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Understanding Economics
5th edition
by Mark Lovewell
Copyright © 2009 by McGraw-Hill
Ryerson Limited. All rights reserved.
Chapter 7
Economic Welfare and Income Distribution
Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.
Learning Objectives
After this chapter you will be able to:
1.
2.
3.
4.
5.
understand the concepts of consumer surplus and deadweight loss, and
explain how these concepts can further our understanding of the
operation of markets
distinguish spillover costs and benefits and the ways that government
addresses these issues
summarize how income is distributed among Canadian households,
how this distribution is measured, and the factors underlying this
distribution
identify the causes of poverty and the way poverty is measured
evaluate the effectiveness of government intervention to change the
distribution of income
Copyright © 2009 by McGraw-Hill
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Marginal and Total Benefit
 Both consumers and producers gain from market
activity.
 For consumers, these gains can be measured by
marginal and total benefit.
 Marginal benefit is the extra satisfaction, expressed in
dollar terms, from consuming a certain unit of a
product.
 Total benefit is the total satisfaction, expressed in dollar
terms, from consuming a product.
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Consumer Surplus (a)
 Consumer surplus shows the extent to which
consumers pay a lower price than the highest one they
are willing to pay.
 It is defined as the net benefit, expressed in dollar
terms, from buying a product at its market price.
 It is found, either for an individual or in an entire
market, by subtracting total expenditure from total
benefit.
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Consumer Surplus (b)
Figure 7.1, page 175
Consumer’s Demand Curve for Pizzas
Consumer’s Demand
Schedule for Pizzas
($ per
pizza)
$14
12
10
Quantity
Demanded
(D)
(pizzas)
1
2
3
Total Benefit
($)
14
26 (14 + 12)
36 (14 + 12 + 10)
16
Price ($ per pizza)
Price
A+B = Total Benefit
B = Total expenditure
14
12
10
A = $6
D
8
4
0
B = $30
1
2
3
4
Quantity (pizzas per week)
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Consumer Surplus (c)
Figure 7.2, page 176
Market Demand Curve for Pizzas
Market Demand Schedule
for Pizzas
($ per
pizza)
18
14
10
Quantity Demanded
(D)
(thousands of
pizzas)
0
50
100
Price ($ per pizza)
Price
18
16
14
12
10
8
6
4
2
0
A+B = Total Benefit
B = Total Expenditures
A = $400,000
D
B = $1 million
50
4
Quantity (thousands of pizzas per week)
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Producer Surplus
 Producer surplus shows the extent to which producers
receive a price different from the lowest one they are
willing to accept.
 It is defined as the difference between the price
received from selling each unit of a product and the
marginal cost of producing it.
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Producer Surplus for a Market
Figure 7.3, page 177
18
Price ($ per pizza)
16
14
S
12
10
C = $400 000
8
6
4
D
2
0
50
100
Quantity (thousands of pizzas per week)
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The Case of Perfect Competition
 In a perfectly competitive market, the requirement of
marginal-cost pricing is met.
 Based on this requirement, equilibrium will occur
where marginal benefit equals marginal cost, and both
consumer surplus and producer surplus are
maximized.
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The Case of Perfect Competition
Figure 7.4, page 178
S
18
Price ($ per pizza)
16
14
12
Consumer Surplus
10
Producer Surplus
8
6
4
2
D
0
50
100
150
Quantity (thousands of pizzas per week)
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When a Market Becomes
Uncompetitive
 When a market becomes uncompetitive, for example
due to government policy, price rises. The result is that
a portion of the consumer surplus becomes producer
surplus.
 Also there is a net reduction in both the consumer
surplus and producer surplus due to the reduction in
market output. This net reduction is known as the
deadweight loss.
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When a Market Becomes Uncompetitive
Figure 7.6, page 179
S
18
Price ($ per pizza)
16
14
12
Deadweight
Loss
10
8
6
4
2
D
0
50
75
100
150
Quantity (thousands of pizzas per week)
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Spillover Costs (a)

Spillover costs are the negative external effects of
producing or consuming a product.
 Adding these costs to private costs vertically raises the
supply curve.
 The preferred outcome is at a lower quantity than in a
perfectly competitive market.
 Government intervention (e.g. an excise tax) can
produce the preferred outcome.
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Spillover Costs (b)
Figure 7.6, Page 182
Market Demand Curve for Strawberries
Demand and Supply
Schedules for Gasoline
$2.50
2.00
1.50
1.00
0.05
Quantity
Quantity
Demanded
Supplied
(D)
(S0)
(S1)
(millions of litres)
4
5
6
7
8
8
7
6
5
4
S0
2.50
6
5
4
3
2
Spillover
Costs,
Excise
Tax
a
Price ($ per litre)
Price
($ per
litre)
S1
2.00
1.50
b
1.00
0.50
D
0
1
2
3
4
5
6
Millions of Litres
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7
8
Spillover Benefits (a)

Spillover benefits are the positive external effects of
producing or consuming a product.
 Adding these benefits to private benefits raises the
demand curve.
 The preferred outcome is at a higher quantity than
occurs in a perfectly competitive market.
 Government intervention (e.g. a consumer subsidy) can
produce the preferred outcome.
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Spillover Benefits (b)
Figure 7.7, page 184
Demand and Supply Curves for an
Engineering Education
Demand and Supply Schedules
for an Engineering Education
Enrollment
Quantity
Demanded
Supplied
(D0)
(D1)
(S)
(thousands of students)
$6000
5000
4000
3000
2000
8
9
10
11
12
10
11
12
13
14
12
11
10
9
8
b
5000
Tuition ($ per year)
Tuition
($ per
year)
S
6000
a
4000
Spillover
Benefits,
Student
Subsidy
3000
2000
D0
D1
1000
0
8
9 10 11 12 13 14
Thousands of Students
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Canadian Distribution of Income
 Canada’s distribution of income can be shown using
the Lorenz curve.
 This curve is a graph showing the cumulative
distribution of income for households categorized into
five groups based on their income levels.
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Income Distribution in Selected
Years
Figure 7.8, page 187
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Percentage of Total Pre-Tax Income
Received by Each Fifth of Households
1951
1961
1971
1981
1991
2006
4
11
18
23
43
4
12
18
25
41
4
11
18
25
43
5
11
18
25
42
5
10
17
25
44
4
10
16
24
47
Average of total
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Average
Income
(2006)
$13
31
51
77
152
800
800
300
800
600
65 500
The Lorenz Curve
Figure 7.9, page 183
e
Distribution of
Household Income
Share of
Income in
2000 (%)
Lowest
Second
Third
Fourth
Highest
4
10
16
24
47
Cumulative Distribution of
Household Income
Cumulative Share
of Income
in 2000 (%)
Lowest
Lowest
Lowest
Lowest
20%
40%
60%
80%
100%
4
14
30
54
100
=
=
=
=
4
14
30
54
+
+
+
+
(a)
10(b)
16(c)
24(d)
47(e)
Cumulative Share of
Income (%)
100
80
Perfect
Equality
60
c
40
20
0
d
b
Perfect
Inequality
a
20
40
60
Households (%)
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80
100
Interpreting the Lorenz Curve
 In using the Lorenz curve as a distribution measure, it
is useful to compare it with curves for two hypothetical
economies:
 For an economy of perfect quality, where all have
identical incomes, the Lorenz curve would be a 45degree line emanating from the origin.
 For an economy of perfect inequality, where one
household receives all of the economy’s income, the
Lorenz curve would follow the horizontal and vertical
axes of the graph.
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The Gini Coefficient
 The Gini coefficient provides a single numerical
measure of income distribution.
 It is defined as the area between a Lorenz curve and the
45-degree line of perfect equality, divided by the entire
triangular area under the 45-degree line.
 The coefficient varies from 0 to 1, with 0 representing
perfect equality and 1 representing perfect inequality.
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Wage Determinants (a)

There are seven main wage determinants:
 labour productivity
 education
 experience
 job conditions
 regional disparities
 market power
 discrimination
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Distribution of Earnings (2006)
Figure 7.10, page 190
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Labour Productivity
 In any given market, labour productivity determines
the wage of that worker.
 Labour productivity is defined as output per worker in a
given time.
 It is the most important determinant of wages.
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Education

Education:
 usually adds to a worker’s pay but has opportunity costs
as well
 serves two main purposes (consumption and investment
in human capital)

A student will undertake an educational program if its
benefits (both monetary and nonmonetary) exceed its
opportunity costs.
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Education and Average Family Income (2006)
Figure 7.11, page 191
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Age and Average Income (2006)
Figure 7.12, page 192
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Labour Unions

There are two main types of labour unions:
 Industrial unions include all workers in a certain
industry.
 Craft unions include workers in a particular occupation
and restrict who can be members.
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Job Discrimination

Job discrimination relates to hiring, wage, and
promotion decisions based on criteria other than a
worker’s credentials or performance.
 Job discrimination can be direct, in which case
employees are paid different amounts for substantially
the same work.
 Job discrimination can also be indirect, involving a
discriminatory division of jobs.
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Reasons for Income Inequality (Other Incomes)

There are three main reasons for income inequality in
addition to wage determinants:
 risk-taking
 ability
 wealth

Wealth is more unequally distributed than income.
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Distribution of Wealth in Selected Countries
Figure 7.13, page 195
Share of Wealth Held by
Top Wealth Holders (%)
90
80
70
Sweden (1975)
60
Canada (1984)
50
France (1986)
40
US (1986)
30
20
10
0
Top 1%
Top 5%
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Top 20%
The Poverty Line



The poverty line is the income level below which a
household is classified as poor.
In Canada, a household is considered to be poor if it
spends more than 63% of its after-tax income on food,
clothing, and shelter.
In dollar terms, the poverty line depends on the
number of household members and the size of the
community they live in.
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The Poverty Line for Various Households (2006)
Figure 7.14, page 197
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The Incidence of Poverty (a)
 Poverty rates are higher among unattached individuals
than among families, except for lone-parent families
with a female head.
 Unattached females have particularly high poverty
rates as well.
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The Incidence of Poverty (b)
Figure 7.15, page 198
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The Canadian Welfare Society


A welfare society is one in which the government plays
a major role in attempting to ensure the economic
well-being of its citizens.
Transfer payments and personal income taxes are the
most important elements of Canada’s welfare society.
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Transfer Payments and Income
Equity (a)
 Transfer payments are now usually based on the
principle of means testing rather than universality.
 Transfer payments are greatest as a percent of income
for the poorest fifth of households, but the secondpoorest fifth of households receives the largest share of
these payments.
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Transfer Payments and Income Equity (b)
Figure 7.16, page 201
Average Transfer
Payments
Received
(2006)
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Average of Total
Transfer Payments
as a Percent of
Total Income
(2006)
$7 200
9 700
8 400
7 500
5 100
7 600
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51.9%
30.6
16.4
9.7
3.3
11.6
Share Received
of Total Transfer
Payments
(2006)
19.9%
25.7
22.2
19.8
13.3
Principles of Taxation

There are two main principles of taxation:
 benefits received (e.g. gasoline taxes for roadwork)
 ability to pay (e.g. personal income tax)
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Taxes and Income

Taxes are related to income in three possible ways:
 progressive taxes (which increase as a proportion of
income as income rises)
 proportional taxes (which stay constant as a proportion
of income as income rises)
 regressive taxes (which decrease as a proportion of
income as income rises)
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Taxes and Income Equity
 Personal income taxes are progressive, with the
proportion of income paid in tax rising significantly
with a household’s income level.
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Personal Income Taxes and Income Equity (2006)
Figure 7.17, page 203
Average Personal
Income Taxes
Paid
Lowest 20%
Second 20%
Third 20%
Fourth 20%
Highest 20%
Average of Total
Personal Income Taxes
as a Percent of
Total Income
$ 700
2 800
6 700
12 600
33 300
11 200
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5.3%
8.8
13.0
16.1
21.8
17.1
Share Paid
of Total Personal
Income Taxes
1.3%
5.0
11.9
22.4
59.4
The Doomsday Prophet

Thomas Malthus formulated a theory of population
based on two principles:
 food increases in an algebraic progression (1,2,3…)
 population increases in a geometric progression (1,2,4…)

He predicted that over time population growth would
outstrip growth in the food supply with disastrous
effects
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A Malthusian Time Chart
page 209
A Malthusian Time Chart
Year
Food
Population
1
1
1
25
2
2
50
3
4
75
4
8
100
5
16
125
6
32
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150
7
64
175
8
128
200
9
256
225
10
512
Wages, Rent, Interest, and Profit (OLC)
Rent

Rent is the payment for the use of a productive
resource available in only a fixed amount.
 Land receives a rent because its supply is perfectly
inelastic.
 The equilibrium rent for a particular type of land varies
with demand for this land (e.g. a rise in the price of beef
affects the rent for ranching land).
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Wages, Rent, Interest, and Profit (OLC)
Equilibrium in the Market for Land
Figure A
Demand and Supply Curves for Land
Demand and Supply
Schedules for Land
Quantity
Demanded
(D)
Quantity
Supplied
(S)
(millions of hectares)
$14
12
10
8
6
4
5
6
7
8
6
6
6
6
6
Rent ($ per year)
Rent
($ per
year)
S
14
12
10
e
8
6
D
4
2
0
1
2
3
4
5
6
7
Millions of Hectares
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8
9
Wages, Rent, Interest, and Profit (OLC)
Changes in the Demand for Land
Figure B
Demand and Supply Curves for Land
Demand and Supply
Schedules for Land
$14
12
10
8
6
Quantity
Quantity
Demanded
Supplied
(S)
(D0)
(D1)
(millions of hectares)
4
5
6
7
8
5
6
7
8
9
6
6
6
6
6
Rent ($ per year)
Rent
($ per
year)
S
14
b
12
10
a
8
6
D0 D1
4
2
0
1
2
3
4
5
6
7
Millions of Hectares
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8
9
Wages, Rent, Interest, and Profit (OLC)
Interest
 Interest is related to the supply of capital resources,
and can also be viewed as a financial income.
 When money is lent, the lender requires repayment
not only of the loan principal but also a charge for the
use of the money.
 Interest is payment for the opportunity cost of the
money being used.
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Wages, Rent, Interest, and Profit (OLC)
The Range of Interest Rates

Four factors affect interest rates:
 credit risk
 the loan period
 collateral
 the size of the loan
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Wages, Rent, Interest, and Profit (OLC)
Profit


Critics of capitalism attribute profit to the power of
business owners rather than to their contributions to
the economy.
However, profit can also be seen as a return to
entrepreneurs for their risk-taking. From this
perspective, it is a an essential private incentive for
taking risks.
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The Role of Labour Unions (a)
(Online Learning Centre)
 Unions represent members’ interests through
collective bargaining. Both unions and employers
make collective agreements which bind both parties
for a given period.
 When agreement is impossible, mediation or
arbitration can be used to bring about a settlement.
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The Role of Labour Unions (b)
(Online Learning Centre)
 If no settlement is reached, union members can work
to rule, or stage a strike.
 Employers may use a lockout to bring about a
settlement.
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Reaping the Rewards
(Online Learning Centre)



David Ricardo developed a theory of rent based on
varying grades of land.
According to his theory, a rise in the demand for wheat
increases wheat prices and increases rent as poorer
land is brought into cultivation.
He predicted that higher wheat prices would lead to
higher money wages and lower profits.
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Ricardo’s Theory of Rent
Figure A
Land Rents per Hectare
Land Rents per Hectare
(when production costs are $100 per hectare)
$5
10
Grade A
(50 kg
output)
Grade B
(40 kg
output)
150
100
[($5 x 50) – $100]
400
[($5 x 50) - $100]
300
Grade C
(20 kg
output)
0
100
Grade D
(10 kg
output)
not
cultivated
0
400
Wage ($ per year)
Wheat
Price
($)
$400
$300
300
200
$150
$100
100
0
A
B
$100
$0
$0
C
D
Grade of Land
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Chapter 7
The End
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