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Markets and the Economics of the Public Sector

Stacey Troup, Rinetta Stewart, Tim Houseman, Elizabeth Kramer, Hannah Provost &

Shelby Logbeck

Principles of Microeconomics/ECO-365

July 25, 2016

Ashok Padhi

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Markets and the Economics of the Public Sector

This Week 2 group paper will explain why the equilibrium of supply and demand is

desirable. The team will then explain the efficiency of markets and the costs of taxation and

benefits of international trade as they relate to the concept of consumer and producer surplus.

Continuing into how externalities may prevent market equilibrium while discussing the various

government policies used to remedy inefficiencies in markets caused by externalities. Finally,

we will analyze the difference between the efficiency of a tax system and the equity of same as it

refers to costs imposed on taxpayers utilizing the benefit system.

Why the Equilibrium of Supply and Demand is Desirable

Equilibrium occurs when the price of a good or service is set at the intersection of the

demand and supply curves. At this equilibrium price, the quantity demanded is equal to the

quantity supplied.

The General Equilibrium Theory was developed over time and is a collection of the work

of many economists. Adam Smith’s invisible hand theory and laissez-faire economics form the

foundation for this body of work. The theory was expanded and formalized by Leon Walras, a

French economist from the 1800s. Walras was a new kind of economist; he desired to be a

journalist and novelist but devoted himself to the study of economics at the request of his father

(Walker, 1987). Accordingly, he was able to take a different approach to economics than his

counterparts at the universities.

Walras’ theory can be summarized: “The laissez-faire operation of the price mechanism,

in an environment of deregulated competitive markets where agents are motivated by self-

interest, will produce not chaos but coherence, in the sense of market clearing, optimal

outcomes” (Bryant, 2009).

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This statement has many components that explain why a market functions best at

equilibrium. First, market economies are formed by dual agents (buyers and sellers) who are

acting in their own interest. Buyers want to pay the lowest price possible, while sellers want to

receive the highest price possible. The actions that buyers and sellers take towards their goals are

called price discovery – the culmination of negotiations between buyers and sellers will result in

equilibrium price.

This state of market equilibrium is preferable to other market conditions because when

markets are in equilibrium, they are cleared. All buyers willing to pay equilibrium price have

been able to make their purchases. Buyers have paid the lowest possible price available in the

market, and sellers have received the highest possible price. In short, the market has acted in a

highly efficient manner, using price to ensure that there is no excess or shortage of goods.

Efficiency, Taxation and International Trade

Consumer and producer surplus is defined as measuring the overall welfare of the buying

and selling process. This consumer and producer surplus gives the opportunity for companies to

look at both sides. One side can be when a company makes a good and wants to sell while the

other side would be when a consumer wants to buy a good that a company is producing. The

savings a consumer can obtain when purchasing a good at less than what they are willing to pay

is a direct example of the term consumer surplus. On the other hand, producer surplus is when a

company produces over the cost of making said good and selling it. With that said, this profit is

another fundamental element in managing and recording within the buying and selling process as

a whole. A market can be both successful and efficient if and when the middle ground is

founded and run on both the purchasing and selling of said goods. The efficiency of markets is

measured by the consumers being allowed to buy a good at a lesser price, while keeping in mind

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that the producer is still making a profit for sold goods. One factor can have an impact on each

side of the selling process is taxes. The cost of taxation can diminish profit. When taxes are

imposed on a consumer, there is the risk that a consumer would want to pay less for a product.

On the producer side, taxes can force a company to sell their product for a higher price, to ensure

they are making a profit. Either way, taxes can impact both the consumer and producer. As

negative as taxes may seem, there are benefits. Taxes allow funds to be raised for areas such as

public services. “When a tax is levied the total surplus is negatively affected and the outcome of

a market is distorted. This amount of change is called the deadweight loss” (Mankiw, 2015).

The consumer and producer surplus can reap benefits from international trade as well.

International trade allows for a larger audience. A large audience overall equals a larger surplus.

One benefit from the producer aspect can be a greater likelihood of the good being sold. On the

other hand, international trade allows for the consumer to have more options when looking to

purchase a product. Both consumers and producers alike are looking to obtain more at a lower

cost. Currency is circulated through international trade. As a result, the more currency that is in

circulation means there is a lesser value. With that said, there is a downfall to international trade.

Many transactions in today’s business world are conducted electronically. By conducting

purchases electronically, circulation of currency is no longer affected.

Demand Curve, Supply Curve & Equilibrium

Externalities can prevent both socially optimal market equilibrium, or lead to market

failure. In the absence of externalities, equilibrium price is the point at which the cost to the

producer meets the willingness to pay of the consumer. In the presence of negative externalities,

the producer often does not shoulder all costs which result in a production excess. When

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positive externalities are present, the consumer does not reap all the rewards of the produced

good, resulting in underproduction (Caplan, N.D.).

Externalities may be positive or negative. A positive externality rewards the third party

beyond what the consumer is willing to demand. One example of a positive externality is the

production of electric cars. Use of electric cars reduces emissions resulting in a better

environment for everyone and everything. However, the costs associated with electric cars are

excessive not only financially, but also in convenience. The owner of an electric car needs to be

able to have convenient charging stations throughout the travel area as well as the owner’s home

for the best benefit (Idaho National Laboratory, N.D.)

The International Council on Clean Transportation (ICCT) report “Driving

Electrification: A global comparison of fiscal incentive policy for electric vehicles” which

studies the efforts of various countries to make electric cars more attractive to consumers. These

efforts primarily include tax credits for consumers and subsidies to manufacturers (ICCT, N.D.)

“On Friday, December 18, 2015, President Obama signed the Consolidated Appropriations Act

of 2016 (H.R. 2029)”. This resulting legislation provides tax credits for electric car owners who

installed EV charging equipment in 2015 (U.S. Department of Energy, N.D.). Additional

incentives the government may take advantage of include a gasoline tax hike.

An example of a negative externality is pollution. The total cost of a good that pollutes

the environment during manufacture is greater than the cost of production alone as it harms other

people, animals and the environment (Caplan, N.D.). The “social cost includes the private cost

of the producers plus the costs to those adversely affected by the pollution” (Mankiw, 2015).

One tactic governments use is to apply restrictions on pollution; leading manufacturers to reduce

their output in order create an optimal equilibrium and a reduced cost to society

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Price Controls, Taxes & Elasticity in Pricing

The government uses a system of taxation to collect taxes from firms, households and

individuals based on what they own (assets), what they make (income) or how much they spend

(transaction value). “The primary aim of a tax system is to raise revenue for government”

(Mankiw, 2015).

An efficient tax system refers to the costs which it imposes on taxpayers referred to as

small deadweight losses and small administrative burdens. The deadweight loss of a tax is the

reduction of economic well-being of taxpayers in excess of the amount of revenue raised by the

government (Mankiw, 2015). Deadweight loss can be a surplus loss to the consumer, producer

or both (Boundless Economics, 2016).  Causes of deadweight loss can include actions that

prevent the market from achieving equilibrium conditions and may include taxes (Boundless

Economics, 2016).  Administrative Burdens are costs imposed on firms, households, and

individuals when complying with information obligations stemming from Government

regulation. “The administrative burden of any tax system is part of the inefficiency it creates”

(Mankiw, 2015).

Tax equity refers to how the tax burden is distributed across the population. How people

pay taxes depends on benefits they receive from government services; a taxation principle

known as the “benefits principle”. “The benefits principle attempts to make public goods similar

to private goods” (Mankiw, 2015). There are many ways to evaluate the equity of a tax system

including the evaluation of one's ability to pay. “This system has two notions of equity: vertical

and horizontal.” “The vertical equity notion states that taxpayers with a greater ability to pay

taxes should pay a larger amount, whereas the horizontal equity notion implies that taxpayers

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with the same or similar abilities to pay taxes should pay the same amount. Tax equity evaluates

the indirect effect of taxes” (Mankiw, 2015).

Conclusion

We as a team agree that the markets are affected by externalities which prevent them

from achieving equilibrium. Taxation, while having a negative impact on the public sector as it

creates additional cost, is offset by positive externalities which provide an incentive to the buyer.

Equilibrium is important for the supply curve as it puts influencing sources in balance, creating a

level pricing. Negative externalities, we agree, are not just negative to the buyer but to society

and nature as a whole.

While the policymakers often step in to help create equilibrium, they cannot impede on

every industry and every market but rather seek to enforce those with the greatest negative

impact on our environment.

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References

Berman, B. (2016). Incentives for Plug-in Hybrid and Electric Cars. Retrieved from Plug In

Cars: http://www.plugincars.com/federal-and-local-incentives-plug-hybrids-and-electric-

cars.html

Boundless Economics. (2016, 05 26). How Taxes Impact Efficiency: Deadweight Losses.

Retrieved from Boundless: https://www.boundless.com/economics/textbooks/boundless-

economics-textbook/taxes-and-public-finance-16/introduction-to-taxes-84/how-taxes-

impact-efficiency-deadweight-losses-324-12421/

Bryant, W. (2009). General Equilibrium: Theory and Evidence. WSPC. Retrieved from

http://site.ebrary.com.contentproxy.phoenix.edu/lib/apollolib/detail.action?

docID=10422484

Caplan, B. (N.D.). Externalities. Retrieved from The Library of Economics and Liberty:

http://www.econlib.org/library/Enc/Externalities.html

ICCT. (N.D.). Fiscal Incentives Spurring Electric Vehicles Sales, But In Widely Divergent Ways.

Retrieved from The International Council on Clean Transportation:

http://www.theicct.org/news/fiscal-incentives-spurring-electric-vehicles-sales-widely-

divergent-ways

Idaho National Laboratory. (N.D.). How Do Gasoline & Electric Vehicles Compare. Retrieved

from Idaho National Laboratory:

https://avt.inl.gov/sites/default/files/pdf/fsev/compare.pdf

Mankiw, N. (2015). Principles of Microeconomics (7th ed.). Retrieved from

https://phoenix.vitalsource.com/#/books/9781305892811/cfi/6/10!/4/2/2@0:0.

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U.S. Department of Energy. (N.D.). Federal Tax Credits for All-Electric and Plug-in Hybrid

Vehicles. Retrieved from U.S. Department of Energy:

https://www.fueleconomy.gov/feg/taxevb.shtml

Walker, D. A. (2008). Walras, Léon (1834–1910). The New Palgrave Dictionary of Economics.

Retrieved from Dictionary of Economics Online:

http://www.dictionaryofeconomics.com/article?id=pde2008_W000019