Download D - McGraw Hill Higher Education

Chapter 7
TAXATION AND
GOVERNMENT
INTERVENTION
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
Today’s lecture will:
• Show how equilibrium maximizes
consumer and producer surplus.
• Demonstrate the burden of taxation
to consumers and producers.
• Explain why the person who
physically pays the tax is not
necessarily the person who bears
the burden of the tax.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-3
Today’s lecture will:
• Demonstrate how an effective price
ceiling is the equivalent of a tax on
producers and a subsidy to consumers.
• Define rent seeking and show how it is
related to elasticity.
• State the general rule of political
economy.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-4
Producer and Consumer Surplus
• Consumer surplus - the value the consumer
gets from buying a product, less its price.
 It is the area below the demand curve and above
the price.
• Producer surplus – the value the producer
sells a product for less the cost of producing
it.
 It is the area above the supply curve but below the
price the producer receives.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-5
Producer and Consumer Surplus
$10
9
8
7
6
5
4
3
2
1
0
Consumer
Surplus
Producer
Surplus
S
D
CS = ½(5x5) = 12.5 =
Area of blue triangle
PS = ½(5x5) = 12.5 =
Area of orange triangle
The combination of
producer and consumer
surplus is maximized at
market equilibrium.
1 2 3 4 5 6 7 8 9 10
Quantity
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-6
Producer and Consumer Surplus
$10
9
8
7
6
5
4
3
2
1
0
Combined consumer and
producer surplus decreases
when price is above
equilibrium.
If price is $6,
Consumer Surplus:
CS = 1/2 ($4x4) = $8
S
Lost surplus = ½($2x1) = $1
Producer Surplus gains 2x4 = 8
units of lost consumer surplus
D
1 2 3 4 5 6 7 8 9 10
Quantity
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-7
Costs of Taxation
Price
Consumer
surplus
A per unit tax t shifts supply
from S0 to S1 and increases
price to P1 and decreases
quantity to Q1.
S1
S0
A
P1
tax
B
P0
C
E
D
P1–t
Deadweight
loss
F
Producer
surplus
Q1
McGraw-Hill/Irwin
D
Q0
Quantity
Consumer surplus is
A+B+C before the tax
and A after the tax.
Producer surplus is
D+E+F before the tax
and F after the tax.
Government revenue=B+D
Deadweight loss=C+E
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-8
The Costs of Taxation
 Direct cost of revenue paid to the
government
 Deadweight loss - loss of consumer and
producer surplus that is not gained by the
government
 Administrative costs of compliance –
resources used by the government to
administer the tax and individuals and
businesses to comply with it
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-9
Tax Burden
• The person who physically pays the tax is not
•
necessarily the person who bears the burden
of the tax.
The more inelastic one’s relative demand and
supply, the larger the tax burden one will bear.
 If demand is more inelastic than supply, consumers
will pay the higher share.
 If supply is more inelastic than demand, suppliers
will pay the higher share.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-10
Who Bears the Tax Burden?
Equal elasticity
Equal burden
Demand is more inelastic
Larger consumer burden
S1
$70
tax S
0
60
50
D
0
$70
Quantity of luxury boats
S0
60
50
D
590
0
510 600
McGraw-Hill/Irwin
Price of luxury boats
Price of luxury boats
S1
500 600
Quantity of luxury boats
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-11
Who Bears the Tax Burden
Fraction of tax borne
by demander
Fraction of tax borne
by supplier
McGraw-Hill/Irwin
ES

E D  ES
ED

E D  ES
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-12
Who Bears the Tax Burden?
Tax burden is independent of who pays the tax.
Supplier pays the taxSupply shifts
S1
Price of luxury boats
D
$70
tax S
0
60
50
Price of luxury boats
Consumer pays the taxDemand shifts
$70
60
510 600
Quantity of luxury boats
McGraw-Hill/Irwin
D0
50
tax
D1
0
0
S
510 600
Quantity of luxury boats
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-13
Social Security Taxes
• Both employer and employee contribute the
•
•
same percentage of before-tax wages to the
Social Security fund.
Although the employer and employee
contribute the same percentage, they do not
share the burden equally.
On average, labor supply tends to be less
elastic than labor demand, so the Social
Security tax burden is primarily on employees.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-14
Sales Taxes
• Sales taxes are paid by retailers on the basis
•
•
•
of their sales revenue.
Since sales taxes are broadly defined to
include most goods and services, consumers
find it hard to substitute to avoid the tax.
Demand is inelastic so consumers bear the
greater burden of the tax.
As consumers increase purchases on the
Internet where sales are not taxed, retail stores
will bear a greater burden of the sales tax.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-15
Government Intervention as
Implicit Taxation
• Government intervention in the form of price
•
•
controls can be viewed as a combination tax
and subsidy.
A price ceiling is an implicit tax on producers
and an implicit subsidy to consumers that
causes a welfare loss identical to the loss from
taxation.
A price floor is a tax on consumers and a
subsidy for producers that transfers consumer
surplus to producers.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-16
Effect of a Price Ceiling
Consumer
surplus (A+B+D)
Price
A
P0
P1
Welfare loss
(C+E)
B
D
C
E
F
Transferred to
consumers (D)
Producer
surplus (F)
Q1
McGraw-Hill/Irwin
S
Price ceiling
Q0
D
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-17
Effect of a Price Floor
Consumer
surplus (A)
Price
Price floor
A
S
P1
P0
B
D
F
McGraw-Hill/Irwin
C
E
Welfare loss
(C+E)
to
Producer Transferred
surplus producers (B)
(B+D+F)
Q1
Q0
D
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-18
The Difference Between Taxes
and Price Controls
• Price ceilings create shortages and
taxes do not unless people try to
evade them.
• Taxes leave people free to choose
how much to supply and consume as
long as they pay the tax.
• Shortages also create black markets.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-19
Rent Seeking and Politics
• Price controls, which transfer surplus
•
•
from one group to another are an example
of rent-seeking behavior.
Individuals spend money and use
resources to lobby governments to
institute policies that increase their own
surplus.
Public choice economists argue that when
all rent seeking and tax consequences are
netted out, there is often not a net gain to
the public.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-20
Inelastic Demand and
Incentives to Restrict Supply
Price
S0
P0
Revenue lost
S1
P1
Revenue gained
Total Revenue
D
Q0 Q1
McGraw-Hill/Irwin
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-21
Inelastic Supplies and
Incentives to Restrict Prices
• When supply is inelastic, consumers
have incentives to restrict prices.
• When supply is inelastic and demand
increases, prices increase causing
consumers to lobby for price
controls.
• Rent control in New York City is an
example.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-22
Price Floors and Elasticity of
Demand and Supply
• The surplus created by a price floor is
larger if demand and supply are elastic.
P
P
surplus
S
surplus
D
PF
PE
PF
PE
S
D
QD
McGraw-Hill/Irwin
QS
Q
QD QS
Q
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-23
Long-Run and Short-Run
Elasticities
Short run
supply
P
Long run
supply
P1
P2
Larger long-run
elasticities result
in smaller price
increases when
demand increases.
P0
D1
D0
Q0
McGraw-Hill/Irwin
Q1
Q2
Q3
Q
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-24
Summary
• Consumer surplus is the net benefit a consumer
•
•
•
gets from purchasing a good.
Producer surplus is the net benefit a producer
gets from selling a good.
Equilibrium maximizes the combination of
consumer and producer surplus.
Taxes create a loss of consumer and producer
surplus known as deadweight loss, which is
graphically represented by the welfare loss
triangle.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-25
Summary
• The cost of taxation to consumers and
•
•
producers includes the actual tax paid, the
deadweight loss, and the costs of
administering the tax.
Relative elasticities determine who bears the
burden of the tax. The more inelastic one’s
demand or supply, the larger the burden of the
tax.
Price ceilings and floors, like taxes, result in
loss of consumer and producer surplus.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-26
Summary
• Price ceilings transfer producer surplus
to consumers; they are a tax on
producers and a subsidy to consumers.
• Price floors transfer consumer surplus to
producers; they are a tax on consumers
and a subsidy to producers.
• The more elastic supply and/or demand
is, the greater the surplus with an
effective price floor and the greater the
shortage is with an effective price ceiling.
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-27
Review Question 7-1 Given the following demand and
supply of pizza, find consumer and producer surplus.
Price
$10
$9
Consumer surplus:
½ x ($10-6) x 100 = $200
S
$8
$7
Producer surplus:
½ x ($6-4) x 100 = $100
$6
$5
D
$4
50
100
150
200
250
300
Quantity
McGraw-Hill/Irwin
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.
7-28
Review Question 7-2 Given the following demand and
supply of pizza, show the effects of a price floor at $8.
Price
$10
S
Consumer surplus
$9
Price floor
$8
$7
Deadweight loss
$6
$5
Producer surplus
$4
D
50
McGraw-Hill/Irwin
100
150
200
250
300
Quantity
Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved.