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Economics
Chapter 12
Efficiency, Equity
and the Role of Government
Assumption

Classical economics


Market economy


Invisible hand
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 ($)
P ($)
Surplus
S
S
4
2
D
Shortage
0
300
700
Q
(units)
D
0
300
700
Q
(units)

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 ($)
S = MC
A
Pe
D = MB
B
0
Qe
Q
(units)
Consumer surplus

Willingness to pay =
P1 + P 2 + P3 + P 4 + …
(Q1)

( Q2 ) ( Q 3 ) ( Q 4 )
Consumer surplus = Willingness to pay – actual payment
P ($)
Consumer
Surplus
Price
Actual
payment
Actual payment
0
D: Willingness to pay curve
Q
Producer surplus

Minimum supply price = P1 + P2 + P3 + P4 + …
(Q1)

( Q2 ) ( Q3 ) ( Q4 )
Producer surplus = Actual revenue - Minimum supply price
P ($)
Producer
Surplus
S: Minimum supply price curve
Price
Actual
payment
0
Q

Consumer surplus = MB – P
Producer surplus = P – MC

At equilibrium,



Consumer surplus is maximized, i.e. MB – Pe = 0 ∴ MB = Pe
Producer surplus is maximized, i.e. Pe – MC = 0 ∴Pe = MC
P ($)
S = MC
Pe
D = MB
0
Qe
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
Rationing function
1.



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

Therefore, A will have the good finally
Buyer C: $500
Function of price
2.

Function of allocation
 what’s the quantity to be consumed?
Incentives or market information
 If excess demand (i.e. Qd > Qs),





Consumer is willing to pay more to get the good
Price   Qd & Qs
Until: MB = P = MC
Market efficiency
If increase in demand (i.e. demand curve shifts rightward),






D
Market Price 
Producer is willing to produce more (law of supply)
Qt  (higher quantity  effect on allocation)
Until: MB = P = MC
Market efficiency
Function of price

Given that the quantity is fixed


P ($)
The one has the highest
willingness to pay gets the goods.
Rationing function
0

Given that the price is fixed


S
Consumer will determine the
quantity according to their MB,
i.e. Quantity at P=MB
Function of allocation
1
Q (units)
P ($)
10
0
S
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 = $8, Qe = 10 units,
If output level = 5 units
[i.e. Q < Qe]
 consumers want to buy more
 producers can’t sell more
 total social surplus not maximized
 quantity level where MB ≠ MC
 the market is inefficient
P ($)
S = MC
8
D = MB
0
10
Q
(units)
P ($)
S = MC
12
4
D = MB

Deadweight loss
0
5
Q
(units)
Deadweight loss due to under-production


Under-production = Social optimal output - Quantity transacted

Qt < Qe

quantity level where MC < MB
Deadweight loss in the market
P ($)
S = MC
Pd

Solution:
Increase production can bring
a rise in total social surplus
Ps
D = MB
0
Qt
Qe
Q
(units)
Deadweight loss


At market equilibrium
 Pe = $8, Qe = 10 units,
If output level = 15 units
[i.e. Q > Qe]
 consumers don’t want to pay higher
price
 producers can’t sell at a higher price
 total social surplus not maximized
 quantity level where MB ≠MC
 the market is inefficient
P ($)
S = MC
8
D = MB
0
Deadweight loss
(units)
P ($)
S = MC
10
6
D = MB
0

Q
10
15
Q
(units)
Deadweight loss


Over-production = Quantity transacted – Social optimal output

Qt > Qe

quantity level where MC > MB
Deadweight loss in the market
P ($)
S = MC

Solution:
Decrease production can bring
a rise in total social surplus
Ps
Pd
D = MB
0
Qe
Qt
Q
(units)
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) = $2
P ($)
S = MC
9
7
D = MB
0
2
4
Q
(units)
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 = $12
P ($)
S = MC
9
7
5
D = MB

If Qt = 6 units
 Deadweight loss
= MC – MB (of the 5th and 6th units)
= ($8 + $9) – ($6 + $5) = $6
0
4
2
Q
(units)
Market intervention and inefficiency
Assumption:


In perfectly competitive market,




MB = MC
Total social surplus is max.
Market efficiency
No other forces to affect market equilibrium
Market intervention and inefficiency
Price ceiling








Price ceiling is set at P1.
Price  from P0 to P1.
Qt  from Q0 to Q1.
Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC
Deadweight loss
P ($)
S = MC
Deadweight
loss
P0
P1
D = MB
0
Q1
Q0
Q
(units)
Market intervention and inefficiency
P ($)
S = MC
C.S.
Pe
P.S.
D = MB
0
Qe
Q
(units)
P ($)
S = MC
C.S.
Deadweight
loss
P.S.
Pc
D = MB
0
Qt
Q
(units)
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 ($)
S = MC
P1
Deadweight
loss
P0
D = MB
0
Q1
Q0
Q
(units)
Market intervention and inefficiency
P ($)
S = MC
C.S.
Pe
P.S.
D = MB
0
Qe
Q
(units)
P ($)
S = MC
C.S.
Pf
Deadweight
loss
P.S.
D = MB
0
Qt
Q
(units)
Market intervention and inefficiency
Quota








Quota is set at Q1.
Qt  from Q0 to Q1.
Price  from P0 to P1.
Quantity transacted is less than
the socially optimal output Q0
Under-production Q0 - Q1 occurs
At Q1, MB > MC
Deadweight loss
S1
P ($)
S0
P1
Deadweight
loss
P0
D = MB
0
Q1
Q0
Q
(units)
Market intervention and inefficiency
P ($)
S = MC
C.S.
Pe
P.S.
D = MB
0
Qe
Q
(units)
P ($)
S = MC
C.S.
Pf
Deadweight
loss
P.S.
D = MB
0
Qt
Q
(units)
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 ($)
S1
S0
P1
Deadweight
loss
P0
D = MB
0
Q1
Q0
Q
(units)
Market intervention and inefficiency
P ($)
S = MC
C.S.
Pe
P.S.
D = MB
0
Qe
P ($)
Q
(units)
S1 = MC + Tax
S0 = MC
C.S.
P1
Tax
revenue
Deadweight
loss
P.S.
D = MB
0
Qt
Q
(units)
Market intervention and inefficiency
Unit subsidy








Supply  from S0 to S1.
Price  from P0 to P1.
Qt  from Q0 to Q1.
Quantity transacted is greater than
the socially optimal output Q0
Over-production Q1 – Q0 occurs
At Q1, MB < MC
Deadweight loss
P ($)
S0
Deadweight
loss
S1
P0
P1
D = MB
0
Q0 Q1
Q
(units)
Market intervention and inefficiency
P ($)
S = MC
C.S.
Pe
P.S.
D = MB
0
Q
Qe
(units)
P ($)
S0 = MC
P.S.
Subsidy
benefit
Pe
C.S.
Deadweight
loss
S1 = MC + Subsidy
P1
D = MB
0
Qt
Q
(units)
Summary of Market intervention and inefficiency
Deadweight loss due to…
Q
Price ceiling
Price floor
Quota
MB & MC
P1 < P 0
Under production /
Under consumption
Q1 < Q0
P1 > P 0
MB > MC
P1 > P 0
Unit tax
Unit subsidy
P
P1 > P 0
Over production /
Over consumption
Q1 > Q0
P1 < P 0
MB < MC
Elasticity of demand and deadweight loss
Price ceiling

Ed of D0 > Ed of D1
P ($)
P ($)
S0
S0
Deadweight
loss
P0
P1
Deadweight
loss
P0
P1
D
0



Q1 Q0
Q
(units)
D
0
Q1 Q0
Q
(units)
Higher the elasticity of demand, smaller the ( MB – MC )
Same under-production
Smaller deadweight loss
Deadweight
loss
Elasticity of demand and deadweight loss
Price floor

Ed of D0 > Ed of D1
P ($)
P ($)
S0
S0
P1
P0
Deadweight
loss
P1
P0
Deadweight
loss
D
D
0



Q1
Q0
Q
(units)
0
Q1 Q0
Q
(units)
Higher the elasticity of demand, greater the ( MB – MC )
Greater under-production
Greater deadweight loss
Elasticity of demand and deadweight loss
Quota

Ed of D0 > Ed of D1
P ($)
S1
P1
P0
P ($)
S0
Deadweight
loss
S1
S0
P1
Deadweight
loss
P0
D
D
0



Q1
Q0
Q
(units)
0
Q1
Q0
Higher the elasticity, of demand, smaller the ( MB – MC )
Same under-production
Smaller deadweight loss
Q
(units)
Elasticity of demand and deadweight loss
Unit tax

Ed of D0 > Ed of D1
P ($)
P1
P0
S1
P ($)
S1
S0
S0
D
P1
P0
Deadweight
loss
Deadweight
loss
0


Q1
Q0
Q
(units)
Greater under-production
Greater deadweight loss
D
0
Q1 Q0
Q
(units)
Elasticity of demand and deadweight loss
Unit subsidy

Ed of D0 > Ed of D1
P ($)
D
S1
P0
P1
0


P ($)
S0
Deadweight
loss
Q0
Q1
Q
(units)
Greater over-production
Greater deadweight loss
S0
S1
P0
Deadweight
loss
P1
D
0
Q0 Q1
Q
(units)
Elasticity of supply and deadweight loss
Price ceiling

Es of S0 > Es of S1
P ($)
P ($)
Deadweight
loss
S1
S0
P0
Deadweight
loss
P0
P1
P1
D
0



Q1
Q0
Q
(units)
D
0
Q1Q0
Higher the elasticity of supply, larger the ( MB – MC )
Greater under-production
Greater deadweight loss
Q
(units)
Elasticity of supply and deadweight loss
Price floor

Es of S0 > Es of S1
P ($)
P1
P0
P ($)
S0
Deadweight
loss
S1
P1
P0
Deadweight
loss
D
0



Q1 Q0
Q
(units)
D
0
Q1 Q0
Higher the elasticity of supply, smaller the ( MB – MC )
Same under-production
Smaller deadweight loss
Q
(units)
Elasticity of supply and deadweight loss
Quota

Es of S0 > Es of S1
P ($)
P ($)
S0
P1
P0
Deadweight
loss
S1
P1
P0
Deadweight
loss
D
0



Q1 Q0
Q
(units)
D
0
Q1 Q0
Higher the elasticity of supply, smaller the ( MB – MC )
Same under-production
Smaller deadweight loss
Q
(units)
Elasticity of demand and deadweight loss
Unit tax

Es of S0 > Es of S1
P ($)
D
S0
P0
Deadweight
loss



Q1
Q0
S0
D
S1
P1
0
S1
P ($)
Q
(units)
Higher the elasticity of supply
Greater under-production
Greater deadweight loss
P1
P0
0
Deadweight
loss
Q1
Q0
Q
(units)
Elasticity of demand and deadweight loss
Unit subsidy

Es of S0 > Es of S1
P ($)
D
S1
P1



Deadweight
loss
Q0
Q1
S1
D
S0
P0
0
S0
P ($)
Q
(units)
Higher the elasticity of supply
Greater over-production
Greater deadweight loss
P0
Deadweight
loss
P1
0
Q0
Q1
Q
(units)
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 wellbeing 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 wellbeing 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
P ($)
MSC
External
Cost

For the sake of the whole society,



Production decision based on MPC





The socially optimal output should be at Q1.
MSC = MSB
Quantity transacted = Q0
At Q0, MSC > MSB or MSC > MPB
Over-production occurs (Q0 > Q1)
Market inefficiency
Deadweight loss
MPC
P1
Deadweight
loss
P0
D=MPB=MSB
0
Q1 Q0
Q
(units)
Q

MSB
6
4
10
2
13
7
4
11
3
12
8
4
12
4
11
9
4
13
5
10
10
4
14
6
9
11
4
15
P ($)
MSC
MPC
12
Deadweight
loss
10
D=MPB=MSB
0
3 5
Q
(units)
Without the external cost:
Qe = 5 units, Pe = MSB = MPC = $10
In the view of the whole society:


MSC
14


External
cost
1


MPC
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
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
B
Parking
Farming
Land (Own by A)
Option 1 (Use the land himself):
A: Use the land for car park and gain $50.
B: Nothing to do. No gain.
A
B
Parking
(MB = $50)
Farming
(MB =
$100)
Land (Own by A)
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
B
Parking
(MB = $50)
Farming
(MB =
$100)
Land (Own by B)
Option 1 (Use the land by himself):
A: Nothing to do. No gain.
B: Farm the land and gain $100.
A
B
Parking
(MB =
$200)
Farming
(MB =
$100)
Land (Own by B)
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
B
Parking
(MB =
$200)
Farming
(MB =
$100)
Land
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
A
B
Parking
(MB =
$200)
Farming
(MB =
$100)
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 wellbeing 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 $0.5  Better environment
 Learning Math
 Personal knowledge  help your little brother
Positive externalities

More examples:
 Industrial training by firm
 Education
 Health provision
 Vaccination and immunization
 Arts and sporting participation
 Estate renewal
 Fire safety equipment
 New invention
Deadweight due to under-production



From individual’s point of view:
Efficient output = Q0 where MPB = MPC
From society’s point of view:
Efficient output = Q1 where MSB = MSC
For the sake of the whole society,



Production decision based on MPC





The socially optimal output should be at Q1.
MSC = MSB
Quantity transacted = Q0
At Q0, MSB > MSC or MSB > MPC
Under-production occurs (Q0 < Q1)
Market inefficiency
Deadweight loss
P ($)
Deadweight
loss
S=MPC=MSC
P1
P0
External
Benefit
MSB
MPB
0
Q0 Q1
Q
(units)
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.
Measures
Monthly domestic
household income
(HK$)
Number
Percentage
(%)
< 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
12,226,546
100
Total
Measures
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
(Y-axis is the % of households.)
(X-axis measures the %
of total income received
by 10% 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…
Households
Income
20%
20%
40%
40%
60%
60%
80%
80%
100%
100%
Lorenz curve

Closer to the line of equality, more
equal in distribution
Lorenz curve
Decile
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)

100
Cumulative % of household
income
90
80
70
60
50
40
30
20
10
0
10 20 30 40 50 60 70 80 90 100
Cumulative % of number of
households
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
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
0.4 =
Gini coefficient
(Worldwide, Human Development Report 2009 )
1
Norway
25.8
21
United Kingdom
36
2
Australia
35.2
22
Germany
28.3
3
Iceland
..
23
Singapore
42.5
4
Canada
32.6
24
Hong Kong, China (SAR)
43.4
5
Ireland
34.3
25
Greece
34.3
6
Netherlands
30.9
26
Korea (Republic of)
31.6
7
Sweden
25
27
Israel
39.2
8
France
32.7
28
Andorra
..
9
Switzerland
33.7
29
Slovenia
31.2
10
Japan
24.9
30
Brunei Darussalam
..
11
Luxembourg
30.8
31
Kuwait
..
12
Finland
26.9
32
Cyprus
..
13
United States
40.8
33
Qatar
..
14
Austria
29.1
34
Portugal
38.5
15
Spain
34.7
35
United Arab Emirates
..
16
Denmark
24.7
36
Czech Republic
25.8
17
Belgium
33
37
Barbados
..
18
Italy
36
38
Malta
..
19
Liechtenstein
..
39
Bahrain
..
20
New Zealand
36.2
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



Country B



Total income = $10,000,000, Population = 2 persons
Per-capita income = $5,000,000
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$1) to spend everyday
 Absolute poverty
Economic mobility
1.
It is the movement of people among income groups.
2.
Ability to move up or down the economic ladder within a
lifetime or from one generation to another.
3.
Movements up the ladder can be due to hard work or
good luck.
4.
Movement down the ladder can be due to laziness or
bad luck.
5.
It may reflect transitory variation in income or more
persistent changes in income.
Sources of inequality

Labour income





Salaries
Commision
Bonus
Allowance
Non-labour income



Interest from deposit
Dividends from shares
Rent from leasing out properties
Sources of inequality
1.
Human capital





Level of education
Experience
Skills
Health
Professional qualification
Sources of inequality
Human capital
1.
a.

Skill
Demand




High-skilled workers can
perform well, but low-skilled
workers cannot
At any level of employment,
firms are willing to pay a
higher wage for high-skilled
worker
D H > DS
Supply



Cost of training high-skilled
worker is more
Higher wage is expected for
compensation of high-cost
training
SH > SL
SH
Wage ($)
WH
DH
SL
WL
DL
0


QL QH
Q
(labours)
 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
Human capital
1.
Age difference
b.
Experience



Productivity



c.
Older more experience  higher wage
Younger  less experience  lower wage
Old  less energetic  lower wage
Younger  more energetic  higher wage
Interruptions to career



Chronic disease
Maternity leave
Working women needs to take care of their children
Sources of inequality
Discrimination
2.




Age
Gender
Ethnic group
Religion
Difference in the degree of specialization
3.


Couple have to choose to allocate time between working
or taking care of the home
Working male (More income?) vs. Housewife
Sources of inequality
Unequal ownership of capital
4.
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
Superstar phenomenon
5.
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 inequality
Others
6.















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:



Advantages




equal in amount of resource allocation or
equal in opportunity to have resource allocation
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 welfare
Guarantee 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
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)

Disadvantage: High cost of calculation and collection
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:



With adequate resources (e.g. education)




Wealth
Ability
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)




Regressive tax (e.g. sales tax)

If unit tax = $10,000
 Case 1 (Rich)



Case 2 (Middle class)




Income = $50,000/mth
= $600,000p.a.
Tax = $58,400
% to income = 9.73%

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%
Case 2 (Middle class)



Income = $600,000p.a.
% to income = 1.67%
Income = $240,000p.a.
% to income = 4.1%
Case 3 (Poor)


Income = $96,000p.a.
% to income = 10.4%
So, progress tax helps income redistribution
but proportion tax worsens income disparity.
(Book 5A, Chapter 6)
Trade-off between equity and efficiency

To equalize income


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To have market efficiency
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redistribution income from the rich to the poor
tax and transfers is inevitable
disincentive effect on production
market inefficiency
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?