byMarkLovewell
Copyright2009byMcGrawHillRyerson UnderstandingEconomics
5thedition Limited.Allrightsreserved.
Chapter 7 Economic Welfare and Income Distribution
Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.
LearningObjectives
After this chapter you will be able to:
1. 2. 3. 4. 5.
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
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
MarginalandTotalBenefit
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ConsumerSurplus(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ConsumerSurplus(b)
Figure7.1,page175
Consumers Demand Curve for Pizzas Consumers Demand Schedule for Pizzas
Price ($ per pizza) $14 12 10 Price ($ per pizza) Quantity Demanded (D) (pizzas) 1 2 3 Total Benefit ($) 14 26 (14 + 12) 36 (14 + 12 + 10) 16
14
A+B = Total Benefit B = Total expenditure A = $6 D
12
10
8 4 B = $30
0
1
2
3
4
Quantity (pizzas per week)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ConsumerSurplus(c)
Figure7.2,page176
Market Demand Curve for Pizzas Market Demand Schedule for Pizzas
Price ($ per pizza) Price ($ per pizza) 18 14 10 Quantity Demanded (D) (thousands of pizzas) 18 16 14 12 10 8 6 4 2 0 A+B = Total Benefit B = Total Expenditures A = $400,000 D
0 50 100
B = $1 million 50 4
Quantity (thousands of pizzas per week)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ProducerSurplus
Producer surplus shows the extent to which producers
receive a price different from the lowest one they are willing to accept. It is defined as the difference between the price received from selling each unit of a product and the marginal cost of producing it.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ProducerSurplusfora Market
Figure7.3,page177
18 16
Price ($ per pizza)
14 12 10 8 6 4 2 D C = $400 000 S
0
50
100
Quantity (thousands of pizzas per week)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheCaseofPerfect Competition
In a perfectly competitive market, the requirement of
marginal-cost pricing is met. Based on this requirement, equilibrium will occur where marginal benefit equals marginal cost, and both consumer surplus and producer surplus are maximized.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheCaseofPerfect Competition
Figure7.4,page178
18 16 S
Price ($ per pizza)
14 12 10 8 6 4 2
Marginal Cost
Consumer Surplus Producer Surplus
Marginal Benefit
Marginal Cost
Marginal Benefit
D 150
0
50
100
Quantity (thousands of pizzas per week)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
WhenaMarketBecomes 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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
WhenaMarketBecomesUncompetitive
Figure7.6,page179
18 16 S
Price ($ per pizza)
14 12 10 8 6 4 2 D 0 50 75 100 150
E
F G
Deadweight Loss
Quantity (thousands of pizzas per week)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
SpilloverCosts(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
SpilloverCosts(b)
Figure7.6,Page182
Market Demand Curve for Strawberries Demand and Supply Schedules for Gasoline
Price ($ per litre) Price ($ per litre) $2.50 2.00 1.50 1.00 0.05 Quantity Quantity Demanded Supplied (D) (S0) (S1) (millions of litres) 4 5 6 7 8 8 7 6 5 4 6 5 4 3 2 S1 2.50
a
S0
Spillover Costs, Excise Tax
2.00 1.50 1.00 0.50
b
D 0 1 2 3 4 5 6 7 8
Millions of Litres
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
SpilloverBenefits(a)
Spillover benefits are the positive external effects of producing or consuming a product.
Adding these benefits to private benefits raises the demand
curve. The preferred outcome is at a higher quantity than occurs in a perfectly competitive market. Government intervention (e.g. a consumer subsidy) can produce the preferred outcome.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
SpilloverBenefits(b)
Figure7.7,page184
Demand and Supply Schedules for an Engineering Education
Tuition ($ per year) $6000 5000 4000 3000 2000 Enrollment Quantity Demanded Supplied (D0) (D1) (S) (thousands of students) 8 9 10 11 12 10 11 12 13 14 12 11 10 9 8
Demand and Supply Curves for an Engineering Education
6000
b
S
Spillover Benefits, Student Subsidy
5000 Tuition ($ per year) 4000 3000 2000 1000
a
D0
D1
0
8
9
10 11 12 13 14
Thousands of Students
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
CanadianDistributionofIncome
Canadas 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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
IncomeDistributionin SelectedYears
Figure7.8,page187
PercentageofTotalPreTaxIncome ReceivedbyEachFifthofHouseholds 1951 Lowest20% Second20% Third20% Fourth20% Highest20% Averageoftotal 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 Average Income (2006) $13800 31800 51300 77800 152600 65500
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheLorenzCurve
Figure7.9,page183
100 e
CumulativeShareof Income(%)
Distributionof HouseholdIncome Shareof Incomein 2000(%) Lowest Second Third Fourth Highest 4 10 16 24 47 Lowest Lowest Lowest Lowest
CumulativeDistributionof HouseholdIncome CumulativeShare ofIncome in2000(%) 20% 40% 60% 80% 100% 4 14 30 54 100 (a) 4+10(b) 14+16 (c) 30+24(d) 54+47(e)
80 60 40 20 a 20 b Perfect Equality c Perfect Inequality 60 80 100 d
= = = =
0
40
Households(%)
Copyright2008byMcGrawHillRyerson Limited.Allrightsreserved.
InterpretingtheLorenz 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 economys income, the Lorenz curve would follow the horizontal and vertical axes of the graph.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheGiniCoefficient
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
WageDeterminants(a)
There are seven main wage determinants:
labour productivity education experience job conditions regional disparities market power discrimination
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
DistributionofEarnings(2006)
Figure7.10,page190
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
LabourProductivity
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Education
Education:
usually adds to a workers pay but has opportunity costs as
well serves two main purposes (consumption and investment in human capital)
A student will undertake an educational if program its benefits (both monetary and nonmonetary) exceed its opportunity costs.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
EducationandAverageFamilyIncome (2006)
Figure7.11,page191
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
AgeandAverageIncome (2006)
Figure7.12,page192
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
LabourUnions
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
JobDiscrimination
Job discrimination relates to hiring, wage, and promotion decisions based on criteria other than a workers 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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ReasonsforIncomeInequality(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
DistributionofWealthinSelectedCountries
Figure7.13,page195
90
ShareofWealthHeldby TopWealthHolders(%)
80 70 60 50 40 30 20 10 0 Top1% Top5% Top20% Sweden(1975) Canada(1984) France(1986) US(1986)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ThePovertyLine
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ThePovertyLineforVariousHouseholds (2006)
Figure7.14,page197
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheIncidenceofPoverty(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheIncidenceofPoverty(b)
Figure7.15,page198
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheCanadianWelfare Society
A welfare society is one in which the government plays a major role in attempting to ensure the economic wellbeing of its citizens. Transfer payments and personal income taxes are the most important elements of Canadas welfare society.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TransferPaymentsand IncomeEquity(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.
Copyright2010byMcGrawHillRyerson Limited.Allrightsreserved.
TransferPaymentsandIncomeEquity(b)
Figure7.16,page201
AverageTransfer Payments Received (2006) Lowest20% Second20% Third20% Fourth20% Highest20% AverageofTotal $7200 9700 8400 7500 5100 7600
TransferPayments asaPercentof TotalIncome (2006) 51.9% 30.6 16.4 9.7 3.3 11.6
ShareReceived ofTotalTransfer Payments (2006) 19.9% 25.7 22.2 19.8 13.3
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
PrinciplesofTaxation
There are two main principles of taxation:
benefits received (e.g. gasoline taxes for roadwork) ability to pay (e.g. personal income tax)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TaxesandIncome
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)
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TaxesandIncomeEquity
Personal income taxes are progressive, with the
proportion of income paid in tax rising significantly with a households income level.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
PersonalIncomeTaxesandIncomeEquity (2006)
Figure7.17,page203
AveragePersonal IncomeTaxes Paid Lowest20% Second20% Third20% Fourth20% Highest20% AverageofTotal $700 2800 6700 12600 33300 11200 PersonalIncomeTaxes asaPercentof TotalIncome 5.3% 8.8 13.0 16.1 21.8 17.1 SharePaid ofTotalPersonal IncomeTaxes 1.3% 5.0 11.9 22.4 59.4
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheDoomsdayProphet
Thomas Malthus formulated a theory of population based on two principles:
food increases in an algebraic progression (1,2,3) population increases in a geometric progression (1,2,4)
He predicted that over time population growth would outstrip growth in the food supply with disastrous effects
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
AMalthusianTimeChart
page209
AMalthusianTimeChart Year Food Population 1 1 1 25 2 2 50 3 4 75 4 8 100 5 16 125 6 32 150 7 64 175 8 128 200 9 256 225 10 512
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(OLC) Rent
Rent is the payment for the use of a productive resource available in only a fixed amount.
Land receives a rent because its supply is perfectly inelastic. The equilibrium rent for a particular type of land varies with
demand for this land (e.g. a rise in the price of beef affects the rent for ranching land).
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(OLC) EquilibriumintheMarketforLand
FigureA
Demand and Supply Schedules for Land
Rent($peryear) Rent ($ per year) Quantity Demanded (D) Quantity Supplied (S)
Demand and Supply Curves for Land
14 12 10 8 6 4 2 e
S
(millions of hectares) $14 12 10 8 6 4 5 6 7 8 6 6 6 6 6
D
0
1
2
3
4
5
6
7
8
9
MillionsofHectares
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(OLC) ChangesintheDemandforLand
FigureB
Demand and Supply Schedules for Land
Rent($peryear) Rent ($ per year) Quantity Quantity Demanded Supplied (S) (D0) (D1) (millions of hectares) 4 5 6 7 8 5 6 7 8 9 6 6 6 6 6
Demand and Supply Curves for Land
14 12 10 8 6 4 2 a
S
b
$14 12 10 8 6
D0 D1
0
1
2
3
4
5
6
7
8
9
MillionsofHectares
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(OLC) TheRangeofInterestRates
Four factors affect interest rates:
credit risk the loan period collateral the size of the loan
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Wages,Rent,Interest,andProfit(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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheRoleofLabourUnions(a) (OnlineLearningCentre)
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
TheRoleofLabourUnions(b) (OnlineLearningCentre)
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
ReapingtheRewards (OnlineLearningCentre)
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.
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
RicardosTheoryofRent
FigureA
Land Rents per Hectare
(when production costs are $100 per hectare) Wheat Price ($) $5 10 Grade A (50 kg output) 150 [($5x50)$100] 400 [($5x50)$100] Grade B (40 kg output) 100 300 Grade C (20 kg output) 0 100 Grade D (10 kg output) not cultivated 0
Land Rents per Hectare
400
$400 $300
Wage($peryear)
300 200 100
$150 $100 $100 $0 $0 D
0
A
B
C
GradeofLand
Copyright2009byMcGrawHillRyerson Limited.Allrightsreserved.
Chapter 7 The End
Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.