Topic 4 - Applications of the Demand and Supply: Normative Considerations

Question 1

What does the term “Welfare Economics” refer to?

Answer 1

Welfare economics is the study of how the allocation of resources affects economic wellbeing.

Question 2

What is “Consumer Surplus” used for?

Answer 2

Consumer surplus measures the economic welfare of the buyer’s (demand) side of the market.

Question 3

What is “Producer Surplus” used for?

Answer 3

Producer surplus measures the economic welfare of the seller’s (supply) side of the market.

Question 4

Define “Willingness to pay”?

Answer 4

Willingness to pay is the maximum amount that a buyer will pay for a good.

Question 5

How is “Consumer Surplus” calculated?

Answer 5

Consumer surplus is calculated by taking the buyer’s willingness to pay for a good and subtracting the amount the buyer actually pays for that good.

Question 6

How would you measure “Consumer Surplus” using a demand curve?

Answer 6

You can measure the consumer surplus on a demand curve graph by calculating the area below the demand curve, and above the price of the good.

Question 7

How is “Producer Surplus” calculated?

Answer 7

Producer surplus is calculated by taking the amount a seller is paid for a good and subtracting the cost to the seller of producing that good (It’s their profit).

Question 8

How would you measure “Producer Surplus” using a supply curve?

Answer 8

You can measure the producer surplus on a supply curve by calculating the area below the price of the good and above the supply curve.

Question 9

What is the “Pareto-Efficient Allocation”?

Answer 9

The Pareto-efficient allocation is a theoretical allocation in which there is no other feasible allocation in which some participant of the economy is strictly better off and no-one is worse off.

Question 10

What is “Total Surplus”?

Answer 10

Total surplus is the sum of both producer surplus and consumer surplus.

It can also be calculated by taking the value of a good to the consumers and subtracting the cost to the sellers of producing that good.

Question 11

True/False: In isolation a competitive market becomes a Pareto-efficient allocation.

Answer 11

True.

Question 12

What are the conditions for which a competitive market becomes a Pareto-efficient allocation?

Answer 12

1. There must not be market power.
2. There must not be externalities, public goods, or common resources.
3. There must not be asymmetric information about the good traded in the market.

Question 13

True/False: The difference between the total surplus before and after a tax is introduced is considered lost.

Answer 13

False. A good portion of the difference between the total surpluses is given to the government therefore is not lost.

Question 14

True/False: The entire difference between the total surplus before and after a tax is introduced is given to the government as tax.

Answer 14

False. The introduction of a tax will reduce the quantity of the good that is traded, the amount taxed per good multiplied by the number of goods traded is what gives us the total tax revenue.

Question 15

Define “Deadweight Loss”?

Answer 15

A deadweight loss is the reduction in total surplus that results from a market distortion such as a tax.

Question 16

Why does a tax cause a “Deadweight Loss”?

Answer 16

A deadweight loss occurs after a tax is introduced because the people will reduce the quantity of the good that is traded.

Question 17

How does the concept of elasticity interact with “Deadweight Loss”?

Answer 17

The more elastic the demand and supply for a good the larger the deadweight loss will be. Therefore to minimize deadweight loss the government should ideally tax inelastic goods.

Question 18

What happens to the total tax revenue and deadweight loss as you increase the tax rate?

Answer 18

Increased taxation will cause reduced economic activity, this will cause the total tax revenue to begin to reduce, while the deadweight loss continues to grow exponentially.

Question 19

What is a “Laffer Curve”?

Answer 19

The Laffer Curve depicts the relationship between tax rates and tax revenue.

Question 20

What is “Supply-Side Economics”?

Answer 20

Supply-side economics refers to the views of Ronald Regan and Arthur Laffer, who proposed that a tax cut would induce more people to work more, which would raise economic well being and thereby have the potential to increase tax revenues (Depends on where you are on the Laffer Curve).

Question 21

What is an “Externality”?

Answer 21

An externality arises when a person engages in an activity that influences the well being of a bystander and yet the person neither pays nor receives any compensation for that effect.

Question 22

If a bystander is adversely affected by an activity without receiving compensation this is called?

Answer 22

This is called a “Negative Externality”.

Question 23

If a bystander is beneficially affected by an activity without giving compensation this is called?

Answer 23

This is called a “Positive Externality”.

Question 24

True/False: Externalities are only caused by producers of goods/services.

Answer 24

False. Consumers can also cause externalities, for example car exhaust fumes are a negative externality arising from the consumption of petrol.

Question 25

What is the “Social Optimum”?

Answer 25

The social optimum is the ideal quantity of a good to be traded to maximise the benefits of a positive externality or minimise the damage of a negative externality.

Question 26

How does the “Social Optimum” relate to the equilibrium?

Answer 26

With a negative externality the equilibrium is too high compared to the social optimum.
With a positive externality the equilibrium is too low compared with the social optimum.

Question 27

What does it mean to “Internalise” an externality?

Answer 27

Internalising an externality involves altering the incentives so that people take account of the external effects of their actions. Ideally this achieves the socially optimum output.

Question 28

What is a “Command-And-Control” policy?

Answer 28

The command-and-control approach consists of a ‘command’ which sets a standard (the maximum level of permissible pollution), and a ‘control’ which monitors and enforces the standard.

Question 29

What are the two types of standards in environmental policy?

Answer 29

1. Ambient standards set the minimum desired level of air or water quality, or the maximum level of a pollutant that must be maintained.
2. An emissions standard specifies the maximum level of permitted emissions.

Question 30

What are the advantages of using standards?

Answer 30

1. They are easy to understand.

2. They are a pragmatic approach when there is uncertainty about the effects of the externality.

Question 31

What are the disadvantages of standards over market-based instruments (such as taxes or subsidies)?

Answer 31

1. Firms have no incentives to exceed the standard.

2. Standards tend to be less cost-effective than market-based instruments.