪ This is impossible, and why centrally-planned

economies are never very efficient.

CONCLUSION

▪ This chapter used welfare economics to

demonstrate one of the Ten Principles:

Markets are usually a good way to

organize economic activity.

▪ Important note:

We derived these lessons assuming

perfectly competitive markets.

▪ In other conditions we will study in later

chapters, the market may fail to allocate

resources efficiently…

CONCLUSION

▪ Such market failures occur when:

▪ a buyer or seller has market power—the ability to

affect the market price.

▪ transactions have side effects, called externalities,

that affect bystanders. (example: pollution)

▪ We’ll use welfare economics to see how public policy

may improve on the market outcome in such cases.

▪ Despite the possibility of market failure, the analysis

in this chapter applies in many markets, and the

invisible hand remains extremely important.

SUMMARY

• The height of the D curve reflects the value of the good to buyers—their willingness to pay for it.

• Consumer surplus is the difference between what buyers are willing to pay for a good and what they

actually pay.

• On the graph, consumer surplus is the area between P and the D curve.

SUMMARY

• The height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if

the price they get is at least as high as their cost.

• Producer surplus is the difference between what sellers receive for a good and their cost of

producing it.

• On the graph, producer surplus is the area between P and the S curve.

SUMMARY

• To measure society’s well-being, we use total surplus, the sum of consumer and producer

surplus.

• Efficiency means that total surplus is maximized, that the goods are produced by sellers with

lowest cost, and that they are consumed by

buyers who most value them.

• Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus.

Application:

The Costs of Taxation Premium PowerPoint

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

N. Gregory Mankiw

Macroeconomics Principles of

Sixth Edition

In this chapter,

look for the answers to these questions:

• How does a tax affect consumer surplus, producer surplus, and total surplus?

• What is the deadweight loss of a tax?

• What factors determine the size of this deadweight loss?

• How does tax revenue depend on the size of the tax?

Review from Chapter 6

▪ A tax

▪ drives a wedge between the price buyers pay

and the price sellers receive.

▪ raises the price buyers pay and lowers the price

sellers receive.

▪ reduces the quantity bought & sold.

▪ These effects are the same whether the tax is

imposed on buyers or sellers, so we do not

make this distinction in this chapter.

The Effects of a Tax P

Eq’m with no tax:

Price = PE

Quantity = QE

Eq’m with

tax = $T per unit:

Sellers receive PS

Quantity = QT

Buyers pay PB

Size of tax = $T

The Effects of a Tax P

Revenue from tax:

$T x QT

QE QT

Size of tax = $T

The Effects of a Tax

▪ Next, we apply welfare economics to measure

the gains and losses from a tax.

▪ We determine consumer surplus (CS),

producer surplus (PS), tax revenue,

and total surplus with and without the tax.

▪ Tax revenue can fund beneficial services

(e.g., education, roads, police),

so we include it in total surplus.

The Effects of a Tax P

Without a tax,

QE QT

B C

D E

CS = A + B + C

PS = D + E + F

Tax revenue = 0

Total surplus

= CS + PS

= A + B + C

+ D + E + F

The Effects of a Tax P

QE QT

B C

D E

CS = A

PS = F

Tax revenue

= B + D

Total surplus

= A + B

+ D + F

With the tax,

The tax reduces

total surplus by

C + E

The Effects of a Tax P

QE QT

B C

D E

C + E is called the

deadweight loss

(DWL) of the tax,

the fall in total

surplus that

results from a

market distortion,

such as a tax.

About the Deadweight Loss P

QE QT

Because of the tax,

the units between

QT and QE are not

sold.

The value of these

units to buyers is

greater than the cost

of producing them,

so the tax prevents

some mutually

beneficial trades.

ACTIVE LEARNING 1 Analysis of tax

A. Compute

CS, PS, and

total surplus

without a tax.

B. If $100 tax

per ticket,

compute

CS, PS,

tax revenue,

total surplus,

and DWL.

The market for

airplane tickets

ACTIVE LEARNING 1 Answers to A

= ½ x $200 x 100

= $10,000

Total surplus

= $10,000 + $10,000

= $20,000

= ½ x $200 x 100

= $10,000

P =

The market for

airplane tickets

ACTIVE LEARNING 1 Answers to B

= ½ x $150 x 75

= $5,625

Total surplus

= $18,750

PS = $5,625

Tax revenue

= $100 x 75

= $7,500

DWL = $1,250

PS =

PB =

A $100 tax on

airplane tickets

What Determines the Size of the DWL?

▪ Which goods or services should govt tax

to raise the revenue it needs?

▪ One answer: those with the smallest DWL.

▪ When is the DWL small vs. large?

Turns out it depends on the price elasticities

of supply and demand.

▪ Recall:

The price elasticity of demand (or supply)

measures how much QD (or QS) changes

when P changes.

When supply

is inelastic,

it’s harder for firms

to leave the market

when the tax

reduces PS.

So, the tax only

reduces Q a little,

and DWL is small.

DWL and the Elasticity of Supply

Size

of tax

DWL and the Elasticity of Supply

Size

of tax

The more elastic is

supply,

the easier for firms

to leave the market

when the tax

reduces PS,

the greater Q falls

below the surplus-

maximizing quantity,

the greater the DWL.

DWL and the Elasticity of Demand

Size

of tax

When demand

is inelastic,

it’s harder for

consumers to

leave the market

when the tax

raises PB.

So, the tax only

reduces Q a little,

and DWL is small.

DWL and the Elasticity of Demand

Size

of tax

The more elastic is

demand,

the easier for buyers

to leave the market

when the tax

increases PB,

the more Q falls

below the surplus-

maximizing quantity,

and the greater the

DWL.

ACTIVE LEARNING 2 Elasticity and the DWL of a tax

Would the DWL of a tax be larger if the

tax were on:

A. Breakfast cereal or sunscreen?

B. Hotel rooms in the short run or

hotel rooms in the long run?

C. Groceries or meals at fancy restaurants?

ACTIVE LEARNING 2 Answers

A. Breakfast cereal or sunscreen

From Chapter 5:

Breakfast cereal has more close substitutes

than sunscreen, so demand for breakfast cereal

is more price-elastic than demand for

sunscreen.

So, a tax on breakfast cereal would cause a

larger DWL than a tax on sunscreen.

ACTIVE LEARNING 2 Answers

B. Hotel rooms in the short run or long run

From Chapter 5:

The price elasticities of demand and supply

for hotel rooms are larger in the long run than

in the short run.

So, a tax on hotel rooms would cause a larger

DWL in the long run than in the short run.

ACTIVE LEARNING 2 Answers

C. Groceries or meals at fancy restaurants

From Chapter 5:

Groceries are more of a necessity and therefore

less price-elastic than meals at

fancy restaurants.

So, a tax on restaurant meals would cause a

larger DWL than a tax on groceries.

ACTIVE LEARNING 3 Discussion question

▪ The government must raise tax revenue to pay

for schools, police, etc. To do this, it can either

tax groceries or meals at fancy restaurants.

▪ Which should it tax?

How Big Should the Government Be?

▪ A bigger government provides more services,

but requires higher taxes, which cause DWLs.

▪ The larger the DWL from taxation,

the greater the argument for smaller government.

▪ The tax on labor income is especially important;

it’s the biggest source of govt revenue.

▪ For the typical worker, the marginal tax rate

(the tax on the last dollar of earnings) is about 40%.

▪ How big is the DWL from this tax?

It depends on elasticity….

How Big Should the Government Be?

▪ If labor supply is inelastic, then this DWL is

small.

▪ Some economists believe labor supply is

inelastic, arguing that most workers work

full-time regardless of the wage.

How Big Should the Government Be?

Other economists believe labor taxes are highly

distorting because some groups of workers have

elastic supply and can respond to incentives:

▪ Many workers can adjust their hours,

e.g., by working overtime.

▪ Many families have a 2nd earner with discretion

over whether and how much to work.

▪ Many elderly choose when to retire based on the

wage they earn.

▪ Some people work in the “underground economy”

to evade high taxes.

The Effects of Changing the Size of the Tax

▪ Policymakers often change taxes, raising some

and lowering others.

▪ What happens to DWL and tax revenue when

taxes change? We explore this next….

Q2 Q1

DWL and the Size of the Tax

causes the DWL

to more than

double.

Doubling the tax

2T T

Initially, the tax is

T per unit.

initial

DWL

new

DWL

DWL and the Size of the Tax

3T T causes the DWL

to more than

triple.

Tripling the tax

Initially, the tax is

T per unit.

initial

DWL

new

DWL

DWL and the Size of the Tax

DWL

Tax size

Summary

When a tax increases,

DWL rises even more.

Implication

When tax rates are

low, raising them

doesn’t cause much

harm, and lowering

them doesn’t bring

much benefit.

When tax rates are

high, raising them is

very harmful, and

cutting them is very

beneficial.

Revenue and the Size of the Tax

2T T

When the

tax is small,

increasing it

causes tax

revenue to rise.

Revenue and the Size of the Tax

3T 2T When the

tax is larger,

increasing it

causes tax

revenue to fall.

The Laffer curve

shows the

relationship

between

the size of the tax

and tax revenue.

Revenue and the Size of the Tax

Tax size

Tax

revenue

The Laffer curve

SUMMARY

• A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds

the revenue the tax raises for the govt.

• The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the

deadweight loss (DWL) of the tax.

• A tax has a DWL because it causes consumers to buy less and producers to sell less, thus

shrinking the market below the level that

maximizes total surplus.

SUMMARY

• The price elasticities of demand and supply measure how much buyers and sellers respond

to price changes. Therefore, higher elasticities

imply higher DWLs.

• An increase in the size of a tax causes the DWL to rise even more.

• An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls

because the tax reduces the size of the market.

Application:

International Trade Premium PowerPoint

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

N. Gregory Mankiw

Macroeconomics Principles of

Sixth Edition

In this chapter,

look for the answers to these questions:

• What determines how much of a good a country will import or export?

• Who benefits from trade? Who does trade harm? Do the gains outweigh the losses?

• If policymakers restrict imports, who benefits? Who is harmed? Do the gains from restricting

imports outweigh the losses?

• What are some common arguments for restricting trade? Do they have merit?

Introduction

▪ Recall from Chapter 3:

A country has a comparative advantage in a

good if it produces the good at lower opportunity

cost than other countries.

Countries can gain from trade if each exports the

goods in which it has a comparative advantage.

▪ Now we apply the tools of welfare economics

to see where these gains come from and

who gets them.

The World Price and Comparative Advantage

▪ PW = the world price of a good,

the price that prevails in world markets

▪ PD = domestic price without trade

▪ If PD < PW,

▪ country has comparative advantage in the good

▪ under free trade, country exports the good

▪ If PD > PW,

▪ country does not have comparative advantage

▪ under free trade, country imports the good

The Small Economy Assumption

▪ A small economy is a price taker in world markets:

Its actions have no effect on PW.

▪ Not always true—especially for the U.S.—but

simplifies the analysis without changing its lessons.

▪ When a small economy engages in free trade,

PW is the only relevant price:

▪ No seller would accept less than PW, since

she could sell the good for PW in world markets.

▪ No buyer would pay more than PW, since

he could buy the good for PW in world markets.

A Country That Exports Soybeans Without trade,

PD = $4

Q = 500

PW = $6

Under free trade,

▪ domestic

consumers

demand 300

▪ domestic producers

supply 750

▪ exports = 450

500 300

Soybeans

exports

750

A Country That Exports Soybeans Without trade,

CS = A + B

PS = C

Total surplus

= A + B + C

With trade,

CS = A

PS = B + C + D

Total surplus

= A + B + C + D

Soybeans

exports A

B D

C gains

from trade

Without trade,

PD = $3000, Q = 400

In world markets,

PW = $1500

Under free trade,

how many TVs

will the country

import or export?

Identify CS, PS, and

total surplus without

trade, and with trade.

$1500

200

$3000

400 600

Plasma TVs

ACTIVE LEARNING 1 Analysis of trade

Under free trade,

▪ domestic consumers

demand 600

▪ domestic producers

supply 200

▪ imports = 400

$1500

200

$3000

600

Plasma TVs

imports

ACTIVE LEARNING 1 Answers

Without trade,

CS = A

PS = B + C

Total surplus

= A + B + C

With trade,

CS = A + B + D

PS = C

Total surplus

= A + B + C + D

$1500

$3000

Plasma TVs

B D

gains

from trade

imports

ACTIVE LEARNING 1 Answers

total surplus

producer surplus

consumer surplus

direction of trade

rises

falls

rises

imports

PD > PW

rises

falls

exports

PD < PW

Summary: The Welfare Effects of Trade

Whether a good is imported or exported,

trade creates winners and losers.

But the gains exceed the losses.

Other Benefits of International Trade

▪ Consumers enjoy increased variety of goods.

▪ Producers sell to a larger market, may achieve

lower costs by producing on a larger scale.

▪ Competition from abroad may reduce market

power of domestic firms, which would increase

total welfare.

▪ Trade enhances the flow of ideas, facilitates the

spread of technology around the world.

Then Why All the Opposition to Trade?

▪ Recall one of the Ten Principles from Chapter 1:

Trade can make everyone better off.

▪ The winners from trade could compensate the losers

and still be better off.

▪ Yet, such compensation rarely occurs.

▪ The losses are often highly concentrated among

a small group of people, who feel them acutely.

The gains are often spread thinly over many people,

who may not see how trade benefits them.

▪ Hence, the losers have more incentive to organize

and lobby for restrictions on trade.

Tariff: An Example of a Trade Restriction

▪ Tariff: a tax on imports

▪ Example: Cotton shirts

PW = $20

Tariff: T = $10/shirt

Consumers must pay $30 for an imported shirt.

So, domestic producers can charge $30 per shirt.

▪ In general, the price facing domestic buyers &

sellers equals (PW + T ).

$30

Analysis of a Tariff on Cotton Shirts

PW = $20

Free trade:

buyers demand 80

sellers supply 25

imports = 55

T = $10/shirt

price rises to $30

buyers demand 70

sellers supply 40

imports = 30

$20

Cotton shirts

40 70 80

imports imports

$30

Analysis of a Tariff on Cotton Shirts

Free trade

CS = A + B + C

+ D + E + F

PS = G

Total surplus = A + B

+ C + D + E + F + G

Tariff

CS = A + B

PS = C + G

Revenue = E

Total surplus = A + B

+ C + E + G

$20

Cotton shirts

D E

F C

70 80

deadweight

loss = D + F

$30

Analysis of a Tariff on Cotton Shirts

D = deadweight loss

from the

overproduction

of shirts

F = deadweight loss

from the under-

consumption

of shirts

$20

Cotton shirts

D E

F C

70 80

deadweight

loss = D + F

Import Quotas: Another Way to Restrict Trade

▪ An import quota is a quantitative limit on imports

of a good.

▪ Mostly has the same effects as a tariff:

▪ Raises price, reduces quantity of imports.

▪ Reduces buyers’ welfare.

▪ Increases sellers’ welfare.

▪ A tariff creates revenue for the govt. A quota

creates profits for the foreign producers of the

imported goods, who can sell them at higher price.

▪ Or, govt could auction licenses to import to

capture this profit as revenue. Usually it does not.

Arguments for Restricting Trade

1. The jobs argument

Trade destroys jobs in industries that compete

with imports.

Economists’ response:

Look at the data to see whether rising imports

cause rising unemployment…

U.S. Imports & Unemployment, Decade averages, 1961–2010

1 9

6 1

1 9

7 0

1 9

7 1

1 9

8 0

1 9

8 1

1 9

9 0

1 9

9 1

2 0

0 0

2 0

0 1

2 0

1 0

Imports

(% of GDP)

Unemployment

(% of labor force)

Arguments for Restricting Trade

1. The jobs argument

Trade destroys jobs in the industries that compete

against imports.

Economists’ response:

Total unemployment does not rise as imports rise,

because job losses from imports are offset by

job gains in export industries.

Even if all goods could be produced more cheaply abroad, the country need only have a

comparative advantage to have a viable export industry and to gain from trade.

Arguments for Restricting Trade

2. The national security argument

An industry vital to national security should be

protected from foreign competition, to prevent

dependence on imports that could be disrupted

during wartime.

Economists’ response:

Fine, as long as we base policy on true security

needs.

But producers may exaggerate their own

importance to national security to obtain

protection from foreign competition.

Arguments for Restricting Trade

3. The infant-industry argument

A new industry argues for temporary protection

until it is mature and can compete with foreign

firms.

Economists’ response:

Difficult for govt to determine which industries

will eventually be able to compete and whether

benefits of establishing these industries exceed

cost to consumers of restricting imports.

Besides, if a firm will be profitable in the long run,

it should be willing to incur temporary losses.

Arguments for Restricting Trade

4. The unfair-competition argument

Producers argue their competitors in another

country have an unfair advantage,

e.g. due to govt subsidies.

Economists’ response:

Great! Then we can import extra-cheap products

subsidized by the other country’s taxpayers.

The gains to our consumers will exceed the

losses to our producers.

Arguments for Restricting Trade

5. The protection-as-bargaining-chip argument

Example: The U.S. can threaten to limit imports

of French wine unless France lifts their quotas

on American beef.

Economists’ response:

Suppose France refuses. Then the U.S. must

choose between two bad options:

A) Restrict imports from France, which reduces

welfare in the U.S.

B) Don’t restrict imports, which reduces U.S.

credibility.

Trade Agreements

▪ A country can liberalize trade with

▪ unilateral reductions in trade restrictions

▪ multilateral agreements with other nations

▪ Examples of trade agreements:

▪ North American Free Trade Agreement

(NAFTA), 1993

▪ General Agreement on Tariffs and Trade

(GATT), ongoing

▪ World Trade Organization (WTO), est. 1995,

enforces trade agreements, resolves disputes

SUMMARY

• A country will export a good if the world price of the good is higher than the domestic price without trade.

Trade raises producer surplus, reduces consumer

surplus, and raises total surplus.

• A country will import a good if the world price is lower than the domestic price without trade.

Trade lowers producer surplus but raises consumer

and total surplus.

• A tariff benefits producers and generates revenue for the govt, but the losses to consumers exceed

these gains.

SUMMARY

• Common arguments for restricting trade include: protecting jobs, defending national security,

helping infant industries, preventing unfair

competition, and responding to foreign trade

restrictions.

• Some of these arguments have merit in some cases, but economists believe free trade is

usually the better policy.

A Country That Imports Plasma TVs

Without trade,

PD = $3000

Q = 400

PW = $1500

Under free trade,

▪ domestic

consumers

demand 600

▪ domestic producers

supply 200

▪ imports = 400

$1500

200

$3000

400 600

Plasma TVs

imports

A Country That Imports Plasma TVs

Without trade,

CS = A

PS = B + C

Total surplus

= A + B + C

With trade,

CS = A + B + D

PS = C

Total surplus

= A + B + C + D

$1500

$3000

Plasma TVs

B D

gains

from trade

imports

On 12/31/2004,

U.S. quotas on

apparel & textile

products expired.

During Jan 2005:

▪ U.S. imports of these

products from China

increased over 70%.

▪ Loss of 12,000 jobs

in U.S. textile industry.

The U.S. textile industry

& labor unions fought for

new trade restrictions.

The National Retail

Federation opposed any

restrictions.

In the News: Textile Imports from China

November 2005:

Bush administration agreed

to limit growth in imports

from China.

Production and Growth

Premium PowerPoint

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

N. Gregory Mankiw

Macroeconomics Principles of

Sixth Edition

In this chapter,

look for the answers to these questions:

• What are the facts about living standards and growth rates around the world?

• Why does productivity matter for living standards?

• What determines productivity and its growth rate?

• How can public policy affect growth and living standards?

A typical family with all their possessions in the U.K., an advanced economy

GDP per capita: $36,130

Life expectancy: 80 years

Adult literacy: 99%

A typical family with all their possessions in Mexico, a middle income country

GDP per capita: $14,270

Life expectancy: 76 years

Adult literacy: 86%

A typical family with all their possessions in Mali, a poor country

GDP per capita: $1,090

Life expectancy: 52 years

Adult literacy: 46%

GDP per capita, 2009

Growth rate, 1970–2009

China $6,828 7.4%

Singapore $50,633 4.7%

India $3,296 3.3%

Japan $32,418 2.2%

Spain $32,150 2.1%

Israel $27,656 2.1%

Colombia $8,959 1.9%

United States $45,989 1.8%

Canada $37,808 1.7%

Philippines $3,542 1.3%

Rwanda $1,136 1.1%

New Zealand $28,993 1.1%

Argentina $14,538 1.0%

Saudi Arabia $23,480 0.6%

Chad $1,300 0.4%

Incomes and Growth Around the

World

FACT 1:

There are

vast

differences

in living

standards

around the

world.

GDP per capita, 2009

Growth rate, 1970–2009

China $6,828 7.4%

Singapore $50,633 4.7%

India $3,296 3.3%

Japan $32,418 2.2%

Spain $32,150 2.1%

Israel $27,656 2.1%

Colombia $8,959 1.9%

United States $45,989 1.8%

Canada $37,808 1.7%

Philippines $3,542 1.3%

Rwanda $1,136 1.1%

New Zealand $28,993 1.1%

Argentina $14,538 1.0%

Saudi Arabia $23,480 0.6%

Chad $1,300 0.4%

Incomes and Growth Around the

World

FACT 2:

There is

also great

variation

in growth

rates across

countries.

Incomes and Growth Around the World

Since growth rates vary, the country rankings can

change over time:

▪ Poor countries are not necessarily doomed to

poverty forever, e.g. Singapore incomes were

low in 1960 and are quite high now.

▪ Rich countries can’t take their status for

granted: They may be overtaken by poorer but

faster-growing countries.

Incomes and Growth Around the World

Questions:

▪ Why are some countries richer than others?

▪ Why do some countries grow quickly while

others seem stuck in a poverty trap?

▪ What policies may help raise growth rates and

long-run living standards?

Productivity

▪ Recall one of the Ten Principles from Chap. 1:

A country’s standard of living depends

on its ability to produce g&s.

▪ This ability depends on productivity,

the average quantity of g&s produced

per unit of labor input.

▪ Y = real GDP = quantity of output produced

L = quantity of labor

so productivity = Y/L (output per worker)

Why Productivity Is So Important

▪ When a nation’s workers are very productive,

real GDP is large and incomes are high.

▪ When productivity grows rapidly, so do living

standards.

▪ What, then, determines productivity and its

growth rate?

Physical Capital Per Worker

▪ Recall: The stock of equipment and structures

used to produce g&s is called [physical] capital,

denoted K.

▪ K/L = capital per worker.

▪ Productivity is higher when the average worker

has more capital (machines, equipment, etc.).

▪ i.e.,

an increase in K/L causes an increase in Y/L.

Human Capital Per Worker

▪ Human capital (H):

the knowledge and skills workers acquire

through education, training, and experience

▪ H/L = the average worker’s human capital

▪ Productivity is higher when the average worker

has more human capital (education, skills, etc.).

▪ i.e.,

an increase in H/L causes an increase in Y/L.

Natural Resources Per Worker

▪ Natural resources (N): the inputs into production

that nature provides, e.g., land, mineral deposits

▪ Other things equal,

more N allows a country to produce more Y.

In per-worker terms,

an increase in N/L causes an increase in Y/L.

▪ Some countries are rich because they have

abundant natural resources

(e.g., Saudi Arabia has lots of oil).

▪ But countries need not have much N to be rich

(e.g., Japan imports the N it needs).

Technological Knowledge

▪ Technological knowledge: society’s

understanding of the best ways to produce g&s

▪ Technological progress does not only mean

a faster computer, a higher-definition TV,

or a smaller cell phone.

▪ It means any advance in knowledge that boosts

productivity (allows society to get more output

from its resources).

▪ e.g., Henry Ford and the assembly line.

Tech. Knowledge vs. Human Capital

▪ Technological knowledge refers to society’s

understanding of how to produce g&s.

▪ Human capital results from the effort people

expend to acquire this knowledge.

▪ Both are important for productivity.

The Production Function

▪ The production function is a graph or equation

showing the relation between output and inputs:

Y = A F(L, K, H, N)

F( ) is a function that shows how inputs are

combined to produce output

―A‖ is the level of technology

▪ ―A‖ multiplies the function F( ),

so improvements in technology (increases in ―A‖)

allow more output (Y) to be produced from any

given combination of inputs.

The Production Function

▪ The production function has the property

constant returns to scale: Changing all inputs

by the same percentage causes output to change

by that percentage. For example,

▪ Doubling all inputs (multiplying each by 2)

causes output to double:

Y = A F(L, K, H, N)

2Y = A F(2L, 2K, 2H, 2N)

▪ Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10%:

1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)

The Production Function

▪ If we multiply each input by 1/L, then

output is multiplied by 1/L:

Y/L = A F(1, K/L, H/L, N/L)

▪ This equation shows that productivity

(output per worker) depends on:

▪ the level of technology (A)

▪ physical capital per worker

▪ human capital per worker

▪ natural resources per worker

Y = A F(L, K, H, N)

ACTIVE LEARNING 1 Discussion Question

Which of the following policies do you think would be most effective at boosting growth and living standards in a poor country over the long run?

a. Offer tax incentives for investment by local firms

b. ‖ ‖ ‖ ‖ ‖ by foreign firms

c. Give cash payments for good school attendance

d. Crack down on govt corruption

e. Restrict imports to protect domestic industries

f. Allow free trade

g. Give away condoms

ECONOMIC GROWTH

AND PUBLIC POLICY

Next, we look at the ways

public policy can affect

long-run growth in productivity

and living standards.

Saving and Investment

▪ We can boost productivity by increasing K,

which requires investment.

▪ Since resources scarce, producing more capital

requires producing fewer consumption goods.

▪ Reducing consumption = increasing saving.

This extra saving funds the production of

investment goods.

(More details in the next chapter.)

▪ Hence, a tradeoff between current and future

consumption.

Diminishing Returns and the Catch-Up Effect

▪ The govt can implement policies that raise

saving and investment. (Details in next chapter.)

Then K will rise, causing productivity and living

standards to rise.

▪ But this faster growth is temporary,

due to diminishing returns to capital:

As K rises, the extra output from an additional

unit of K falls….

Output per

worker

(productivity)

The Production Function & Diminishing Returns

K/L

Y/L

Capital per worker

If workers

have little K,

giving them more

increases their

productivity a lot.

If workers already

have a lot of K,

giving them more

increases

productivity

fairly little.

the property whereby poor

countries tend to grow more rapidly than rich ones

The catch-up effect:

K/L

Y/L

Poor country

starts here Rich country starts here

Poor country’s

growth

Rich country’s

growth

Example of the Catch-Up Effect

▪ Over 1960–1990, the U.S. and S. Korea devoted

a similar share of GDP to investment, so you

might expect they would have similar growth

performance.

▪ But growth was >6% in Korea and only 2% in

the U.S.

▪ Explanation: the catch-up effect.

In 1960, K/L was far smaller in Korea than

in the U.S., hence Korea grew faster.

Investment from Abroad

▪ To raise K/L and hence productivity, wages, and

living standards, the govt can also encourage

▪ foreign direct investment:

a capital investment (e.g., a factory) that is

owned & operated by a foreign entity

▪ foreign portfolio investment:

a capital investment financed with foreign

money but operated by domestic residents

▪ Some of the returns from these investments

flow back to the foreign countries that supplied

the funds.

Investment from Abroad

▪ Especially beneficial in poor countries that cannot

generate enough saving to fund investment

projects themselves.

▪ Also helps poor countries learn state-of-the-art

technologies developed in other countries.

Education

▪ Govt can increase productivity by promoting

education–investment in human capital (H).

▪ Public schools, subsidized loans for college

▪ Education has significant effects: In the U.S.,

each year of schooling raises a worker’s wage

by 10%.

▪ But investing in H also involves a tradeoff

between the present & future:

Spending a year in school requires sacrificing

a year’s wages now to have higher wages later.

Health and Nutrition

▪

Property Rights and Political Stability

▪ Recall:

Markets are usually a good

way to organize economic activity.

The price system allocates resources

to their most efficient uses.

▪ This requires respect for property rights, the

ability of people to exercise authority over the

resources they own.

Property Rights and Political Stability

▪ In many poor countries, the justice system

doesn’t work very well:

▪ Contracts aren’t always enforced

▪ Fraud, corruption often go unpunished

▪ In some, firms must bribe govt officials for

permits

▪ Political instability (e.g., frequent coups) creates

uncertainty over whether property rights will be

protected in the future.

Property Rights and Political Stability

▪ When people fear their capital may be stolen by

criminals or confiscated by a corrupt govt,

there is less investment, including from abroad,

and the economy functions less efficiently.

Result: lower living standards.

▪ Economic stability, efficiency, and healthy

growth require law enforcement, effective courts,

a stable constitution, and honest govt officials.

Free Trade

▪ Inward-oriented policies

(e.g., tariffs, limits on investment from abroad)

aim to raise living standards by avoiding

interaction with other countries.

▪ Outward-oriented policies (e.g., the elimination

of restrictions on trade or foreign investment)

promote integration with the world economy.

Free Trade

▪ Recall: Trade can make everyone better off.

▪ Trade has similar effects as discovering new

technologies—it improves productivity and living

standards.

▪ Countries with inward-oriented policies have

generally failed to create growth.

▪ e.g., Argentina during the 20th century.

▪ Countries with outward-oriented policies have

often succeeded.

▪ e.g., South Korea, Singapore, Taiwan after 1960.

Research and Development

▪ Technological progress is the main reason why

living standards rise over the long run.

▪ One reason is that knowledge is a public good:

Ideas can be shared freely, increasing the

productivity of many.

▪ Policies to promote tech. progress:

▪ Patent laws

▪ Tax incentives or direct support for

private sector R&D

▪ Grants for basic research at universities

Population Growth

…may affect living standards in 3 different ways:

1. Stretching natural resources

▪ 200 years ago, Malthus argued that pop. growth

would strain society’s ability to provide for itself.

▪ Since then, the world population has increased

sixfold. If Malthus was right, living standards

would have fallen. Instead, they’ve risen.

▪ Malthus failed to account for technological

progress and productivity growth.

Population Growth

2. Diluting the capital stock

▪ Bigger population = higher L = lower K/L

= lower productivity & living standards.

▪ This applies to H as well as K:

fast pop. growth = more children

= greater strain on educational system.

▪ Countries with fast pop. growth tend to have lower

educational attainment.

Population Growth

To combat this, many developing countries use

policy to control population growth.

▪ China’s one child per family laws

▪ Contraception education & availability

▪ Promote female literacy to raise opportunity cost of

having babies

2. Diluting the capital stock

Population Growth

3. Promoting tech. progress

▪ More people

= more scientists, inventors, engineers

= more frequent discoveries

= faster tech. progress & economic growth

▪ Evidence from Michael Kremer:

Over the course of human history,

▪ growth rates increased as the world’s

population increased

▪ more populated regions grew faster than

less populated ones

ACTIVE LEARNING 2 Review productivity concepts

▪ List the determinants of productivity.

▪ List three policies that attempt to raise living

standards by increasing one of the determinants

of productivity.

ACTIVE LEARNING 2 Answers

Determinants of productivity:

K/L, physical capital per worker

H/L, human capital per worker

N/L, natural resources per worker

A, technological knowledge

Policies to boost productivity:

▪ Encourage saving and investment, to raise K/L

▪ Encourage investment from abroad, to raise K/L

▪ Provide public education, to raise H/L

ACTIVE LEARNING 2 Answers

Determinants of productivity:

K/L, physical capital per worker

H/L, human capital per worker

N/L, natural resources per worker

A, technological knowledge

Policies to boost productivity:

▪ Patent laws or grants, to increase A

▪ Control population growth, to increase K/L

Are Natural Resources a Limit to Growth?

▪ Some argue that population growth is depleting the

Earth’s non-renewable resources, and thus will limit

growth in living standards.

▪ But technological progress often yields ways to

avoid these limits:

▪ Hybrid cars use less gas.

▪ Better insulation in homes reduces the energy

required to heat or cool them.

▪ As a resource becomes scarcer, its market price

rises, which increases the incentive to conserve it

and develop alternatives.

CONCLUSION

▪ In the long run, living standards are determined by

productivity.

▪ Policies that affect the determinants of productivity

will therefore affect the next generation’s living

standards.

▪ One of these determinants is saving and

investment.

▪ In the next chapter, we will learn how saving and

investment are determined, and how policies can

affect them.

SUMMARY

• There are great differences across countries in living standards and growth rates.

• Productivity (output per unit of labor) is the main determinant of living standards in the long run.

• Productivity depends on physical and human capital per worker, natural resources per worker,

and technological knowledge.

• Growth in these factors—especially technological progress—causes growth in living

standards over the long run. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

SUMMARY

• Policies can affect the following, each of which has important effects on growth:

• Saving and investment • International trade • Education, health & nutrition • Property rights and political stability • Research and development • Population growth

• Because of diminishing returns to capital, growth from investment eventually slows down, and poor countries may ―catch up‖ to rich ones.