economics chapter 12 efficiency, equity and the role of government

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.

Q(units)

300 700

Shortage

Q(units)

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 ($)

D = MB

S = MC

Q(units)

Consumer surplus

Willingness to pay = P1 + P2 + P3 + P4 + …

(Q1) ( Q2 ) ( Q3 ) ( Q4 )

Consumer surplus = Willingness to pay – actual payment

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

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

D = MB

S = MC

Q(units)

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

Q (units)1

Q (units)

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)

D = MB

S = MC

D = MB

S = MC

Q(units)

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

D = MB

S = MC

Q(units)

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

D = MB

S = MC

Q(units)

D = MB

S = MC

Q(units)

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

D = MB

S = MC

Q(units)QtQe

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

S = MC

Q(units)42

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

S = MC

Q(units)4 2

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

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

S = MC

Q(units)

D = MB

Deadweight loss

S = MC

Q(units)Qe

D = MB

S = MC

Q(units)

D = MB

Deadweight loss

Price floor Price floor is set at P1.

S = MC

Q(units)

D = MB

Deadweight loss

S = MC

Q(units)Qe

D = MB

S = MC

Q(units)

D = MB

Deadweight loss

Quota Quota is set at Q1.

Qt from Q0 to Q1.

Price from P0 to P1. Quantity transacted is less than

Q(units)

D = MB

Deadweight loss

S = MC

Q(units)Qe

D = MB

S = MC

Q(units)

D = MB

Deadweight loss

Unit tax Supply from S0 to S1.

Q(units)

D = MB

Deadweight loss

S = MC

Q(units)Qe

D = MB

S0 = MC

Q(units)

D = MB

Deadweight loss

S1 = MC + Tax

Tax revenue

Unit subsidy Supply from S0 to S1.

Qt from Q0 to Q1. Quantity transacted is greater than

Over-production Q1 – Q0 occurs

At Q1, MB < MC Deadweight loss

Q(units)

D = MB

Deadweight loss

S = MC

Q(units)Qe

D = MB

S0 = MC

Q(units)

D = MBP1

Deadweight loss

C.S.S1 = MC + Subsidy

Subsidy benefit

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

Q(units)

P0Deadweight loss

Q(units)

Deadweight loss

Price floorEd of D0 > Ed of D1

Higher the elasticity of demand, greater the ( MB – MC ) Greater under-production Greater deadweight loss

Q(units)

P0Deadweight loss

Q(units)

P1 P1Deadweight loss

QuotaEd of D0 > Ed of D1

Higher the elasticity, of demand, smaller the ( MB – MC ) Same under-production Smaller deadweight loss

Q(units)

Deadweight loss

S1P ($)

Q(units)

Deadweight loss

Unit taxEd of D0 > Ed of D1

Greater under-production Greater deadweight loss

Q(units)

Deadweight loss

S1 P ($)

Q(units)

P0Deadweight loss

Unit subsidyEd of D0 > Ed of D1

Greater over-production Greater deadweight loss

Q(units)

Deadweight loss

Q(units)

Deadweight loss

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

Q(units)

Deadweight loss

0 Q(units)

P0Deadweight loss

Price floorEs of S0 > Es of S1

Higher the elasticity of supply, smaller the ( MB – MC ) Same under-production Smaller deadweight loss

Q(units)

P0 Deadweight loss

0 Q(units)

P0 Deadweight loss

QuotaEs of S0 > Es of S1

Higher the elasticity of supply, smaller the ( MB – MC ) Same under-production Smaller deadweight loss

Q(units)

P0 Deadweight loss

0 Q(units)

P0Deadweight loss

Unit taxEs of S0 > Es of S1

Higher the elasticity of supply Greater under-production Greater deadweight loss

Q(units)

P0Deadweight loss

Q(units)

P0Deadweight loss

Unit subsidyEs of S0 > Es of S1

Higher the elasticity of supply Greater over-production Greater deadweight loss

Q(units)

P1Deadweight loss

Q(units)

Deadweight loss

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

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

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

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

Q(units)

D=MPB=MSB

P1Deadweight loss

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

1 14 6 4

2 13 7 4

3 12 8 4

4 11 9 4

5 10 10 4

6 9 11 4

Q(units)

D=MPB=MSB

12Deadweight loss

Q MSB MPC External cost

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)

Parking

Farming

Parking(MB = $50)

Land (Own by A)

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.

Parking(MB = $50)

Land (Own by A)

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.

Parking(MB = $200)

Land (Own by B)

Farming(MB = $100)

Option 1 (Use the land by himself):

A: Nothing to do. No gain.

B: Farm the land and gain $100.

Parking(MB = $200)

Land (Own by 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.

Parking(MB = $200)

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)

Deadweight loss

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

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

Cumulative % of number of households

Gini coefficient =

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

0 < Gini coefficient < 1

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

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)

Wage ($)

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

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

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

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

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

Equalizing income

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%

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%

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?

economics chapter 12 efficiency, equity and the role of government

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