Lecture 2 Basic Micro: scarcity and choice

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Lecture 2Basic Micro scarcity and choice

• Introductory Economics for the Treasury
• Dr. Paul Frijters
• http//econrsss.anu.edu.au/frijters

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Content

• 0. Recap of the previous lecture.
• 1. Some basic terms of production and
  consumption.
• 2. Opportunity costs
• 3. Examples
• 4. Tax some terms and basic points

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Scarcity

• Unlimited Wants
• Humans have many different types of wants and
  needs. Economics looks at man's material wants
  and needs. These are satisfied by consuming
  (using) either goods (physical items such as
  food) or services (non-physical items such as
  heating).
• There are four reasons why wants and needs are
  virtually unlimited
• Goods eventually wear out and need to be
  replaced.
• New or improved products become available.
• People get fed up with what they already own.
• The more you have, the more you want.

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Limited Resources

• Commodities (goods and services) are produced by
  using resources. The resources shown below are
  sometimes called factors of production.

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Essence of resources

• All resources are eventually reducible to labour
  time and natural resources. Physical and other
  capital can be seen as the conserved result of
  previous production. Managerial and
  entrepreneurial effort is actually another form
  of labour and thereby again time.

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Types of Commodity

• A free good is available without the use of
  resources. There is zero opportunity cost, for
  example air. An economic good is a commodity in
  limited supply.
• Expenditure on producer or capital goods is
  called a cost or an investment.

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Production Terminology

• 1. Production transforming the combination of
  production factors into something consumable.
• 2. A transfer a change in ownership of a
  resource or a consumption good.
• 3. Home production untaxed production in
  informal organisations (mostly in households).

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Points of view and pay-offs

• Looking at an occurrence from the point of view
  of many reveals the material pay-offs to each
  concerned.
• The difference between a cost, a transfer, a
  return on an asset, and production depends on the
  judge.

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• Example 1 A lone mother gets a welfare payment
  from tax revenue.
• Translation in economic jargon
• A transfer between one person to another from
  the point of view of the population.
• An output (production) of the state in this
  country, i.e. a return on its asset called
  taxing ability.
• A cost for the person paying the tax.
• A rent on the asset being a lone mother with
  nationality X from the point of view of the
  recipient.

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Example 2 a thief steals your VCR in the night.

• Translation into economic terminology
• A transfer from you to the thief of a consumption
  good from the point of view of the population.
• A cost to the asset living where you are to
  you.
• (Maybe) A negative externality to you of the
  operation of thiefs.
• A return to the input night labour to the
  thief.
• A (negative) output to the asset policing
  capacity of the state.

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The Economic Problem

• The economic problem refers to the scarcity of
  commodities. There is only a limited amount of
  resources available to produce the unlimited
  amount of goods and services we desire.
• Society has to decide which commodities to make.
  For example, do we make missiles or hospitals? We
  have to decide how to make those commodities. Do
  we employ robot arms or workers? Who is going to
  use the goods that are eventually made? Do we
  build a sports hall in Queanbeyan or Belconnen?

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The flip-side of any choice Opportunity Cost \
Value

• The opportunity cost principle states the cost
  (or value) of one good in terms of the next best
  alternative. For example, a gardener decides to
  grow carrots on his allotment. The opportunity
  cost of his carrot harvest is the alternative
  crop that might have been grown instead (eg
  potatoes).

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Opportunity Cost (continued)
Message explicitly or implicitly a choice for X
limits other options, i.e. there are trade-offs
inherent in any choice. The set of possible
choices is called the opportunity set, the
feasibility set, or the budget constraint.
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Illustration The drowning example

• 2 seemingly identical persons are drowning. You
  can swim well and are the only potential saviour.
• 10 seconds until both drown do you save the one
  on the left or the one on the right?

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Translation

• Opportunity set deliberate more than 10
  seconds, save left, save right
• Resources 10 seconds, swimming capacity
• Opportunity cost of save left one life
• Opportunity cost of save right one life
• Opportunity cost of deliberating more than 10
  seconds one life

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Experience of this group?
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Experience of this group?

• More then half deliberated longer than 10
  seconds the opportunity cost of time was not
  recognised quickly enough.
• Many refused to accept that there was a budget
  constraint (i.e. that there was no more time than
  10 seconds or that one could save only one).

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The point of the example?

• 1. One cannot have everything and one cannot
  avoid tough choices.
• 2. Time too is a resource with an opportunity
  cost waiting has an opportunity cost.
• 3. There is not necessarily always a best
  decision.

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Illustration 2 the value of life in practice

• Estimated costs in Euro of a Quality Adjusted
  Life Year (QALY) for various medical procedures,
  environmental regulation, and safety measures.
  Source several US and European health
  departments.

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Continued..

• Message policies implicitly set the value of a
  year of decent life and not all current medical
  and safety choices get an equal bang for the
  buck. An economist would try to cease the more
  ineffective measures in favour of others

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Individual taxation and choice

• 1. Basic terms average taxation, marginal
  taxation, effective marginal taxation,
  progressive taxation, regressive taxation
• 2. Important examples income taxation, means
  testing of welfare, and pension system design.

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Basic terms

• Suppose Your pre-tax revenue equals Y, your tax
  bill equals T, and your side-payments are W.
  Then,
• 1. The average tax is your total tax bill divided
  by your pre-tax revenue. (T/Y)
• 2. The marginal tax is the percentage of the last
  dollar of revenue that gets paid in tax. (dT/dY)
• 3. The effective marginal tax rate is the
  percentage of the last dollar in pre-tax revenue
  that is paid in tax or reduces the side-payments
  (such as welfare benefits, housing benefits,
  child allowances, food stamps, etc.).
  (d(T-W)/dY).
• A tax is progressive when the average tax
  increases with pre-tax revenue.
• A tax is regressive when the average tax
  decreases with pre-tax revenue.

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Examples a simple tax system

• Suppose the tax and welfare system is organised
  as follows
• 1. Individuals without income obtain 10000 AUS
  per year in in-kind welfare benefits.
• 2. There is no marginal tax on the first 20000
  AUS earned
• 3. Marginal taxes after 20000 AUS earned are 50
• 4. Welfare benefits get taken away at a 60 rate
  for every dollar of after-tax income above 5000
  AUS a year

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Interpretation

• - very high Effective Marginal tax rates in the
  area where marginal taxes kick in and welfare
  gets taken away.
• - this is a progressive tax system for high
  incomes and a flat one for low incomes.
• - if you want to raise the same amount of taxes
  without the area of high EMT, one must increase
  marginal taxes somewhere else.

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EMTRs and poverty traps

• A poverty trap is a situation whereby a person
  with generally few marketable skills earns less
  in work than out of work. This is because of very
  high EMTRs which in some cases can have ranges
  above 100 (for instance when Medicare cards are
  taken away). A persons potential income is not
  sufficient to lift him or her over the trap.
• The tax costs of working in such cases for
  instance involve
• Gradual loss of housing benefits
• Gradual loss of welfare benefits
• Gradual loss of Child support
• Gradual loss of rights to state medical insurance
• Extra costs of working (childcare, travel,
  clothes, loss of grey income)

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Example 2 Pension schemes and Eff. Marg. Tax
Rates

• Two possible pension systems
• 1. You save up to 12 of your income every year.
  The sum defines your pension.
• 2. You pay 12 into a pension fund. You get a
  fixed percentage of the average income of the
  last 3 years you work.
• EMTR here is the percentage of a years income
  you lose in tax AND pension reduction.

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Interpretation

• - Pension systems which are based on last-earned
  incomes can give rise to very high EMTRs. This
  fact explains much of the early retirement
  behaviour of the OECD (see Wise and Gruber 1999).
• - Pension systems which are contribution based
  have flat EMTRs of working another year.

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Conclusion

• EMRTs are a way of ascertain the monetary value
  of a certain choice. If this value is less than
  the opportunity cost (also termed the outside
  option), an economist predicts that an individual
  makes another choice.