Download Incidence of a tax

Competitive Markets:
Applications
1
Overview
1.Deadweight Loss
• A Perfectly Competitive Market Without
Intervention Maximizes Total Surplus"
2.Government Intervention – Who Wins and
Who Loses?
3.Examples of Various Government Polices
•
•
•
•
Excise Taxes and Subsidies
Price Ceilings and Price Floors
Production Quotas
Import Tariffs and Import Quotas
Economic Efficiency
Definition: Economic Efficiency means
that the total surplus is maximized.
"All gains from trade (between buyers and
suppliers) are exhausted at the efficient
point."
The perfectly competitive equilibrium
attains economic efficiency.
Surplus Maximization in Competitive Equilibrium
P
Supply
A
Pd E
F
C
P* B
Ps
G
D
Demand
Q1
Q*
Q
Surplus Maximization in Competitive Equilibrium
At the Perfectly Competitive Equilibrium, (Q*,P*),
Total Surplus is maximized.
Consumer's Surplus at (Q*,P*): ABC
Producer's Surplus at (Q*,P*) : DBC
Total Surplus at (Q*,P*): ADC
Deadweight Loss
Definition: A deadweight loss is a reduction in
net economic benefits resulting from an
inefficient allocation of resources.
Consumer's Surplus at (Q1,Pd): AEF
Producer's Surplus at (Q1,Pd) : EFGD
Total Surplus at (Q1,Pd): AFGD
Deadweight Loss at (Q1,Pd): GFC
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Policy: Excise Tax : Key Definitions
•An excise tax (or a specific tax) is an amount
paid by either the consumer or the
producer per unit of the good at the point
of sale.
•Incidence of a tax is a measure of the effect of a
tax on the prices consumers pay and sellers
receive in a market.
•Incidence of tax on consumers
•Incidence of tax on producers
Policy: Excise Tax
INCIDENCE OF A TAX
Pd is the price (including the tax)
paid by buyers.
Ps is the price that sellers
receive, less the tax.
Market clearing requires four conditions
to be satisfied after the tax is in place:
QD
=
QS =
QD =
QD(Pb)
QS(Ps)
QS
Pb − Ps = t
Consumers lose B + C + E.
Producers lose G + F.
The government earns B + C +
G in revenue.
The deadweight loss is E + F.
Policy: Excise Tax
Consumer
Surplus
Producer
Surplus
Government
Receipts from
Tax
Net Benefits
Deadweight
Loss
With No Tax
With Tax
Impact of Tax
A+B+C+E
A
-B-C-E
F+G+H
H
-F-G
Zero
B+C+G
B+C+G
A+B+C+E+
F+G+H
A+B+C+G+
H
-E–F
Zero
E+F
E+F
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A TAX ON GASOLINE
IMPACT OF $1 GASOLINE TAX
The price of gasoline
at the pump increases
from $2.00 per gallon
to $2.44, and the
quantity sold falls from
100 to 89 bg/yr.
Annual revenue from
the tax is (1.00)(89) =
$89 billion (areas A +
D).
The two triangles show
the deadweight loss of
$5.5 billion per year.
IMPACT OF A TAX DEPENDS ON ELASTICITIES OF SUPPLY AND DEMAND
(a) If demand is very inelastic relative to supply, the burden of
the tax falls mostly on buyers.
(b) If demand is very elastic relative to supply, it falls mostly
on sellers.
Incidence of Tax in Two Extreme Cases
P
Pd=P*+T
S’
T
Ps = P*
S
P
D
S
Q
Pd = P*
Ps
= P*-T
T
Q
D
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Back of the Envelope
• "Back of the Envelope" method to calculate the
•
•
•
•
•
•
incidence of a specific tax
Pd/Ps = /
where:  is the own-price elasticity of supply  is the
own-price elasticity of demand
Consider a small tax applied to an economy at point
(Q*,P*)
 =(Q/Q*)/(Pd/P*)… Q/Q*=Pd/P*
 =(Q/Q*)/(Ps/P*)… Q/Q*=Ps/P*
but for market to clear, Q/Q* must be the same for
demand and supply, hence
Pd/P* = Ps/P*
Tax Effect: Example
Let  = -.5 and  = 2.
What is the relative incidence of a specific tax on
consumers and producers?
Pd/Ps = 2/-.5 = - 4
Interpretation: "consumers pay four times as
much as the decrease in price producers receive.
Hence, an excise tax of $1 results in an increase in
consumer price of $.8 and a decrease in price
received by producers of $.2“
Subsidies
Subsidy Payment reducing the buyer’s price below the seller’s
price; i.e., a negative tax.
A subsidy can be thought
of as a negative tax.
Like a tax, the benefit of a
subsidy is split between
buyers and sellers,
depending on the relative
elasticities of supply and
demand.
Conditions needed for the market to clear
with a subsidy:
QD = QD(P )
QS
b
S
Q (Ps)
QS
=
QD =
Ps − Pb = s or Ps = Pb + s
Subsidies
With No
Subsidy
With Subsidy
Impact of
Subsidy
Consumer
Surplus
A+B
A+B+E+G+
K
E+G+K
Producer
Surplus
E+F
B+C+E+F
B+C
Impact on
Government
Budget
Zero
Net Benefits
A+B+E+F
A+B+E+F–J
Deadweight
Loss
Zero
J
-B-C-E-G-K -B-C-E-G-K
-J
-J
-J
Policy: Price Ceilings
Definition: A price ceiling is a legal maximum on the price
per unit that a producer can receive.
If the price ceiling is below the pre-control competitive
equilibrium price, then the ceiling is called binding.
E.G: Housing and Rent controls or Ceilings and shortages for
Food
Policy: Price Ceilings
With No
Price
Ceiling
With Price
Ceiling
Impact of
Ceiling
Consumer
Surplus
Area YAV = 36M
Area YTWS =
40M
+ 4M
Producer
Surplus
Area AVZ = 18M Area SWZ = 8M
- 10M
Net Benefits
Area YZV = 54M
Area YTWZ =
48M
- 6M
Deadweight
Loss
Zero
Area TWV = 6M
Policy: Price Floor
Definition: A price floor is a minimum price that consumers can
legally pay for a good.
Price floors sometimes are referred to as price supports.
If the price floor is above the pre-control competitive
equilibrium price, it is said to be binding.
E.G: Minimum wage law
Policy: Price Floor
Consumer
Surplus
Producer
Surplus
Net Benefits
Deadweight
Loss
With No
Price Floor
With Price Floor
Impact of Price
Floor
Area YAV =
36M
Area AVZ
=18M
Area YZV =
54M
Zero
Area YTR = 16M
-20M
Area RTWZ = 32M
+ 14M
Area YTWZ = 48M
-6M
Area TWV = 6M
-6M
Policy: Production Quotas
Definition: A production quota is a limit on either the
number of producers in the market or on the amount that
each producer can sell.
The quota usually has a goal of placing a limit on the total
quantity that producers can supply to the market.
Policy: Production Quotas
Consumer
Surplus
Producer
Surplus
Net Benefits
Deadweight
Loss
With No
Quota
A+B+F
With Quota
F
Impact of
Quota
-A-B
C+E
A+E
A-C
A+B+C+E
+F
Zero
A+E+F
-B-C
B+C
B+C