economics chapter 12 efficiency, equity and the role of government
TRANSCRIPT
Economics
Chapter 12
Efficiency, Equity
and the Role of Government
Assumption
Classical economics Invisible hand
Market economy Price mechanism
Perfectly competitive market Many buyers and sellers Homogeneous goods No entry or exit barriers Perfect information
Marginal Benefit (MB) the additional benefit the consumer can get by
buying one more unit of good. the maximum willingness to pay
Marginal Cost (MC) the change in total cost brought about by a
change in one unit of output. the additional cost the producer would like to pay
for producing one more unit of good. the minimum supply-price
Efficiency Total social surplus is maximized.
In perfectly competitive market, the market price automatically adjust to equilibrium level. Consumer surplus is maximized. Producer surplus is maximized. i.e. Total social surplus is maximized. Market achieves efficiency automatically.
P ($)
0
D
S
Q(units)
2
300 700
Shortage
P ($)
0
D
S
Q(units)
4
300 700
Surplus
Total social surplus Total net benefits from econ. activities (buy and sell). Total benefit – Total cost Total benefit = Area A + Area B Total cost = Area B Total social surplus = Area A
In a perfect market, total social surplus will be maximized with a market price. P ($)
0
D = MB
S = MC
Q(units)
Pe
Qe
B
A
Consumer surplus
Willingness to pay = P1 + P2 + P3 + P4 + …
(Q1) ( Q2 ) ( Q3 ) ( Q4 )
Consumer surplus = Willingness to pay – actual payment
Q
P ($)
0
Price
D: Willingness to pay curveActual
paymentActual payment
Consumer Surplus
Actual payment
Producer surplus
Minimum supply price = P1 + P2 + P3 + P4 + …
(Q1) ( Q2 ) ( Q3 ) ( Q4 )
Producer surplus = Actual revenue - Minimum supply price
Q
P ($)
0
Price
S: Minimum supply price curveProducer Surplus
Consumer surplus = MB – P Producer surplus = P – MC
At equilibrium, Consumer surplus is maximized, i.e. MB – Pe = 0 MB = P∴ e
Producer surplus is maximized, i.e. Pe – MC = 0 P∴ e = MC
P ($)
0
D = MB
S = MC
Q(units)
Pe
Qe
Market efficiency
In conclusion, market efficiency will be achieved at a level MB = Pe = MC MB = MC
Market efficiency: Quantity level where MB = MC
Total social surplus is maximized.
Test yourself
What is the marginal benefit to consumer? Explain the difference between marginal
benefit to consumers and net gain to consumer.
Test yourself
Marginal benefit to consumers is the maximum price which a consumer is willing to pay to get one more unit of a good. (2)
Net gain to consumers (consumer surplus) is the marginal benefit to consumers less the actual payment. (2)
Test yourself
With the aid of a diagram, explain how a fall in clothes price affects the quantity demanded of and the net gain to individual consumers. (6)
Test yourself
According to the law of demand, when price falls, quantity demanded increases. (2)
Net gain to consumers is the consumer surplus. When the actual payment (price) of clothes falls, the consumer surplus (net gain) increases. (2)
Correct diagram (2)
Function of price
1. Rationing function Who can get the product? 價高者得 A signal to the supplier
Products will be distributed to uses with maximum willingness to pay
E.g. Yahoo auction Buyer A: $1000 Buyer B: $700 Buyer C: $500
Therefore, A will have the good finally
Function of price2. Function of allocation
what’s the quantity to be consumed? Incentives or market information
If excess demand (i.e. Qd > Qs), Consumer is willing to pay more to get the good Price Qd & Qs Until: MB = P = MC Market efficiency
If increase in demand (i.e. demand curve shifts rightward), D Market Price Producer is willing to produce more (law of supply) Qt (higher quantity effect on allocation) Until: MB = P = MC Market efficiency
Function of price
Given that the quantity is fixed The one has the highest
willingness to pay gets the goods.
Rationing function
Given that the price is fixed Consumer will determine the
quantity according to their MB, i.e. Quantity at P=MB
Function of allocation
P ($)
0
S
Q (units)1
P ($)
0
S
Q (units)
10
Deviation from efficiency
Total social surplus has not been maximized Quantity level where MB ≠ MC
2 possibilities Output level: Q ≠ Qe
Price level: P ≠ Pe
Deadweight loss loss in total social surplus
Deadweight loss
At market equilibrium Pe = $8, Qe = 10 units,
If output level = 5 units [i.e. Q < Qe] consumers want to buy more producers can’t sell more total social surplus not maximized quantity level where MB ≠ MC the market is inefficient
Deadweight loss
Q(units)
P ($)
0
D = MB
S = MC
8
10
P ($)
0
D = MB
S = MC
Q(units)
12
5
4
Deadweight loss due to under-production
Under-production = Social optimal output - Quantity transacted
Qt < Qe quantity level where MC < MB
Deadweight loss in the market
Solution:Increase production can bring a rise in total social surplus
P ($)
0
D = MB
S = MC
Q(units)
Pd
Qt
Ps
Qe
Deadweight loss
At market equilibrium Pe = $8, Qe = 10 units,
If output level = 15 units [i.e. Q > Qe] consumers don’t want to pay higher
price producers can’t sell at a higher price total social surplus not maximized quantity level where MB ≠MC the market is inefficient
Deadweight loss
P ($)
0
D = MB
S = MC
Q(units)
8
10
P ($)
0
D = MB
S = MC
Q(units)
10
15
6
Deadweight loss
Over-production = Quantity transacted – Social optimal output Qt > Qe quantity level where MC > MB
Deadweight loss in the market
Solution:Decrease production can bring a rise in total social surplus
P ($)
0
D = MB
S = MC
Q(units)QtQe
Pd
Ps
Calculation of deadweight loss due to under-production Price ($) 10 9 8 7 6 5 4
Qd 1 2 3 4 5 6 7
Qs 7 6 5 4 3 2 1
Equilibrium level: Pe = $7 , Qe = 4 units
Max. total social surplus= ($10-$4) + ($9-$5) + ($8-$6) + ($7-$7) 1st unit 2nd unit 3rd unit 4th unit
= $6 + $4 + $2 = $12
If Qt = 2 units Method 1: Deadweight loss
= Max.TSS at equil. – TSS at 2units= $12 – ($6 + $4) = $2
Method 2: Deadweight loss= MB – MC (of the 3rd and 4th units)= ($8 + $7) – ($7 + $6) = $2
P ($)
0
S = MC
Q(units)42
7
9
D = MB
Calculation of deadweight loss due to over-production Price ($) 10 9 8 7 6 5 4
Qd 1 2 3 4 5 6 7
Qs 7 6 5 4 3 2 1
Equilibrium level: Pe = $7 , Qe = 4 units
Max. total social surplus= ($10-$4) + ($9-$5) + ($8-$6) + ($7-$7) 1st unit 2nd unit 3rd unit 4th unit
= $6 + $4 + $2 +$0 = $12
If Qt = 6 units Deadweight loss
= MC – MB (of the 5th and 6th units)= ($8 + $9) – ($6 + $5) = $6
P ($)
0
S = MC
Q(units)4 2
7
9
D = MB5
Market intervention and inefficiency
Assumption: In perfectly competitive market,
MB = MC Total social surplus is max. Market efficiency No other forces to affect market equilibrium
Market intervention and inefficiency
Price ceiling Price ceiling is set at P1.
Price from P0 to P1.
Qt from Q0 to Q1. Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC Deadweight loss
P ($)
0
S = MC
Q(units)
Q0
D = MB
P0
Deadweight loss
Q1
P1
Market intervention and inefficiency
P ($)
0
S = MC
Q(units)Qe
D = MB
P ($)
0
S = MC
Q(units)
Qt
D = MB
Pe
Pc
Deadweight loss
C.S.
P.S.
C.S.
P.S.
Market intervention and inefficiency
Price floor Price floor is set at P1.
Price from P0 to P1.
Qt from Q0 to Q1. Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC Deadweight loss
P ($)
0
S = MC
Q(units)
Q0
D = MB
P0
Deadweight loss
Q1
P1
Market intervention and inefficiency
P ($)
0
S = MC
Q(units)Qe
D = MB
P ($)
0
S = MC
Q(units)
Qt
D = MB
Pe
Pf
Deadweight loss
C.S.
P.S.
C.S.
P.S.
Market intervention and inefficiency
Quota Quota is set at Q1.
Qt from Q0 to Q1.
Price from P0 to P1. Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC Deadweight loss
P ($)
0
S0
Q(units)
Q0
D = MB
P0
Deadweight loss
Q1
P1
S1
Market intervention and inefficiency
P ($)
0
S = MC
Q(units)Qe
D = MB
P ($)
0
S = MC
Q(units)
Qt
D = MB
Pe
Pf
Deadweight loss
C.S.
P.S.
C.S.
P.S.
Market intervention and inefficiency
Unit tax Supply from S0 to S1.
Price from P0 to P1.
Qt from Q0 to Q1. Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC Deadweight loss
P ($)
0
S0
Q(units)
Q0
D = MB
P0
Deadweight loss
Q1
P1
S1
Market intervention and inefficiency
P ($)
0
S = MC
Q(units)Qe
D = MB
P ($)
0
S0 = MC
Q(units)
Qt
D = MB
Pe
P1
Deadweight loss
C.S.
P.S.
C.S.
P.S.
S1 = MC + Tax
Tax revenue
Market intervention and inefficiency
Unit subsidy Supply from S0 to S1.
Price from P0 to P1.
Qt from Q0 to Q1. Quantity transacted is greater than
the socially optimal output Q0
Over-production Q1 – Q0 occurs
At Q1, MB < MC Deadweight loss
P ($)
0
S0
Q(units)
Q0
D = MB
P0
Deadweight loss
Q1
P1
S1
Market intervention and inefficiency
P ($)
0
S = MC
Q(units)Qe
D = MB
Pe
C.S.
P.S.
P ($)
0
S0 = MC
Q(units)
Qt
D = MBP1
Deadweight loss
P.S.
C.S.S1 = MC + Subsidy
Subsidy benefit
Pe
Summary of Market intervention and inefficiency
Deadweight loss due to… Q P MB & MC
Price ceiling
Under production / Under consumption
Q1 < Q0
P1 < P0
MB > MCPrice floor P1 > P0
Quota P1 > P0
Unit tax P1 > P0
Unit subsidy Over production / Over consumption
Q1 > Q0 P1 < P0 MB < MC
Elasticity of demand and deadweight loss
Price ceilingEd of D0 > Ed of D1
Higher the elasticity of demand, smaller the ( MB – MC ) Same under-production Smaller deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0Deadweight loss
Q1
P ($)
0
S0
Q(units)
Q0
D
P0
Deadweight loss
Q1
P1P1
Deadweight loss
Elasticity of demand and deadweight loss
Price floorEd of D0 > Ed of D1
Higher the elasticity of demand, greater the ( MB – MC ) Greater under-production Greater deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0Deadweight loss
Q1
P ($)
0
S0
Q(units)
Q0
D
P0
Q1
P1 P1Deadweight loss
Elasticity of demand and deadweight loss
QuotaEd of D0 > Ed of D1
Higher the elasticity, of demand, smaller the ( MB – MC ) Same under-production Smaller deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0
Deadweight loss
Q1
P1
S1P ($)
0
S0
Q(units)
Q0
D
P0
Deadweight loss
Q1
P1
S1
Elasticity of demand and deadweight loss
Unit taxEd of D0 > Ed of D1
Greater under-production Greater deadweight loss
P ($)
0
S0
Q(units)
Q0
DP0
Deadweight loss
Q1
P1
S1 P ($)
0
S0
Q(units)
Q0
D
P0Deadweight loss
Q1
P1
S1
Elasticity of demand and deadweight loss
Unit subsidyEd of D0 > Ed of D1
Greater over-production Greater deadweight loss
P ($)
0
S0
Q(units)
Q0
DP0
Deadweight loss
Q1
P1
S1
P ($)
0
S0
Q(units)
Q0
D
P0
Deadweight loss
Q1
P1
S1
Elasticity of supply and deadweight loss
Price ceilingEs of S0 > Es of S1
Higher the elasticity of supply, larger the ( MB – MC ) Greater under-production Greater deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0
Deadweight loss
Q1
P ($)
0 Q(units)
Q0
D
P0Deadweight loss
Q1
P1P1
S1
Elasticity of supply and deadweight loss
Price floorEs of S0 > Es of S1
Higher the elasticity of supply, smaller the ( MB – MC ) Same under-production Smaller deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0 Deadweight loss
Q1
P ($)
0 Q(units)
Q0
D
P0 Deadweight loss
Q1
P1 P1
S1
Elasticity of supply and deadweight loss
QuotaEs of S0 > Es of S1
Higher the elasticity of supply, smaller the ( MB – MC ) Same under-production Smaller deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0 Deadweight loss
Q1
P ($)
0 Q(units)
Q0
D
P0Deadweight loss
Q1
P1 P1
S1
Elasticity of demand and deadweight loss
Unit taxEs of S0 > Es of S1
Higher the elasticity of supply Greater under-production Greater deadweight loss
P ($)
0
S0
Q(units)
Q0
D
P0Deadweight loss
Q1
P1
S1
P ($)
0
S0
Q(units)
Q0
D
P0Deadweight loss
Q1
P1
S1
Elasticity of demand and deadweight loss
Unit subsidyEs of S0 > Es of S1
Higher the elasticity of supply Greater over-production Greater deadweight loss
P ($)
0
S1
Q(units)
Q1
D
P1Deadweight loss
Q0
P0
S0
P ($)
0
S1
Q(units)
Q1
D
P1
Deadweight loss
Q0
P0
S0
Assumption to the efficient market
Producers bear the full cost of goods. i.e. MC = Marginal Private Cost (MPC) = Marginal Social Cost (MSC)
Consumers gain the full benefits of goods. i.e. MB = Marginal Private Benefits (MPB) = Marginal Social Benefits
(MSB)
In reality…
An externality occurs … It is the uncompensated impact of one person’s actions on the well-
being of a bystander.
A divergence between the private costs (or benefits) and social costs (or benefits) of production and consumption activities.
External cost (or benefits) exists
Market inefficiency
Deadweight loss
Negative externalities
Uncompensated impact of one person’s actions on the well-being of a bystander which is adverse / bad.
It creates a divergence (external cost) between private and social costs in production or consumption.
Social cost = Private cost + External cost Social cost: Cost borne by a firm and the whole society. Private cost: Cost borne by a firm only. External cost: Cost borne by the society because of a firm’s activity
Negative externalities
Production: Emissions from factories
Air pollution Bad health Road maintenance Inconvenience to public
Consumption: Playing mahjong
Noise Smoking
Air pollution Passive smoke on non-smokers
Negative externalities
More examples: Drug abuse Alcohol abuse Gambling addicted Environment damage caused by chemical fertilizers in
agriculture Anti-social behaviour Littering in public places Noise around the airport Nasty smell near the landfill
Deadweight due to over-production
From individual’s point of view:
Efficient output = Q0 where MPC = MPB From society’s point of view:
Efficient output = Q1 where MSC = MSB
For the sake of the whole society, The socially optimal output should be at Q1. MSC = MSB
Production decision based on MPC Quantity transacted = Q0
At Q0, MSC > MSB or MSC > MPB
Over-production occurs (Q0 > Q1) Market inefficiency Deadweight loss
P ($)
0
MSC
Q(units)
Q1
D=MPB=MSB
P1Deadweight loss
Q0
P0
MPC
External Cost
Without the external cost: Qe = 5 units, Pe = MSB = MPC = $10
In the view of the whole society: External cost is counted The socially optimal output = 3 units, where P = MSB = MSC = $12
Over-production occurs : Qt - Qe = 5 units – 3 units = 2 units Market is inefficient
Deadweight loss = MC of 4th and 5th units – MB of 4th and 5th units
= ( $13 + $14 ) – ($11 + $10 ) = $6
Q MSB MPC External cost
MSC
1 14 6 4
2 13 7 4
3 12 8 4
4 11 9 4
5 10 10 4
6 9 11 4
P ($)
0
MSC
Q(units)
3
D=MPB=MSB
12Deadweight loss
5
10
MPC
Q MSB MPC External cost
MSC
1 14 6 4 10
2 13 7 4 11
3 12 8 4 12
4 11 9 4 13
5 10 10 4 14
6 9 11 4 15
Gov’t intervention to solve negative externalities
Aim at lower production Price control (price ceiling & price floor) Quantity control (quota) Tax
Examples: Criminal laws (e.g. Copyright Law) Command and control (e.g. law to control SARS outbreak) Output quotas for production of pollutants (e.g. Co2 emission quota) Outright prohibition for producers and fines (e.g. illegal parking) Legislation (e.g. minibus installed equipment to control black
smoke) Urban planning (e.g. HK Int’l Airport) Tradable pollution permit Environmental taxation (e.g. Green Tax, Plastic Bag Tax) Help private contracting (by defining the property right)
The Coase theorem (out of syllabus) The Problem of Social Cost (by R.H. Coase, 1960)
If the property rights are well-defined & transaction costs are negligible Efficient market exchange No externalities
Case 1: Smoker A enjoys smoking (Benefit=$30) Non-smoker B suffers (Damage=$20) In the society: Benefit of smoking > Damage of smoking Right of smoking not defined: A continues smoking and B continues suffering If right of smoking is owned by A: A continues smoking and B continues suffering If right of smoking is owned by B:
A can’t smoke If B sells the right of smoking to A by $24 Then A gain from smoking = $30 - $24 = $6 And B gain from selling of smoking right = $24 - $20 = $4
Both A and B gain the surplus, market is efficient.
The Coase theorem (out of syllabus)
Case 2: Smoker A enjoys smoking (Benefit=$10) Non-smoker B suffers (Damage=$20) In the society: Benefit of smoking < Damage of smoking Right of smoking not defined: A continues smoking and B continues
suffering If right of smoking is owned by A:
i. A continues smoking and B continues suffering (inefficient) ii. A sell the right to B by $16 (i.e. A can’t smoke)
Then A gain from selling the right = $16 - $10 = $6 And B gain from buying the right = $20 - $16 = $4
Both A and B gain the surplus, market is efficient If right of smoking is owned by B:
A can’t smoke (A has no gain and B has no loss)
Land
A
Parking
B
Farming
A
Parking(MB = $50)
Land (Own by A)
B
Farming(MB = $100)
Option 1 (Use the land himself):
A: Use the land for car park and gain $50.
B: Nothing to do. No gain.
A
Parking(MB = $50)
Land (Own by A)
B
Farming(MB = $100)
Option 2 (Rent out the land to B): A: Rent out the land to Farmer B by $80. A gain: $80
B: Buy the land with $80 and do the farming. B gain: $100 - $80 = $20
Both A & B gain.
A
Parking(MB = $200)
Land (Own by B)
B
Farming(MB = $100)
Option 1 (Use the land by himself):
A: Nothing to do. No gain.
B: Farm the land and gain $100.
A
Parking(MB = $200)
Land (Own by B)
B
Farming(MB = $100)
Option 2 (Rent out the land to A): A: Rent the land from B by $150 and provide parking service. A gain: $200 - $150 = $50
B: Rent out the land with $150. B gain: $150
Both A & B gain.
A
Parking(MB = $200)
Land
B
Farming(MB = $100)
To enable both Manager A and Farmer B to gain, the gov’t define the property right of the land (to whom with
lower MB) trading of property right both gain (i.e. max. the C.S. and P.S.) TSS is maximized Market efficiency
Conclusion Negative externalities
Over-production Market inefficiency
To solve the problems Try to lower the production by
Market intervention Price ceiling Price floor Quota Tax
Regulations Well-defined the property right
Trading of the property right
Positive externalities
Uncompensated impact of one person’s actions on the well-being of a bystander which is beneficial.
It creates a divergence (external benefit) between private and social benefits in production or consumption.
Social benefit = Private benefit + External benefit Social benefit: Benefit brought by a firm and the whole society. Private benefit: Benefit brought by a firm only. External benefit: benefit brought by the society because of a firm’s
activity
Externalities
Positive externalities Production:
Farmer grows flowers in his own garden.
Attracting bees Pollinate other flowers outside. Water Cube (National Aquatics Center)
2008 Olympic Game Tour spot & Public swimming pool Many shops nearby can have more tourists to buy thing.
Consumption: Use less plastic bags
Save $0.5 Better environment Learning Math
Personal knowledge help your little brother
Positive externalities
More examples: Industrial training by firm Education Health provision Vaccination and immunization Arts and sporting participation Estate renewal Fire safety equipment New invention
Deadweight due to under-production
From individual’s point of view:
Efficient output = Q0 where MPB = MPC From society’s point of view:
Efficient output = Q1 where MSB = MSC
For the sake of the whole society, The socially optimal output should be at Q1. MSC = MSB
Production decision based on MPC Quantity transacted = Q0
At Q0, MSB > MSC or MSB > MPC
Under-production occurs (Q0 < Q1) Market inefficiency Deadweight loss
S=MPC=MSCP ($)
0 Q(units)
Q1
MPB
P1
Deadweight loss
Q0
P0
MSB
External Benefit
Gov’t intervention to solve positive externalities
Aim at increasing production Subsidy
Lower the cost of consumption (Demand curve shifts upward) Lower the cost of production (Supply curve shifts downward)
Examples: Lower the cost (e.g. students grants and low-interest loan) Command and control (e.g. compulsory 12-year free education) Improve information flow (e.g. health aware program) Protect the rights of inventors (e.g. copyrights and patents) Legislation (e.g. minibus installed equipment to control black smoke) Help private contracting (by defining the property right)
The lighthouse in economics (R.H.Coase, 1974)
Light from the lighthouse Important to ship (positive externality) If provided by the gov’t Inefficient
Question: Who would like to build a lighthouse? Trinity House (15th – 18th century) as an agent, own the rights from the gov’t Private producer built lighthouses and get money from Trinity House Ship owners needed to pay for the usage of light Reference:
R. H. Coase (1974). The Lighthouse in Economics, <<Journal of Law and Economics>>, Vol. 17, No. 2 (Oct., 1974), pp. 357-376. The University of Chicago Press
Conclusion
Positive externalities Under-production Market inefficiency
To solve the problems Try to increase the production by
Market intervention Subsidy
Regulations Well-defined the property right
Income inequality
Seriousness of income disparity An unavoidable problem in market economy. The problem of income disparity
social conflicts
unstable living environment
discourage economic activities
hinder economic growth
Normal distribution(Less problem in income disparity)
Skewed distribution(With problem in income disparity)
High income groups own most of the income of the society.
Low income groups are extremely poor in the society.
High and low income groups own most of the income of the society.
MeasuresMonthly domestic household income
(HK$)
Number Percentage (%)
Measures
< 2,000 86,736 3.9
2,000 – 3,999 118,779 5.3
4,000 – 5,999 121,605 5.5
6,000 – 7,999 146,010 6.6
8,000 – 9,999 147,081 6.6
10,000 – 14,999 339,269 15.2
15,000 – 19,999 279,217 12.5
20,000 – 24,999 225,292 10.1
25,000 – 29,999 162,783 7.3
30,000 – 39,999 221,101 9.9
40,000 – 59,999 194,723 8.7
> or = 60,000 183,750 8.3
Total 12,226,546 100
Income Mode:$10,000-14,999(largest %)
Income Median:$17250(the income group where the 50% in)
Interpretation
When: mean > median > mode$27719 $17250 $12500
It means: many low-income households a few middle-income households very few high-income households
Income distribution by decile group
Monthly domestic household income distribution by ‘decile groups’
The larger the difference between the percentage of monthly income or between the median of households in different decile groups, the more serious is the problem of income inequality.
Decile (10) groups
(X-axis measures the % of total income received by 10% of households.)
(Y-axis is the % of households.)
Quintiles(5) or fifth share groups
Analysis The % of total income earned
by the highest-income group (the highest 20%) increases from 1971 to 2001.
The % of total income earned by the lowest-income group (the lowest 20%) decreases from 1971 to 2001.
So, income inequality increases.
The problem of Income disparity is worsening.
Fig.1 Changes of the percentage of total income earned by different income groups.
HK Statistics:
Income distribution by decile group
Lorenz curve The cumulate % of income
against the cumulate % of households
Line of equality: households earn 20% of total
income and so on…
Lorenz curve Closer to the line of equality, more
equal in distribution
Households Income
20% 20%
40% 40%
60% 60%
80% 80%
100% 100%
Lorenz curveDecile
Gp.Income Households Accumulate
1st 3% 10% 3%
2nd 4% 20% 7%
3rd 3% 30% 10%
4th 5% 40% 15%
5th 7% 50% 22%
6th 7% 60% 29%
7th 10% 70% 39%
8th 13% 80% 52%
9th 15% 90% 68%
10th 32% 100% 100%
Gini coefficient (Corrado Gini, 1884-1965)
0 10 20 30 40 50 60 70 80 90 100
100
90
80
70
60
50
40
30
20
10
Cumulative % of number of households
Cum
ulat
ive
% o
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Gini coefficient =
Gini coefficient (Corrado Gini, 1884-1965)
If Gini coefficient = 0 Area ABC = 0 Lorenz curve = Line of equality Perfect equality
If Gini coefficient = 1 Area ABC = Area ADC Lorenz curve = Line AD and DC Perfect inequality
Gini coefficient (Corrado Gini, 1884-1965)
0 < Gini coefficient < 1
0.4 =
Value Meaning
Less than 0.2 Absolutely even wealth distribution
0.2 – 0.3 Relatively even wealth distribution
0.3 – 0.4 Reasonably even wealth distribution
0.4 – 0.5 Uneven wealth distribution
More than 0.6 The problem of income disparity is serious
Gini coefficient (Worldwide, Human Development Report 2009 )
1 Norway 25.8
2 Australia 35.2
3 Iceland ..
4 Canada 32.6
5 Ireland 34.3
6 Netherlands 30.9
7 Sweden 25
8 France 32.7
9 Switzerland 33.7
10 Japan 24.9
11 Luxembourg 30.8
12 Finland 26.9
13 United States 40.8
14 Austria 29.1
15 Spain 34.7
16 Denmark 24.7
17 Belgium 33
18 Italy 36
19 Liechtenstein ..
20 New Zealand 36.2
21 United Kingdom 36
22 Germany 28.3
23 Singapore 42.5
24 Hong Kong, China (SAR) 43.4
25 Greece 34.3
26 Korea (Republic of) 31.6
27 Israel 39.2
28 Andorra ..
29 Slovenia 31.2
30 Brunei Darussalam ..
31 Kuwait ..
32 Cyprus ..
33 Qatar ..
34 Portugal 38.5
35 United Arab Emirates ..
36 Czech Republic 25.8
37 Barbados ..
38 Malta ..
39 Bahrain ..
40 Estonia 36
Worst: Namibia - 74.3
Limitations No consideration of economic structure
Low income disparity if economies rely on primary and secondary production, e.g. farm work or factory worker
Large income disparity if economies rely on tertiary production, e.g. high-wage financial service
Total household income vs. Per-capita income Country A and B have the same Gini coefficient (e.g. 0) Country A
Total income = $10,000,000, Population = 2 persons Per-capita income = $5,000,000
Country B Total income = $10,000,000, Population = 10 persons Per-capita income = $1,000,000
Country A’s people have more income.
Limitations
Redistribution effects Gini coefficient does not fully reflect gov’t
Healthcare Education Housing
Current income vs. Permanent income 2 workers have the same life time income However, at the same year
Young worker: Earn less current income Experienced worker: Earn more current income
Limitations
Income mobility Work hard, earn more Temporary low income ≠ Poor forever So, at a particular time, income disparity might not be
a serious problem
Population Aging group low income households
Gini coefficient
Other indexes
Gross National Income GDP, GNP and GDP per capita (to be discussed in Macroeconomics)
Human nations development index (HDI, 人類發展指數 ) United Nations Measurement of health, education standards, living standards… From 0 to 1
More than 0.8 high (rich) 0.5 – 0.79 moderate Less than 0.5 low (poor)
Poverty Line (貧窮線 ) Less than US$1 everyday Absolute poverty If a country has more than 25% population (<US$1) to spend everyday
Absolute poverty
Economic mobility
1. It is the movement of people among income groups.
2. Ability to move up or down the economic ladder within a lifetime or from one generation to another.
3. Movements up the ladder can be due to hard work or good luck.
4. Movement down the ladder can be due to laziness or bad luck.
5. It may reflect transitory variation in income or more persistent changes in income.
Sources of inequality
Labour income Salaries Commision Bonus Allowance
Non-labour income Interest from deposit Dividends from shares Rent from leasing out properties
Sources of inequality
1. Human capital Level of education Experience Skills Health Professional qualification
Sources of inequality1. Human capital
a. Skill Demand
High-skilled workers can perform well, but low-skilled workers cannot
At any level of employment, firms are willing to pay a higher wage for high-skilled worker
DH > DS
Supply Cost of training high-skilled
worker is more Higher wage is expected for
compensation of high-cost training
SH > SL
Q(labours)
SL
Wage ($)
0 QH
WH
QL
WL
SH
DL
DH
WH > WL
Higher the productivity of the skill more training is needed higher cost of training higher wage larger the differential of high-skilled work and low-skilled worker
Sources of inequality
1. Human capitalb. Age difference
Experience Older more experience higher wage Younger less experience lower wage
Productivity Old less energetic lower wage Younger more energetic higher wage
c. Interruptions to career Chronic disease Maternity leave Working women needs to take care of their children
Sources of inequality
2. Discrimination Age Gender Ethnic group Religion
3. Difference in the degree of specialization Couple have to choose to allocate time between working
or taking care of the home Working male (More income?) vs. Housewife
Sources of inequality
4. Unequal ownership of capital Inequality in wealth is greater than inequality in income
Born to be rich: huge saving for next generation Marriage to a higher socioeconomic class More ownership of wealth More non-labour income
5. Superstar phenomenon A few superstar dominate a single field outperform all others earn a large share of the income pool E.g.
Movie stars: Tom Cruise, Donnie Yen Musicians: Michael Jackson, Andy Lau Athletes: C.Ronaldo, L.B.James, Usain Bolt
Sources of inequality6. Others
Compensating differentials High-risk job higher wage Unpleasant working environment higher wage
Ability With physical and mental strength higher wage
Personality Ambition in career development Self-motivation
Beauty Attractive people more chance & can earn more E.g. models, TV stars
Economic cycle affecting different industries Rapid growth More investment D of workers Higher
wage Chance
More luck more chance of promotion higher wage
Policy concern
Assuming 2 chefs in the kitchen Chef A bakes a pizza Chef B does nothing
Which method of allocation is good? Method 1 (Work more, earn more)
Chef A eats the whole pizza Chef B eats nothing
Method 2 (Equality) Chef A eats ½ pizza Chef B eats ½ pizza
Policy concern
How about if … there is only one oven? Chef A owns all the resources of making the pizza? Chef B knows now to cook noodles only? Chef B doesn’t feel well? Chef B has already worked for 10 hours? Chef A is a pizza expert?
Do you think the method you suggested is fair?
Policy concern
Assuming 2 students are competing for an university offer Student A is not clever but works very hard Student B is clever and so he spends less time to
study
If finally… they score the same in the exam, which one should
get the offer? student B gets the offer, is it fair to Student A?
Why or why not?
In market economy…
Resource allocation Under perfect competition
market price helps achieve efficiency.
But in reality: function of price has limitations e.g. existence of externality Gov‘t intervention is necessary
In market economy…
Income distribution Under perfect competition
Individual’s income = market value of one’s output
But in reality: Individual’s income is affected by one’s ability, resources
owned, etc. Income inequality is inevitable Gov‘t intervention is necessary to avoid social conflicts.
Efficiency vs. Equity
Efficiency Allocation of resources is determined by market
demand and supply
Advantages Max. total social surplus The least possible social cost Work more, earn more incentive to increase
productivity
Disadvantages Inequity: People has less purchasing power suffers
Efficiency vs. Equity Equity
A concept of fairness in resource allocation Without clear definition:
equal in amount of resource allocation or equal in opportunity to have resource allocation
Advantages Fair and justice Less social conflict (is it really true?) Protecting the human right
Disadvantages Inefficiency: Cost of reallocation of resources Discourage production
Equalizing income
Redistribution of income
Gov’t gets money from the rich
Then resources, in terms of money, goods or services, are redistributed to those who are in need, esp. the poor
Equalizing income
Social welfareGuarantee a basic livelihood
Comprehensive Social Security Assistance (CSSA) Unemployment allowance (people who are unemployed and
unable to work) Lower the incentives to search job
Subsidized services Subsidy on some services, such as education and gov’t clinic Improve living standard better chance to climb up the social ladder
Equalizing income
Taxation
Guarantee gov’t income for providing social welfare and gov’t expenditure.
By taxing more on the high income group, wealth can be transfer from high income group to low income group
Equalizing income Taxation
Progress tax (e.g. salary tax) Tax rate increase as taxable income increases Assume:
Income = $600,000, Personal allowance = $180,000 Taxable income = $600,000 - $180,000 = $420,000
Disadvantage: High cost of calculation and collection
Year of assessment 2008/09
Net chargeable income
Salaries tax rate Tax revenue
On the first $40,000 2% $800
On the next $40,000 7% $2,800
On the next $40,000 12% $4,800
Remainder $300,000 17% $51,000
Total $58,400
($420,000 - $40,000 - $40,000 - $40,000)
Equalizing income
Taxation Constant tax rate
Property tax rate = 15% Profit tax rate = 16.5%
The gov’t assumes high income group can afford buying flats
Income redistribution effect, but not as good as progressive tax
Disadvantage: High cost of calculation and collection
Equalizing income
Law
Minimum wage laws Min. wage to protect workers’ livelihood Esp. to workers low level of skill and experience
Disadvantage: High cost of legislation, monitoring and punishment
Equalizing opportunity With equal opportunities, equity is achieved. People have different starting point:
Wealth Ability
With adequate resources (e.g. education) Same opportunity for development Able to get through the constraints of uneven factors
People can earn by their own ability Examples in HK:
Equal Opportunity Commission Sex Discrimination Ordinance Race Discrimination Ordinance Disability Discrimination Ordinance
Equalizing income Taxation
Progress tax (e.g. salary tax) Case 1 (Rich)
Income = $50,000/mth = $600,000p.a.
Tax = $58,400 % to income = 9.73%
Case 2 (Middle class) Income = $20,000/mth
= $240,000p.a. Tax = $2200 % to income = 0.9%
Case 3 (Poor) Income = $8,000/mth
= $96,000p.a. Tax = $0 % to income = 0%
Disadvantage: High cost of calculation and collection
Regressive tax (e.g. sales tax) If unit tax = $10,000
Case 1 (Rich) Income = $600,000p.a. % to income = 1.67%
Case 2 (Middle class) Income = $240,000p.a. % to income = 4.1%
Case 3 (Poor) Income = $96,000p.a. % to income = 10.4%
Disadvantage: High cost of calculation and collection
So, progress tax helps income redistributionbut proportion tax worsens income disparity.(Book 5A, Chapter 6)
Trade-off between equity and efficiency To equalize income
redistribution income from the rich to the poor tax and transfers is inevitable disincentive effect on production market inefficiency
To have market efficiency no gov’t intervention will be made the rich has more wealth, so helps generate more wealth the poor has less bargaining power, so suffers more income disparity is more serious income inequality
How can the gov’t keep the balance between equity and efficiency?