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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 To have market efficiency 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?