Definitions and Diagrams

Section 2 – Market FailureExternalities

Negative Externality of Consumption Without Intervention

Positive Externality of Consumption Without Intervention

Correcting externalities

Negative Externality of Consumption After Intervention

Section 3 – Macroeconomics diagrams

Measuring national income and introduction to development

Circular Flow diagram

As money passes around the economy, from firms to households and vice versa, some will leave in the form of withdrawals, such as saving, taxes, and spending on imports, and some will enter in the form of injections, such as investment, government spending, and revenue from exports.

These are not considered inside the circular flow diagram because they do not do any ‘work’ inside the economy.

Macroeconomics models

The Aggregate demand curve

The AD curve shows the total demand in an economy, and thus output, from households, firms, the government, and the international sector at different price levels. A fall in prices from PL1 to PL2 leads to an increase in real output from Y1 to Y2.

It is downward sloping because as price falls, people will demand more and vice versa.

The Short-Run aggregate supply curve

In the short-run, increases in output will normally only be achieved by increases in average costs. These are passed on to the consumers through higher prices. So, an increase in output from Y1 to Y2 will only be achieved with an increase in prices from P1 to P2.



Taxes

Proportional taxes are the easiest to understand: no matter the income earned, the fraction of that income that has to be paid as taxes is fixed. For example, in that case someone who earns 10 thousand dollars a year and someone who earned a million dollars a year will both have to pay 15% of it as taxes. The fraction is fixed; therefore the line makes a 45° angle: it is proportional.

Progressive taxes are so called when the fraction of income paid as taxes increases at the income increases. For example, the person earning 10 thousand dollars a year will pay only 10% of taxes, while the person earning a million dollars a year will pay 20% of taxes. The fraction is not fixed, therefore as income increases the fraction increases, and the curve on the graph is higher than the proportional one.

Regressive taxes are a quite strange concept, as it implies that the more money someone earns the smaller fraction of it he has to pay as taxes. In that case, the 10 thousand dollars person will pay 20% of it as taxes, while the million dollars person will only pay 10%.  The fraction is not fixed, but as income increases it decreases, and the curve on the graph is lower than the proportional one.