1.2.8 Consumer & producer surplus, 1.2.9 Indirect taxes & subsidies, 1.2.10 Alternative views of consumer behaviour

Question 1

Define consumer surplus

1.2.8

Answer 1

The value that consumers gain from consuming a good/service over and above the market price.
The welfare society gains.

Question 2

Define producer surplus

1.2.8

Answer 2

The difference between the price received by firms i.e. market price, for a good or service and the price at which they would have been prepared to supply that good/service

Question 3

Define profit motive

1.2.8

Answer 3

Incentive to provide more to the market at higher prices to earn more profit.

Question 4

What is the consumer surplus made up of?

1.2.8

Answer 4

People’s individual evaluations.
Added together is the total consumer surplus.
Where a firm can identify customers who are willing to pay different prices they can use price discrimination e.g. peak & off peak train travel

Question 5

What happens to consumer surplus when PED is:

1. Perfectly elastic
2. Relatively elastic
3. Perfectly inelastic
4. Relatively inelastic

Answer 5

1. Consumer surplus is zero (price people pay matches exactly what they are willing to pay)
2. Relatively low consumer surplus
3. Infinite as demand does not respond to a price change. Whatever the price, the Qd remains the same.
4. High level of consumer surplus

Question 6

How does a change in supply affect consumer surplus?

1.2.8

Answer 6

Higher supply costs; rise in market price & decrease in consumer surplus

Question 7

How does a change in demand affect consumer surplus?

1.2.8

Answer 7

Increase demand; consumer surplus increases

Question 8

Define marginal social benefit (MSB)

1.2.8

Answer 8

The additional benefit that society gains from consuming an extra unit of a good.

Question 9

Define deadweight loss

1.2.8

Answer 9

The loss in producer and consumer surplus due to an inefficient level of production.
Perhaps resulting from market failure or government failure.

Question 10

How does a change in supply affect producer surplus?

1.2.8

Answer 10

Higher supply costs; rise in market price, inc in prod surplus

Question 11

How does a change in demand affect producer surplus?

1.2.8

Answer 11

Increase demand; higher market price & quantity, inc. prod surplus.

Question 12

Define Indirect Tax

1.2.9

Answer 12

A tax levied on expenditure on goods or services.

Question 13

Define Direct Tax

1.2.9

Answer 13

A tax charged directly to an individual base on a component of income.

Question 14

Types of indirect tax

1.2.9

Answer 14

Specific indirect taxes
- A sales tax that is set at a constant amount per unit of sales

Ad Valorem indirect taxes
- A sales tax that is set at a percentage of the price
e.g. VAT (+20% to unit price)
or EXCISE duties (tax levied on certain goods & commodities produced/sold within a country e.g. tobacco/alcohol)

Question 15

Define incidence of a tax

1.2.9

Answer 15

The way in which the burden of paying a sales tax is divided between buyers and sellers.

Question 16

What happens when PED is inelastic to gov. revenue from ad valorem tax?

1.2.9

Answer 16

Gov. revenue from ad valorem taxes are larger if demand is price inelastic.

Question 17

What does PED determine?

1.2.9

Answer 17

PED Determines the incidence of tax as the more inelastic the good, the more tax can be borne on the consumer as the price does not affect the demand as much.

Question 18

Incidence of tax and:

1. Perfectly inelastic demand
2. Perfectly elastic demand

1.2.9

Answer 18

1. Producers can pass on the full value of the tax as an inc in price for consumers won’t affect demand.
2. Cannot raise the tax; producers must bear the entire burden of the tax.

Question 19

Define subsidy

1.2.9

Answer 19

A grant given by the government to producers to encourage production of a good or service.

Question 20

Effect of subsidies on:

1. Inelastic PED
2. Elastic PED

1.2.9

Answer 20

1. Subsidy has larger effect on new equilibrium price, thus consumer gains more, the more inelastic the good is.
2. Subsidy has stronger effect on new equilibrium quantity. Little price change.

Question 21

Questions to think about subsidies

1.2.9

Answer 21

Are the subsidies effective in meeting their aims?

• Will they achieve the desired stimulus to demand/consumption?
• Is a subsidy sufficient? Might other incentives be needed?

Will a subsidy affect productivity/efficiency?

• Subsidies for investment & research can bring positive spillovers.
• Firms may become dependent on state aid/financial assistance

How much does the subsidy cost and who benefits?
- Is subsidy self-financing? Will it create more revenue or does it create an expensive burden for tax payers?

Does the subsidy help correct market failure?
e.g. is employment higher with child care subsidies or does a subsidy lead to undesired unintended consequences?

Question 22

Arguments for producer subsidies

1.2.9

Answer 22

• Keep prices down & control inflation
• Correct market failure; correcting leads to socially optimum outcome & allocative efficiency e.g. underproduction of merit goods.
• Reduce cost of capital investment projects; stimulate economic growth by inc. LRAS
• Slow-down process of long-term decline in an industry e.g. mining/fishing
• Boost demand for an industry during a recession

Question 23

Arguments against producer subsidies

1.2.9

Answer 23

• Opportunity cost of money spent; expensive for gov.
• Distort free market allocation;lead to gov. failure
• Usually funded by tax payers, who may derive no benefit
• Subsidy can artificially protect inefficient firms who need to restructure/encourage laziness & x-inefficiency
• Can achieve objectives of subsidies by alternative means w/ less distorting effects e.g. banning, laws, tax, advertising
• Subsidies used in isolation are less effective than if part of a strategic integrated solution to an economic/social problem
• Export subsidies distort trade in goods & services; can curtail the ability of ELDCs to compete in markets of rich nations

Question 24

What is the impact of a subsidy on producer surplus?

1.2.9

Answer 24

Subsidy will generate more profit so producer has an incentive to increase output.
Producer surplus increases; & revenue increases

Question 25

What happens if you are a member of the WTO?

1.2.9

Answer 25

Shouldn’t be using subsidies or protect companies (unfair advantage)

Question 26

When does x-inefficiency occur?

1.2.9

Answer 26

When a firm lacks the incentive to control costs - causes average cost of production to be higher than necessary.

Question 27

Reasons why consumer may not behave rationally

1.2.10

Answer 27

Failure to forecast future feelings correctly; consumers not maximising utility.
Underestimate addictive nature of some consumption decisions & consumers tend to overestimate the impact of a present consumption decision.

• Habitual behaviour
• Herding
• Bounded rationality
• Altruism vs pure self-interest
• Bounded self-control
• Heuristics
• Nudge theory
• Loss aversion & endowment effect
• Availability bias
• Framing
• Cognitive bias

Question 28

Define habitual behaviour

1.2.10

Answer 28

Where consumers persist in acting in a particular way even when conditions have changed.

Question 29

Define herding

1.2.10

Answer 29

Where people take decisions based on the actions of others, rather than on a rational evaluation of the situation they face.

Can lead to “bubbles” in financial housing markets where excessive high prices exist greater than the true worth of the good/service.
When the bubble bursts, the sector collapses; fall into recession associated w/ falling incomes, AD & inc unemployment.
e.g. dot.com bubble 1995 to 2000 when investors pumped money into internet-based start ups.

Question 30

Define bounded rationality

1.2.10

Answer 30

A situation in which people’s ability to make rational decision is limited by a lack of information or an inability to interpret the information that is available to interpret the information that is available, perhaps because of weakness at computation

Question 31

Define nudge theory

1.2.10

Answer 31

Analysis that suggests that people’s behaviour can be influenced by making desirable decisions easy to make.

Based on the idea that using choice architecture, one can influence the likelihood that one option is chosen over another by individuals.
Allows individuals to maintain freedom of choice & feel in control of decisions they make.

Question 32

Factors affecting bounded rationality

1.2.10

Answer 32

• Time
• Too much choice to understand/evaluate
• Imperfect information

Question 33

Altruism vs self-interest

Answer 33

People do not always act in their own self-interest. Buying eco-friendly goods is more expensive.
Behavioural economists believe moral values, social, emotional and psychological factors play a role.
The assumptions of consumers maximising utility and firms maximising profits do not hold.

Question 34

Bounded self-control

Answer 34

Addictive habits stop our ability to moderate or stop consumption e.g. smoking; or not eating enough healthy food despite our understanding of its benefits.

Question 35

Rule of thumb (Heuristics)

Answer 35

Because of bounded rationality & bounded self-control, consumers take mental shortcuts to make satisfactory decisions.
Satisficing decisions sacrifice some utility to reach a satisfactory outcome e.g. buying on repeat purchase.

Question 36

What is the anchoring effect?

Answer 36

Heavily relying on the first piece of info we are exposed to. This info becomes a reference point for all subsequent decisions that we make.
The challenge is questioning the first piece of information to see if it’s in our best interest to stick with it.

Question 37

What is availability bias?

Answer 37

Type of cognitive bias.
Decisions are made by on the ease of information available.
Results in consumers not risk assessing well.
May under or overestimate a risk, choosing to focus on the wrong risks.
The way these biases manifest is likely to be heavily influenced by media representations of risks.
e.g. grandma smoking w/ no visible adverse effects

Question 38

What is framing?

Answer 38

Consumers are influenced by how decisions are put to them eg. food packaging presents low fat/low sugar may influence purchasing decisions. The way questions are framed in surveys can affect our final answer.

Question 39

What is loss aversion & the endowment effect?

Answer 39

Decisions are made to avoid losses; weighing losses are greater than gains e.g. a person prefers not to lose £10 than find £10.
A consumer may choose to put their money in a low interest saving account rather than invest in low risk shares that are expected to give a high return.

Question 40

What are social norms?

Answer 40

Making decisions based on social etiquette and how to behave in society.
e.g. tipping in some countries, others dont.

Question 41

What is nudge theory?What is choice architecture?

Answer 41

Design of different ways in which choices can be presented to consumers, and the impact of that presentation on consumer decision-making.
Retain consumer sovereignty (the right to choose) but nudging consumers to make certain choices.

Question 42

Examples of nudge theory

Answer 42

In restaurants there is one dish more expensive than the others; decoy effect.
Expect you to buy second most expensive which is a bargain in comparison.

Place salad bar in the centre of the work canteen.

Question 43

Example of default choice and mandated choice

Answer 43

Default choice
Giving people the choice to opt out rather than opt in of donating organs when they die - donations increased from 30% to 85%

Mandated choice
Individual would have to say “yes” or “no” to organ donation

Question 44

Example of restricted choice and framing

Answer 44

Restricted choice - providing school meals without “junk” food.
Framing - providing info to encourage consumption e.g. low sugar on packaging

Question 45

What else can influence peoples decisions and actions?

Answer 45

Positive reinforcement or indirect suggestions

Question 46

What are cons of nudge theory?

Answer 46

Paternalism by gov. Individual freedom/ability to do what one wants is lost
Gov may lack perf info.
Policies may be ineffective/costly to administer & enact meaning gov failure where costs outweigh benefits.
They do not fully correct deep rooted problems e.g. smoking/drinking - Shove policies are more effective.

Question 47

What are shove policies?

Answer 47

Taxes, information policies, subsidies & regulation can discourage use of demerit goods and may be more effective than nudge.

Question 48

What do nudge policies seek to do?

Evaluation?

Answer 48

Seek to alter information, language and presentation but still allowing freedom of choice.
Can be used as complementary policies
Unpredictable, untested and only change minor behaviours.
Effective when people are predictably irrational e.g. lazy to opt out.
Information provision gives individuals the ability to make informed, rational decisions.
Shove policies e.g. tax, subsidies & regulation can be more effective.
Short term policies as they lose impact over time & should be used alongside shove & information policies.
Combo of policies likely to give best outcome that maximises social welfare.

Question 49

Reasons for supporting rational choice theory

Answer 49

If people are making decisions from bounded rationality, then economic average will lead to rational behaviour, even if not everyone makes perfect decisions.
Supporters of rational choice theory argue in many cases, it is rational to use rules of thumb. e.g. choosing between cereal, not rational to spend time choosing between 2 similar options.
Satisficing choice made - do not worry about ‘optimal choice’

Question 50

Impact of technology on decision making

Answer 50

Technology e.g. internet has helped consumers make a more informed choice.