Understanding Economics 5th edition by Mark Lovewell Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Understanding Economics 5th edition by Mark Lovewell Chapter 7 Economic Welfare and Income Distribution Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives After this chapter you will be able to: understand the concepts of consumer surplus and deadweight loss, and explain how these concepts can further our understanding of the operation of markets distinguish spillover costs and benefits and the ways that government addresses these issues summarize how income is distributed among Canadian households, how this distribution is measured, and the factors underlying this distribution identify the causes of poverty and the way poverty is measured evaluate the effectiveness of government intervention to change the distribution of income Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Marginal and Total Benefit Both consumers and producers gain from market activity. For consumers, these gains can be measured by marginal and total benefit. Marginal benefit is the extra satisfaction, expressed in dollar terms, from consuming a certain unit of a product. Total benefit is the total satisfaction, expressed in dollar terms, from consuming a product. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Consumer Surplus (a) Consumer surplus shows the extent to which consumers pay a lower price than the highest one they are willing to pay. It is defined as the net benefit, expressed in dollar terms, from buying a product at its market price. It is found, either for an individual or in an entire market, by subtracting total expenditure from total benefit. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Consumer Surplus (b) Figure 7.1, page 175 Consumer’s Demand Curve for Pizzas Consumer’s Demand Schedule for Pizzas 16 A+B = Total Benefit B = Total expenditure Price ($ per pizza) Quantity Demanded (D) (pizzas) Total Benefit ($) 14 12 A = $6 10 D Price ($ per pizza) 8 $14 1 12 2 10 3 14 26 (14 + 12) 36 (14 + 12 + 10) 4 B = $30 1 2 3 4 Quantity (pizzas per week) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Consumer Surplus (c) Figure 7.2, page 176 Market Demand Curve for Pizzas Market Demand Schedule for Pizzas A+B = Total Benefit B = Total Expenditures 18 16 Price ($ per pizza) Quantity Demanded (D) (thousands of pizzas) 14 12 A = $400,000 10 D Price ($ per pizza) 8 18 0 14 50 10 100 6 4 B = $1 million 2 50 4 Quantity (thousands of pizzas per week) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Producer Surplus Producer surplus shows the extent to which producers receive a price different from the lowest one they are willing to accept. It is defined as the difference between the price received from selling each unit of a product and the marginal cost of producing it. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Producer Surplus for a Market Figure 7.3, page 177 18 16 14 S 12 10 Price ($ per pizza) C = $400 000 8 6 4 D 2 50 100 Quantity (thousands of pizzas per week) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Case of Perfect Competition In a perfectly competitive market, the requirement of marginal-cost pricing is met. Based on this requirement, equilibrium will occur where marginal benefit equals marginal cost, and both consumer surplus and producer surplus are maximized. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Case of Perfect Competition Figure 7.4, page 178 18 16 14 12 Consumer Surplus 10 Price ($ per pizza) Producer Surplus 8 Marginal Benefit 6 4 Marginal Benefit Marginal Cost Marginal Cost 2 D 50 100 150 Quantity (thousands of pizzas per week) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

When a Market Becomes Uncompetitive When a market becomes uncompetitive, for example due to government policy, price rises. The result is that a portion of the consumer surplus becomes producer surplus. Also there is a net reduction in both the consumer surplus and producer surplus due to the reduction in market output. This net reduction is known as the deadweight loss. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

When a Market Becomes Uncompetitive Figure 7.6, page 179 18 16 14 12 E F 10 Deadweight Loss Price ($ per pizza) G 8 6 4 2 D 50 75 100 150 Quantity (thousands of pizzas per week) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Spillover Costs (a) Spillover costs are the negative external effects of producing or consuming a product. Adding these costs to private costs vertically raises the supply curve. The preferred outcome is at a lower quantity than in a perfectly competitive market. Government intervention (e.g. an excise tax) can produce the preferred outcome. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Spillover Costs (b) Figure 7.6, Page 182 Market Demand Curve for Strawberries Demand and Supply Schedules for Gasoline S1 S0 2.50 Spillover Costs, Excise Tax Price ($ per litre) Quantity Demanded Quantity Supplied a 2.00 (D) (S0) (S1) (millions of litres) 1.50 b Price ($ per litre) $2.50 2.00 1.50 1.00 0.05 4 5 6 7 8 8 7 6 5 4 6 5 4 3 2 1.00 0.50 D 1 2 3 4 5 6 7 8 Millions of Litres Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Spillover Benefits (a) Spillover benefits are the positive external effects of producing or consuming a product. Adding these benefits to private benefits raises the demand curve. The preferred outcome is at a higher quantity than occurs in a perfectly competitive market. Government intervention (e.g. a consumer subsidy) can produce the preferred outcome. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Spillover Benefits (b) Figure 7.7, page 184 Demand and Supply Curves for an Engineering Education Demand and Supply Schedules for an Engineering Education 6000 S b Tuition ($ per year) Enrollment Demanded Quantity Supplied 5000 Spillover Benefits, Student Subsidy (D0) (D1) (S) 4000 a (thousands of students) $6000 5000 4000 3000 2000 8 9 10 11 12 10 11 12 13 14 12 11 10 9 8 3000 Tuition ($ per year) 2000 D1 D0 1000 8 9 10 11 12 13 14 Thousands of Students Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Canadian Distribution of Income Canada’s distribution of income can be shown using the Lorenz curve. This curve is a graph showing the cumulative distribution of income for households categorized into five groups based on their income levels. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Income Distribution in Selected Years Figure 7.8, page 187 Percentage of Total Pre-Tax Income Received by Each Fifth of Households Average Income (2006) $13 800 31 800 51 300 77 800 152 600 65 500 Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% Average of total 1951 4 11 18 23 43 1961 4 12 18 25 41 1971 4 11 18 25 43 1981 5 11 18 25 42 1991 5 10 17 25 44 2006 4 10 16 24 47 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Lorenz Curve Figure 7.9, page 183 60 20 40 80 Households (%) Cumulative Share of Income (%) 100 Distribution of Household Income Cumulative Distribution of Household Income Share of Income in 2000 (%) Cumulative Share of Income in 2000 (%) Perfect Equality d c Lowest 4 Second 10 Third 16 Fourth 24 Highest 47 Lowest 20% 4 (a) Lowest 40% 14 = 4 + 10 (b) Lowest 60% 30 = 14 + 16 (c) Lowest 80% 54 = 30 + 24 (d) 100% 100 = 54 + 47 (e) b Perfect Inequality a Copyright © 2008 by McGraw-Hill Ryerson Limited. All rights reserved.

Interpreting the Lorenz Curve In using the Lorenz curve as a distribution measure, it is useful to compare it with curves for two hypothetical economies: For an economy of perfect quality, where all have identical incomes, the Lorenz curve would be a 45-degree line emanating from the origin. For an economy of perfect inequality, where one household receives all of the economy’s income, the Lorenz curve would follow the horizontal and vertical axes of the graph. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Gini Coefficient The Gini coefficient provides a single numerical measure of income distribution. It is defined as the area between a Lorenz curve and the 45-degree line of perfect equality, divided by the entire triangular area under the 45-degree line. The coefficient varies from 0 to 1, with 0 representing perfect equality and 1 representing perfect inequality. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Wage Determinants (a) There are seven main wage determinants: labour productivity education experience job conditions regional disparities market power discrimination Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Distribution of Earnings (2006) Figure 7.10, page 190 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Labour Productivity In any given market, labour productivity determines the wage of that worker. Labour productivity is defined as output per worker in a given time. It is the most important determinant of wages. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Education Education: usually adds to a worker’s pay but has opportunity costs as well serves two main purposes (consumption and investment in human capital) A student will undertake an educational program if its benefits (both monetary and nonmonetary) exceed its opportunity costs. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Education and Average Family Income (2006) Figure 7.11, page 191 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Age and Average Income (2006) Figure 7.12, page 192 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Labour Unions There are two main types of labour unions: Industrial unions include all workers in a certain industry. Craft unions include workers in a particular occupation and restrict who can be members. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Job Discrimination Job discrimination relates to hiring, wage, and promotion decisions based on criteria other than a worker’s credentials or performance. Job discrimination can be direct, in which case employees are paid different amounts for substantially the same work. Job discrimination can also be indirect, involving a discriminatory division of jobs. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Reasons for Income Inequality (Other Incomes) There are three main reasons for income inequality in addition to wage determinants: risk-taking ability wealth Wealth is more unequally distributed than income. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Distribution of Wealth in Selected Countries Figure 7.13, page 195 Sweden (1975) Canada (1984) France (1986) US (1986) 10 20 30 40 50 60 70 80 90 Top 1% Top 5% Top 20% Share of Wealth Held by Top Wealth Holders (%) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Poverty Line The poverty line is the income level below which a household is classified as poor. In Canada, a household is considered to be poor if it spends more than 63% of its after-tax income on food, clothing, and shelter. In dollar terms, the poverty line depends on the number of household members and the size of the community they live in. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Poverty Line for Various Households (2006) Figure 7.14, page 197 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Incidence of Poverty (a) Poverty rates are higher among unattached individuals than among families, except for lone-parent families with a female head. Unattached females have particularly high poverty rates as well. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Incidence of Poverty (b) Figure 7.15, page 198 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Canadian Welfare Society A welfare society is one in which the government plays a major role in attempting to ensure the economic well-being of its citizens. Transfer payments and personal income taxes are the most important elements of Canada’s welfare society. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Transfer Payments and Income Equity (a) Transfer payments are now usually based on the principle of means testing rather than universality. Transfer payments are greatest as a percent of income for the poorest fifth of households, but the second-poorest fifth of households receives the largest share of these payments. Copyright © 2010 by McGraw-Hill Ryerson Limited. All rights reserved.

Transfer Payments and Income Equity (b) Figure 7.16, page 201 Average Transfer Payments Received (2006) $7 200 9 700 8 400 7 500 5 100 7 600 Transfer Payments as a Percent of Total Income (2006) 51.9% 30.6 16.4 9.7 3.3 11.6 Share Received of Total Transfer Payments (2006) 19.9% 25.7 22.2 19.8 13.3 Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% Average of Total Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Principles of Taxation There are two main principles of taxation: benefits received (e.g. gasoline taxes for roadwork) ability to pay (e.g. personal income tax) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Taxes and Income Taxes are related to income in three possible ways: progressive taxes (which increase as a proportion of income as income rises) proportional taxes (which stay constant as a proportion of income as income rises) regressive taxes (which decrease as a proportion of income as income rises) Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Taxes and Income Equity Personal income taxes are progressive, with the proportion of income paid in tax rising significantly with a household’s income level. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Personal Income Taxes and Income Equity (2006) Figure 7.17, page 203 Average Personal Income Taxes Paid $ 700 2 800 6 700 12 600 33 300 11 200 Personal Income Taxes as a Percent of Total Income 5.3% 8.8 13.0 16.1 21.8 17.1 Share Paid of Total Personal Income Taxes 1.3% 5.0 11.9 22.4 59.4 Lowest 20% Second 20% Third 20% Fourth 20% Highest 20% Average of Total Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Doomsday Prophet Thomas Malthus formulated a theory of population based on two principles: food increases in an algebraic progression (1,2,3…) population increases in a geometric progression (1,2,4…) He predicted that over time population growth would outstrip growth in the food supply with disastrous effects Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

A Malthusian Time Chart page 209 Year Food Population 1 25 2 50 3 4 75 4 8 100 5 16 125 6 32 150 7 64 175 8 128 200 9 256 225 10 512 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Wages, Rent, Interest, and Profit (OLC) Rent Rent is the payment for the use of a productive resource available in only a fixed amount. Land receives a rent because its supply is perfectly inelastic. The equilibrium rent for a particular type of land varies with demand for this land (e.g. a rise in the price of beef affects the rent for ranching land). Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Demand and Supply Curves for Land Wages, Rent, Interest, and Profit (OLC) Equilibrium in the Market for Land Figure A Millions of Hectares Demand and Supply Curves for Land Rent ($ per year) 2 1 4 6 8 12 14 3 5 7 9 Demand and Supply Schedules for Land (millions of hectares) Rent ($ per year) Quantity Supplied (S) Demanded (D) S 10 e $14 12 10 8 6 4 5 6 7 8 6 D 6 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Demand and Supply Curves for Land Wages, Rent, Interest, and Profit (OLC) Changes in the Demand for Land Figure B Millions of Hectares Demand and Supply Curves for Land Rent ($ per year) 2 1 4 6 8 14 3 5 7 9 Demand and Supply Schedules for Land (millions of hectares) Rent ($ per year) Quantity Supplied (S) Demanded (D0) (D1) S 12 b 10 a $14 12 10 8 6 4 5 6 7 8 5 6 7 8 9 6 D0 D1 6 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Wages, Rent, Interest, and Profit (OLC) Interest Interest is related to the supply of capital resources, and can also be viewed as a financial income. When money is lent, the lender requires repayment not only of the loan principal but also a charge for the use of the money. Interest is payment for the opportunity cost of the money being used. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Wages, Rent, Interest, and Profit (OLC) The Range of Interest Rates Four factors affect interest rates: credit risk the loan period collateral the size of the loan Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Wages, Rent, Interest, and Profit (OLC) Profit Critics of capitalism attribute profit to the power of business owners rather than to their contributions to the economy. However, profit can also be seen as a return to entrepreneurs for their risk-taking. From this perspective, it is a an essential private incentive for taking risks. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Role of Labour Unions (a) (Online Learning Centre) Unions represent members’ interests through collective bargaining. Both unions and employers make collective agreements which bind both parties for a given period. When agreement is impossible, mediation or arbitration can be used to bring about a settlement. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Role of Labour Unions (b) (Online Learning Centre) If no settlement is reached, union members can work to rule, or stage a strike. Employers may use a lockout to bring about a settlement. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Reaping the Rewards (Online Learning Centre) David Ricardo developed a theory of rent based on varying grades of land. According to his theory, a rise in the demand for wheat increases wheat prices and increases rent as poorer land is brought into cultivation. He predicted that higher wheat prices would lead to higher money wages and lower profits. Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Ricardo’s Theory of Rent Figure A Land Rents per Hectare Wheat Price ($) (when production costs are $100 per hectare) Grade A (50 kg output) Grade B (40 kg Grade C (20 kg Grade D (10 kg C A B D Grade of Land Land Rents per Hectare Wage ($ per year) 100 200 300 400 $400 $ 5 10 150 [($5 x 50) – $100] 400 [($5 x 50) - $100] 100 300 100 not cultivated $300 $150 $100 $100 $0 $0 Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Understanding Economics 5th edition by Mark Lovewell Chapter 7 The End Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.