Markets and the Economics of the Public Sector
Markets and the Economics of the Public Sector
Economists use a variety of tools to help determine the well-being of the market. They can use these tools to determine the equilibrium of supply and demand, concepts of consumer and producer surplus, effects of externalities and government policies, and the efficiency and equity of a tax system. Markets usually can organize economic activity through supply and demand, but sometimes the government can make changes that will improve the market outcomes.
Equilibrium of Supply and Demand
Supply and demand determine what is sold in the market and for how much. There is only one point where the supply and demand curves intersect. This point is called the equilibrium. The price at this point is called the equilibrium price. The quantity at this point is called the equilibrium quantity. A market’s equilibrium only occurs when the quantity that suppliers are willing and able to sell is precisely equal to the quantity that buyers are willing and able to buy. So, why is the equilibrium of supply and demand desirable? At the equilibrium point, both buyers and sellers in the market have been satisfied. When the suppliers cannot sell all the product they want at the market price, there is a surplus or excess supply. When the buyers cannot buy all the product they want at the market price, there is a shortage or excess demand. One party or the other is not satisfied when there is a surplus or a shortage. Eventually, the actions of the buyers and sellers will move the market toward the equilibrium of supply and demand and balance them out, also known as the law of supply and demand. The equilibrium is the desirable point because everything is balanced in the market.
The Concept of Consumer and Producer Surplus
The concept of consumer and producer surplus can be used to explain the efficiency of markets, costs of taxation, and benefits of international trade. Consumer surplus is the difference between what a buyer is willing to pay for a good and the actual amount the buyer pays for it. Consumer surplus is a measurement of the benefits to buyers that participate in the market. A demand curve is a tool used to measure consumer surplus. When the price is low, the consumer surplus increases. When the price is high, the consumer surplus decreases. Producer surplus is the difference between what a seller gets paid for a good and the cost to the seller for providing it. Producer surplus is a measurement of the benefits to sellers that participate in the market. A supply curve is a tool used to measure producer surplus. When the price is high, the producer surplus increases. When the price is low, producer surplus decreases. Consumer and producer surplus are tools that economists use to study market efficiency, costs of taxation, and benefits of international trade.
What are efficiency, costs of taxation, and benefits of international trade? Efficiency is the allocation of resources that maximizes total surplus (the total value to buyers minus the total cost to sellers) for all members of society. The total surplus in a market is the total area below the equilibrium point and between the supply and demand curves. Consumers that value the good more than the price will buy the good and the seller’s costs that are lower than the price will produce and sell the good. When the quantity sold and produced are in equilibrium, the market has efficiently allocated its resources. Taxation provides no benefits to the buyer or the seller but provides revenue to the government that can be used for the needy, roads, police, or other services. When a tax is enacted, the buyer’s price raises and consumer surplus decreases while the seller’s price and producer surplus decrease. The quantity sold falls, and the government collects tax revenue. Due to this fall in quantity sold, there is a decrease in incentives to the buyers and sellers that causes the optimum market to shrink, and resources are allocated inefficiently. The surplus lost by buyers and seller from a tax is higher than the revenue the government receives creating a deadweight loss. The elasticities of supply and demand determine the amount of a tax deadweight loss. The more elastic the supply and demand, the higher the deadweight loss of a tax. Participating in international trade creates a broader market that doesn’t always benefit everyone. As the domestic price changes to equal the world price, the quantity of supply and demand change but are still in equilibrium because now the rest of the world can participate. When the domestic price increases to equal the world price, the country becomes an exporter and the producer surplus increases making the seller better off while the consumer surplus decreases making the buyer worse off. When the domestic price decreases to equal the world price, the country becomes an importer and the consumer surplus increases making the buyer better off while the producer surplus decreases making the seller worse off. In both cases, the economic well-being of the exporting country increases because the gains of the winners exceed the losses of the losers. When a tariff (tax) is placed on imports, the domestic price rises, sellers are better off because they can charge the world price plus the tariff amount, buyers are worse off because the price is higher, and the government raises revenue. The decrease in consumer surplus, increase in producer surplus and increase in government revenue create a fall in total surplus causing a deadweight loss. Other benefits of international trade include a greater variety of goods, increased competition, and lower costs through economies of scale. The concepts of consumer and producer surplus can be used to study and explain the efficiency of markets, costs of taxation, and benefits of international trade.
Externalities and Government Policies
Externalities can prevent market equilibrium, and various government policies can be used to alleviate market inefficiencies caused by externalities. An externality is the cost (negative) or benefits (positive) that a corporation’s activities impose on society. Externalities can be negative or positive. Some examples of negative externalities include pollution, noise, and pesticides. Negative externalities create a cost to society. One of the most significant problems with negative externalities is that businesses have little motivation to prevent them because the additional costs would create a decrease in profits (Biglan, 2009). The social-cost curve is the private costs of the producer plus the cost to society (externality). The equilibrium quantity of the product is higher than the optimum social quantity. Consumers value negative externalities less than the social cost of producing them. A government could impose a tax (internalizing the externality) on the negative externality so that producers would bear the social costs as well as the private costs of manufacturing them. Imposing this tax would make producers take the costs to society into account when manufacturing the product and deciding how much to supply. The market price would then show the tax on the producers and consumers would have an incentive to use smaller quantities. Positive externalities create a benefit that is generated by the production of a good, but the producer cannot receive compensation for this good if there is little or no market for the good. The market price for the good will not show the product’s true value and may cause underproduction of the good (Hall, 2006). Some examples of positive externalities include education, vaccinations, and hybrid cars. The value to society (social-value) is not shown in the demand curve. The equilibrium quantity is lower than the socially optimal quantity. The government can create a subsidy (internalize the externality) to create a greater balance between the market equilibrium and the optimum social point to prevent market failure. Corrective taxes and subsidies are one way the government can promote market efficiency. Another way the government can remedy externalities is by requiring or forbidding certain behaviors (command-and-control policy). There are negative and positive externalities that may prevent market equilibrium, and the government may have to implement various policies to remedy the market inefficiencies caused by these externalities.
Efficiency and Equity of a Tax System
When choosing a tax system, policymakers want one that is efficient and equitable. An efficient tax system strives for small deadweight losses and small administrative burdens. An equitable tax system strives for equality and fairness. The benefits principle tries to make private goods and public goods similar. In other words, people should pay taxes on the government services benefits they receive. The more a person uses a benefit, the more they should pay. The benefits principle suggests that corporations should be taxed proportionately based on the number of services they get from the government (Oakland & Testa, 2000). However, the indirect effects of taxes are usually ignored. The person/corporation that pays the tax bill to the government is not always the one who bears the burden of the tax. As consumers purchase less of a product, the burden falls on the corporation/workers that make and sell the product rather than the buyer. Efficiency and equity are essential characteristics of a working tax system and although it is not always easy to accomplish both the benefits principal can help to achieve an efficient and equitable tax system.
Equilibrium of supply and demand is something that it is desirable in a market because it means that things are balanced. Using the concept of consumer and producer surplus helps to explain market efficiency, costs of taxation, and benefits of international trade by showing what prices consumers are willing and able to pay and what prices sellers are willing and able to sell. Externalities can be negative or positive, may prevent equilibrium in the market, and may require government policies to fix the inefficiencies that occur from these externalities. A positive working tax system is both efficient and equitable and is often based on the benefits principles.
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Oakland, W. H., & Testa, W. A. (2000). The benefit principle as a preferred approach to taxing
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