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Lecture 2 Basic Micro: scarcity and choice


0. Recap of the previous lecture. 1. Some basic terms of ... This fact explains much of the early retirement behaviour of the OECD (see Wise and Gruber 1999) ... – PowerPoint PPT presentation

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Title: Lecture 2 Basic Micro: scarcity and choice

Lecture 2 Basic Micro scarcity and choice
  • Introductory Economics for the Treasury
  • Dr. Paul Frijters
  • http//econrsss.anu.edu.au/frijters

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

  • 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
  • There are four reasons why wants and needs are
    virtually unlimited
  • Goods eventually wear out and need to be
  • New or improved products become available.
  • People get fed up with what they already own.
  • The more you have, the more you want.

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

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.

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.

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).

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

  • 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

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
  • (Maybe) A negative externality to you of the
    operation of thiefs.
  • A return to the input night labour to the
  • A (negative) output to the asset policing
    capacity of the state.

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?

The flip-side of any choice Opportunity Cost \
  • 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

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.
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?

  • 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

Experience of this group?
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).

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

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


  • 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

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.

Basic terms
  • Suppose Your pre-tax revenue equals Y, your tax
    bill equals T, and your side-payments are W.
  • 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.).
  • 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.

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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  • - 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.

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)

Example 2 Pension schemes and Eff. Marg. Tax
  • 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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  • - 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.

  • 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.
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