Download Taxation by another name Price Ceilings Effect of a Price Ceiling

Government Intervention as
Implicit Taxation
Taxation by another name
7-4 Price Control
• 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 producers 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.
Price Ceilings
• A price ceiling is a government-set price
below market equilibrium price.
• It is an implicit tax on producers and an
implicit subsidy to consumers.
Effect of a Price Ceiling
Price
Consumer
surplus
A
P0
P1
Welfare loss
B
D
C
E
F
Transferred to
consumers
Producer
surplus
Q1
S
Price ceiling
Q0
D
Quantity
1
Price Floors
• A price floor is a government-set price
above equilibrium price.
• It is a tax on consumers and a subsidy to
producers.
• Price floors transfer consumer surplus to
producers.
Effect of a Price Floor
Price
Consumer
surplus
Price floor
A
P1
P0
B
D
C
E
F
Transferred to
producers
Producer
surplus
Q1
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.
S
Welfare loss
Q0
D
Quantity
A Price Ceiling with
Forced Supply
• The draft is an example of a price ceiling
with forced supply.
• A draft must be imposed when the wage
offered by the army is below equilibrium and
the quantity of soldiers supplied is below the
quantity demanded.
• The surplus is transferred from the ones
drafted to the government.
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Effect of a Draft on Surplus
Wage
S
Deadweight loss
caused by draft
We
Surplus transferred to
the government
W0
D
QS
QD=Draft
Rent Seeking, Politics,
and Elasticities
• Price controls reduce total producer and
consumer surpluses.
• Governments institute them because
people care more about their own surplus
than about total surplus.
• Individuals spend money to lobby
governments to institute policies that
increase their own surplus.
surplus
Quantity of soldiers
Rent Seeking, Politics,
and Elasticities
Inelastic Demand and Incentives to
Restrict Supply
• Rent seeking – activities designed to transfer
surplus from one group to another.
• Public choice economists integrate economic
analysis of politics with their analysis of the
economy.
• They argue that when all rent seeking and
tax consequences are netted out, there is
often not a net gain to the public.
• When demand is inelastic, such as the demand
for food, producers have incentives to restrict
supply.
• Advances in farming productivity increase
supply, but decrease price.
• Since demand is inelastic, lower prices decrease
total revenue.
• Farmers have an incentive to restrict supply in
order to raise price and increase total revenue.
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Inelastic Demand and
Incentives to Restrict Supply
Inelastic Demand & Producing
more
Price
P0
Price
S0
Revenue lost
P0
S1
P1
P1
Revenue lost
Total Revenue
D
Q0 Q1
S1
Revenue gained
Revenue gained
Total Revenue
S0
Quantity
Q0 Q1
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.
Demand
Quantity
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
PF
PE
surplus
S
surplus
D
PF
PE
S
D
QD
QS
Q
QD QS
Q
4
The Long-Run/Short-Run
Problem of Price Controls
• The problem of price controls worsen from
the short run to the long run.
• In the long run, supply and demand tend
to be much more elastic than in the short
run.
The Long-Run/Short-Run
Problem of Price Controls
• In the face of price controls, potential new
competitors hate to enter the market
thereby strangling supply.
• Vacancy rates drop as potential new
renters scramble to find shrinking
affordable housing.
The Long-Run/Short-Run
Problem of Price Controls
• In the short run there will be small effects
from the price controls.
• There will be huge effects in the long run.
The Long-Run/Short-Run Problems
of Price Controls
• In the long-run
ong-run, supply and demand tend to be
much more elastic than in the short run.
run
• In the short run,
run when demand and supply are
more inelastic, the effects of price controls are
small.
small
• In the long run,
run with more elastic demand and
supply, the shortages or surpluses are larger.
large
5
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
Q1
Q2
Q3
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.
Q
Summary
Summary
• The cost of taxation to consumers and producers
includes the actual tax paid, the deadweight loss,
and the costs of administering the tax.
• Government follows both the benefit principle and
the ability-to-pay principle when deciding on whom
to levy taxes.
• 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.
• 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.
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Review Question 7-1 Given the following demand and
supply of pizza, find consumer and producer surplus.
$10
$9
Review Question 7-2 Given the following demand and
supply of pizza, show the effects of a price floor at $8.
$10
Consumer surplus:
½ x ($10-6) x 100 = $200
S
$8
S
Consumer surplus
$9
Price floor
$8
$7
Producer surplus:
½ x ($6-4) x 100 = $100
$6
$5
D
$4
$7
Deadweight loss
$6
$5
Producer surplus
$4
50
100
150
200
250
D
300
50
100
150
200
250
300
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