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CHAPTER 8 Application: The Costs of Taxation and Price Regulations Economics PRINCIPLES OF N. Gregory Mankiw Premium PowerPoint Slides 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