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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. 2 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. 3 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. 6 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 7