Download application: the costs of taxation

CHAPTER
8
Application:
The Costs of Taxation and Price
Regulations
Economics
PRINCIPLES OF
N. Gregory Mankiw
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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 How does a tax affect consumer surplus, producer surplus,
and total surplus?
 What is the deadweight loss of a tax?
 What factors determine the size of this deadweight loss?
 How does tax revenue depend on the size of the tax?
 What are price ceilings and price floors?
What are some examples of each?
 How do price ceilings and price floors affect market
outcomes?
1
Review from Chapter 6
 A tax
 drives a wedge between the price buyers pay
and the price sellers receive.
 raises the price buyers pay and lowers the price
sellers receive.
 reduces the quantity bought & sold.
 These effects are the same whether the tax is
imposed on buyers or sellers, so we do not make
this distinction in this chapter.
APPLICATION: THE COSTS OF TAXATION
2
The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE
Eq’m with
tax = $T per unit:
Buyers pay PB
Sellers receive PS
Size of tax = $T
S
PB
PE
PS
D
Quantity = QT
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
3
The Effects of a Tax
P
Revenue from tax:
$T x QT
Size of tax = $T
S
PB
PE
PS
D
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
4
The Effects of a Tax
 Next, we apply welfare economics to measure
the gains and losses from a tax.
 We determine consumer surplus (CS),
producer surplus (PS), tax revenue,
and total surplus with and without the tax.
 Tax revenue can fund beneficial services
(e.g., education, roads, police)
so we include it in total surplus.
APPLICATION: THE COSTS OF TAXATION
5
The Effects of a Tax
P
Without a tax,
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
A
S
B
PE
D
C
E
D
F
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
6
The Effects of a Tax
With the tax,
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
P
A
PB
S
B
D
C
E
PS
D
F
The tax reduces
total surplus by
C+E
APPLICATION: THE COSTS OF TAXATION
QT
QE
Q
7
The Effects of a Tax
P
C + E is called the
deadweight loss
(DWL) of the tax,
the fall in total
surplus that
results from a
market distortion,
such as a tax.
A
PB
S
B
D
C
E
PS
D
F
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
8
About the Deadweight Loss
P
Because of the tax,
the units between
QT and QE are not
sold.
The value of these
units to buyers is
greater than the cost
of producing them,
PB
S
PS
D
so the tax prevents
some mutually
beneficial trades.
APPLICATION: THE COSTS OF TAXATION
QT
QE
Q
9
ACTIVE LEARNING
Analysis of tax
A. Compute
CS, PS, and
total surplus
without a tax.
B. If $100 tax
per ticket,
compute
CS, PS,
tax revenue,
total surplus,
and DWL.
1
P
The market for
airplane tickets
$ 400
350
300
S
250
200
150
D
100
50
Q
0
0
25
50
75 100 125
10
ACTIVE LEARNING
Answers to A
CS
= ½ x $200 x 100
= $10,000
1
P
The market for
airplane tickets
$ 400
350
300
S
250
PS
= ½ x $200 x 100 P = 200
= $10,000
150
D
100
Total surplus
= $10,000 + $10,000 50
= $20,000
0
Q
0
25
50
75 100 125
11
ACTIVE LEARNING
Answers to B
CS
= ½ x $150 x 75
= $5,625
A $100 tax on
airplane tickets
P
$ 400
350
300
PS = $5,625
PB = 250
Tax revenue
= $100 x 75
= $7,500
200
PS = 150
Total surplus
= $18,750
50
DWL = $1,250
1
S
D
100
Q
0
0
25
50
75 100 125
12
What Determines the Size of the DWL?
 Which goods or services should govt tax
to raise the revenue it needs?
 One answer: those with the smallest DWL.
 When is the DWL small vs. large?
Turns out it depends on the price elasticities
of supply and demand.
 Recall:
The price elasticity of demand (or supply)
measures how much QD (or QS) changes
when P changes.
APPLICATION: THE COSTS OF TAXATION
13
DWL and the Elasticity of Supply
When supply
is inelastic,
P
it’s harder for firms
to leave the market
when the tax
reduces PS.
So, the tax only
reduces Q a little,
and DWL is small.
S
Size
of tax
D
Q
APPLICATION: THE COSTS OF TAXATION
14
DWL and the Elasticity of Supply
The more elastic is
supply,
the easier for firms
to leave the market
when the tax
reduces PS,
the greater Q falls
below the surplusmaximizing quantity,
P
S
Size
of tax
the greater the DWL.
APPLICATION: THE COSTS OF TAXATION
D
Q
15
DWL and the Elasticity of Demand
When demand
is inelastic,
P
S
it’s harder for
consumers to
leave the market
when the tax
raises PB.
Size
of tax
So, the tax only
reduces Q a little,
D
Q
APPLICATION: THE COSTS OF TAXATION
and DWL is small.
16
DWL and the Elasticity of Demand
The more elastic is
demand,
P
the easier for buyers
to leave the market
when the tax
increases PB,
S
Size
of tax
the more Q falls
below the surplusmaximizing quantity,
D
Q
APPLICATION: THE COSTS OF TAXATION
and the greater the
DWL.
17
ACTIVE LEARNING
2
Elasticity and the DWL of a tax
Would the DWL of a tax be larger if the
tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or
hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?
18
ACTIVE LEARNING
2
Answers
A. Breakfast cereal or sunscreen
From Chapter 5:
Breakfast cereal has more close substitutes
than sunscreen, so demand for breakfast cereal
is more price-elastic than demand for
sunscreen.
So, a tax on breakfast cereal would cause a
larger DWL than a tax on sunscreen.
19
ACTIVE LEARNING
2
Answers
B. Hotel rooms in the short run or long run
From Chapter 5:
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger
DWL in the long run than in the short run.
20
ACTIVE LEARNING
2
Answers
C. Groceries or meals at fancy restaurants
From Chapter 5:
Groceries are more of a necessity and
therefore less price-elastic than meals at
fancy restaurants.
So, a tax on restaurant meals would cause a
larger DWL than a tax on groceries.
21
ACTIVE LEARNING
3
Discussion question
 The government must raise tax revenue to pay
for schools, police, etc. To do this, it can either
tax groceries or meals at fancy restaurants.
 Which should it tax?
22
How Big Should the Government Be?
 A bigger government provides more services,
but requires higher taxes, which cause DWLs.
 The larger the DWL from taxation,
the greater the argument for smaller government.
 The tax on labor income is especially important; it’s
the biggest source of govt revenue.
 For the typical worker, the marginal tax rate
(the tax on the last dollar of earnings) is about 40%.
 How big is the DWL from this tax?
It depends on elasticity….
APPLICATION: THE COSTS OF TAXATION
23
How Big Should the Government Be?
 If labor supply is inelastic, then this DWL is small.
 Some economists believe labor supply is
inelastic, arguing that most workers work
full-time regardless of the wage.
APPLICATION: THE COSTS OF TAXATION
24
How Big Should the Government Be?
Other economists believe labor taxes are highly
distorting because some groups of workers have
elastic supply and can respond to incentives:
 Many workers can adjust their hours,
e.g., by working overtime.
 Many families have a 2nd earner with discretion
over whether and how much to work.
 Many elderly choose when to retire based on the
wage they earn.
 Some people work in the “underground economy”
to evade high taxes.
APPLICATION: THE COSTS OF TAXATION
25
The Effects of Changing the Size of the Tax
 Policymakers often change taxes, raising some
and lowering others.
 What happens to DWL and tax revenue when
taxes change? We explore this next….
APPLICATION: THE COSTS OF TAXATION
26
DWL and the Size of the Tax
Initially, the tax is
T per unit.
P
Doubling the tax
causes the DWL
to more than
double.
new
DWL
S
2T
T
D
initial
DWL
Q2
APPLICATION: THE COSTS OF TAXATION
Q1
Q
27
DWL and the Size of the Tax
Initially, the tax is
T per unit.
Tripling the tax
causes the DWL
to more than
triple.
P
new
DWL
S
T
3T
D
initial
DWL
Q3
APPLICATION: THE COSTS OF TAXATION
Q1
Q
28
DWL and the Size of the Tax
Summary
When a tax increases,
DWL rises even more.
Implication
When tax rates are
low, raising them
doesn’t cause much
harm, and lowering
them doesn’t bring
much benefit.
DWL
When tax rates are
high, raising them is
very harmful, and
cutting them is very
beneficial.
APPLICATION: THE COSTS OF TAXATION
Tax size
29
Revenue and the Size of the Tax
When the
tax is small,
increasing it
causes tax
revenue to rise.
P
PB
S
PB
2T
PS
T
D
PS
Q2
APPLICATION: THE COSTS OF TAXATION
Q1
Q
30
Revenue and the Size of the Tax
P
PB
PB
When the
tax is larger,
increasing it
causes tax
revenue to fall.
S
3T
2T
D
PS
PS
Q3
APPLICATION: THE COSTS OF TAXATION
Q2
Q
31
Revenue and the Size of the Tax
The Laffer curve
Tax
shows the
revenue
relationship
between
the size of the tax
and tax revenue.
The Laffer curve
Tax size
APPLICATION: THE COSTS OF TAXATION
32
Government Policies That Alter the
Private Market Outcome
 Price controls
 Price ceiling: a legal maximum on the price
of a good or service Example: rent control
 Price floor: a legal minimum on the price of
a good or service Example: minimum wage
 Taxes
 The govt can make buyers or sellers pay a
specific amount on each unit bought/sold.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
33
Example 1: Price Ceilings
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium
rent is $1,500 per month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,000, the quantity of
apartments supplied falls to 1,900,000,
and the quantity of apartments
demanded increases to 2,100,000,
resulting in a shortage of 200,000
apartments.
Don’t Let This Happen to You
Don’t Confuse “Scarcity” with “Shortage”
There is no shortage of most scarce goods.
MyEconLab Your Turn:
Test your understanding by doing related problem 3.15 at the end of this chapter.
Example 1: PRICE CEILINGS
A price ceiling
above the
eq’m price is
not binding –
has no effect
on the market
outcome.
P
S
Price
ceilin
g
$2000
$1500
D
20
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Q
35
How Price Ceilings Affect Market Outcomes
The eq’m price
($800) is above
the ceiling and
therefore illegal.
The ceiling
is a binding
constraint
on the price,
causes a
shortage.
P
S
$1500
Price
ceilin
g
$1000
shortage
D
19
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
21
Q
36
Shortages and Rationing
 With a shortage, sellers must ration the goods
among buyers.
 Some rationing mechanisms: (1) Long lines
(2) Discrimination according to sellers’ biases
 These mechanisms are often unfair, and inefficient:
the goods do not necessarily go to the buyers who
value them most highly.
 In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair).
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
37
類似的例子: 路邊停車收費
Price (per
hour)
S
D
E
$30
Price
ceiling
0
A
B Quantity
Shortage
 停車位有市場價值，不收費的路邊停車位形成短
缺。
 不收費時， 永遠無空車位。
 不收費的缺點:
 Inefficient Allocation: 急需要車位的停不到
 Wasted Resources: 找車位的時間浪費
How Price Ceilings Cause Inefficiency
 Inefficiently Low Quantity
 the quantity transacted is below the efficient
market equilibrium quantity
 Inefficient Allocation to Customers
 Wasted Resources
 Inefficiently Low Quality
 Black Markets
More Problems Caused by Price Ceilings
 Inefficient Allocation to consumers: people who want
the good badly and are willing to pay a high price don’t
get it, and those who care relatively little about the
good and are only willing to pay a low price do get it.
 Wasted Resources: people expend money, effort and
time to cope with the shortages caused by the price
ceiling.
More Problems Caused by Price Ceilings
 Inefficiently Low Quality: sellers offer low-quality goods
at a low price even though buyers would prefer a higher
quality at a higher price.
 A black market is a market in which goods or services
are bought and sold illegally—either because it is illegal
to sell them at all or because the prices charged are
legally prohibited by a price ceiling. However, a black
market may improve efficiency.
Price Ceilings: Government Rent Control Policy in Housing Markets
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium
rent is $1,500 per month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,000, the quantity of
apartments supplied falls to 1,900,000,
and the quantity of apartments
demanded increases to 2,100,000,
resulting in a shortage of 200,000
apartments.
Producer surplus equal to the area of
the blue rectangle A is transferred from landlords to renters,
and there is a deadweight loss equal to the areas of yellow triangles B and C.
Black market A market in which buying and selling take place at prices
that violate government price regulations.
What’s the Economic Effect of a Black Market for Apartments?
Suppose that competition among tenants results in the black market rent rising to
$2,000 per month. Use a graph showing the market for apartments, noting any
differences in consumer surplus, producer surplus, and deadweight loss.
Solving the Problem
Step 1: Review the chapter
material.
Step 2: Draw a graph similar
to Figure 4.9, with the addition
of the black market price.
Step 3: Analyze the changes
from Figure 4.9.
Producer surplus has
increased by an amount equal
to rectangles A and E, and
consumer surplus has
declined by the same amount.
Deadweight loss is equal to triangles B and C, the same as in Figure 4.9.
The remaining consumer surplus is the blue triangle D.
Eventually, the market could even end up at the competitive equilibrium.
MyEconLab Your Turn:
For more practice, do related problem 3.14 at the end of this chapter.
EXAMPLE 2: The Market for Unskilled Labor
Wage
paid to
unskille
d
workers
W
S
$4
Eq’m w/o
price
controls
D
500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Quantity of
unskilled
workers
L
45
How Price Floors Affect Market Outcomes
A price floor
below the
eq’m price is
not binding –
has no effect
on the market
outcome.
W
S
$4
Price
floor
$3
D
500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
L
46
How Price Floors Affect Market Outcomes
The eq’m wage ($4)
is below the floor
and therefore
illegal.
The floor
is a binding
constraint
on the wage,
causes a
surplus (i.e.,
unemployment).
W
labor
surplus S
Price
floor
$5
$4
D
400
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
550
L
47
Price Floors: Government Policy in Agricultural Markets
The Economic Effect of a Price Floor
in the Wheat Market
If wheat farmers convince the
government to impose a price floor of
$3.50 per bushel, the amount of wheat
sold will fall from 2.0 billion bushels per
year to 1.8 billion.
If we assume that farmers produce 1.8
billion bushels, producer surplus then
increases by the red rectangle A—which
is transferred from consumer surplus—
and falls by the yellow triangle C.
Consumer surplus declines by the red
rectangle A plus the yellow triangle B.
There is a deadweight loss equal to the
yellow triangles B and C, representing
the decline in economic efficiency due
to the price floor.
In reality, a price floor of $3.50 per
bushel will cause farmers to expand
their production from 2.0 billion to 2.2
billion bushels, resulting in a surplus of
wheat.
The Minimum Wage
Min wage laws
do not affect
highly skilled
workers.
They do affect
teen workers.
Studies:
A 10% increase
in the min wage
raises teen
unemployment
by 1-3%.
W
unemployment S
Min.
wage
$5
$4
D
400
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
550
L
49
ACTIVE LEARNING
Price controls
P
140
Determine
effects of:
130
1
The market for
hotel rooms
S
120
110
A. $90 price
ceiling
100
90
B. $90 price
floor
80
C. $120 price
floor
60
D
70
50
40
0
Q
50 60 70 80 90 100 110 120 130
50
ACTIVE LEARNING
1
A. $90 price ceiling
The price
falls to $90.
P
140
The market for
hotel rooms
S
130
120
Buyers
demand
120 rooms,
sellers
supply 90,
leaving a
shortage.
110
100
90
80
Price
ceiling
D
shortage = 30
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
51
ACTIVE LEARNING
B. $90 price floor
P
140
Eq’m price is
130
above the floor,
120
so floor is not
110
binding.
1
The market for
hotel rooms
S
100
P = $100,
Q = 100 rooms.
90
80
Price floor
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
52
ACTIVE LEARNING
C. $120 price floor
The price
rises to $120.
Buyers
demand
60 rooms,
sellers
supply 120,
causing a
surplus.
P
140
130
120
110
1
The market for
hotel rooms
surplus = 60
S
Price floor
100
90
80
D
70
60
50
40
0
Q
50 60 70 80 90 100 110 120 130
53
How a Price Floor Causes Inefficiency
 Inefficiently low quantity
 Inefficient allocation of sales among sellers
 Wasted resources
 Inefficiently high quality
 Temptation to break the law by selling below the
legal price
More problems caused by a price floor
 Price floors lead to inefficient allocation of sales
among sellers: those who would be willing to sell the
good at the lowest price are not always those who
actually manage to sell it.
 Price floors often lead to inefficiency in that goods of
inefficiently high quality are offered: sellers offer
high-quality goods at a high price, even though
buyers would prefer a lower quality at a lower price.
Evaluating Price Controls
 Recall one of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
 Prices are the signals that guide the allocation
of society’s resources. This allocation is
altered when policymakers restrict prices.
 Price controls often intended to help the poor,
but often hurt more than help.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
56
CHAPTER SUMMARY
 A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the
revenue the tax raises for the govt.
 The fall in total surplus (consumer surplus,
producer surplus, and tax revenue) is called the
deadweight loss (DWL) of the tax.
 A tax has a DWL because it causes consumers to
buy less and producers to sell less, thus shrinking
the market below the level that maximizes total
surplus.
57
CHAPTER SUMMARY
 The price elasticities of demand and supply
measure how much buyers and sellers respond to
price changes. Therefore, higher elasticities imply
higher DWLs.
 An increase in the size of a tax causes the DWL to
rise even more.
 An increase in the size of a tax causes revenue to
rise at first, but eventually revenue falls because
the tax reduces the size of the market.
58
CHAPTER SUMMARY
 A price ceiling is a legal maximum on the price of a
good. An example is rent control. If the price
ceiling is below the eq’m price, it is binding and
causes a shortage.
 A price floor is a legal minimum on the price of a
good. An example is the minimum wage. If the
price floor is above the eq’m price, it is binding
and causes a surplus. The labor surplus caused
by the minimum wage is unemployment.
59