taxation and government...

Taxation and Government Intervention 8

Taxation and Government Intervention

Collecting more taxes than is absolutely

necessary is legalized robbery.

— Calvin Coolidge

CHAPTER 8

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


Consumer Surplus

• Consumer surplus is the value the consumer gets from buying a product, less its price (paying less than you are willing to pay)• It is the area below the demand curve and

above the price• Example: I was willing to pay $1.75 for a

Gatorade but I only paid $1.50

8-2


S

D

P

Q

Consumer surplus=area

below the demand curve and

above price

Draw the Graph: Consumer Surplus

CS

8-3

Q1

P1


Producer Surplus

• Producer surplus is the value the producer sells a product for less the cost of producing it (receiving more than the price you are willing to sell the good for)• It is the area above the supply curve but

below the price the producer receives

• Example: The producer was willing to sell blue t-shirts for $10 but people were willing to pay $12 for them

McGraw-Hill/Irwin Colander, Economics 4


S

D

P

Q

Producer surplus =area above the supply curve and

below price

Draw the Graph: Producer Surplus

PS

8-5

Q1

P1


Calculating CS and PS

• To calculate the CS and PS use the formula for the area of a triangle

• ½(base x height)



Consumer surplus = area of red triangle =

½(5)($5) = $12.50

Producer surplus = area of green triangle = ½(5)($5) =

$12.50

Producer and Consumer Surplus

The combination of producer and consumer surplus is maximized at

market equilibrium

S

D

P

Q

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8 9 10

8-7


S

D

P

Q

Consumer surplus decreases = area of red triangle =

½(5)($4) = $10

Producer surplus increases = areas of green triangle and

rectangle = ½(5)($4)+(5)(2)= $20

Producer and Consumer Surplus

0 1 2 3 4 5 6 7 8

The combination of producer and consumer surplus decreases

when price is greater than equilibrium price

CS

Suppose P increases to $6

PS

Lost surplus (deadweight loss)

= ½($2)(1)

$10987654321

8-8


The Burden of Taxation

• A tax paid by the supplier decreases supply by the amount of the tax

• Taxes result in deadweight loss: the loss of consumer and producer surplus from a tax (that is not gained by the government)• This is shown graphically by the welfare

loss triangle

8-9


S1

D

P

Q


P3

P1

P2

Q1Q2

S2

t

Both producer and consumer surplus decrease

A tax paid by the supplier shifts the supply curve up

by the amount of the tax (t)

Positive government revenue exists

Deadweight loss exists

8-10

The amount of the tax is the distance between the supply curves

CS

PS

DWL


Draw the Graph: A $2 Tax

S1

D

P

QQ1

8-11

•Begin with S+D•Graph a decrease in S to represent the $2 tax

P1

S2

Q2

P2



S1

D

P

Q

4

5

6

Q1Q2

S2

t

8-12


•The distance between the supply curves is $2—the amount of the tax.•Extend your dotted line from S2 until it touches demand • Add numbers to show the $2 tax



S1

D

P

Q

4

5

6

Q1Q2

S2

t

8-13


•Label CS and PS•Label DWL

CS

PS

DWL



S1

D

P

Q

4

5

6

Q1Q2

S2

8-14


•The distance between the supply curves is $2. • The new equilibrium price is $6.•The blue triangle represents DWL as a result of the tax.•Both CS and PS decrease as a result of the tax

(Write the above in your notes to the right of your graph)

CS

PS

DWL


Revenue Box•The revenue box is created by the distance between the supply curves and by drawing a line from each point to the price axis•This results in a smaller area of CS and PS•Using the graph, what is the amount of tax revenue?

• The amount of tax revenue is = 2(8)

=$16

S1

D

P

Q

$4

$5

$6

108

S2

8-15

CS

PS

DWL


What price do buyers pay and sellers keep as a result of a $2 tax?

S1

D

P

Q

$4

$5

$6

108

S2

8-16

CS

PS

• What price do buyerspay?

• They pay $6 (were paying $5 before the tax; an increase of $1)

• What is the price sellers keep?

• $4 (the new price is $6 but they have to pay the $2 tax)

DWL


Who Bears the Burden of Taxation?

• The tax burden (or tax incidence):

• The person who physically pays the tax is not necessarily the person who bears the burden of the tax

8-17


Who Bears the Burden of Taxation?

• The more inelastic one’s relative demand and supply, the larger the tax burden one will bear

• If demand is more inelastic than supply, consumers will pay the higher share

• If supply is more inelastic than demand, suppliers will pay the higher share




SD

S

EE

E

Fraction of tax borne

by demander

SD

D

EE

E

Fraction of tax borne

by supplier

How to calculate the fraction of the tax borne by consumers and producers:

8-19


Example

• Price elasticity of supply is 4

• Price elasticity of demand is 1

• Fraction of tax borne by demander

• 4/1+4= 4/5

• Fraction of tax borne by supplier

• 1/1+4= 1/5


SD

S

EE

E

SD

D

EE

E


Government Intervention as Implicit Taxation

• An effective price ceiling is a government-set price below the market equilibrium price

• A price ceiling acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation

• A price ceiling redistributes surplus from producers to consumers



S

D

P

Q

Application: The Effect of a Price Ceiling

P1

Q1

A price ceiling transfers surplus from producers to

consumers, generates deadweight loss, and

reduces equilibrium quantity

QS

Price ceilingPc

An effective price ceiling is set below market equilibrium price

Shortage

8-22

QD

CS

PS

DWL


Government Intervention as Implicit Taxation

• An effective price floor is a government set price above the market equilibrium

• It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers



S

D

P

Q

Application: The Effect of a Price Floor

P1

Q1

A price floor transfers surplus from consumers to

producers, generates deadweight loss, and reduces equilibrium

quantityQD

Price floorPf

An effective price floor is set above market equilibrium price

Surplus

8-24

QS

CS

PS DWL


Tariffs, Quotas, and World Price


120

S Domestic

D

P

Q

$25 PW

$50

10050

8-25

A

B

C

D E

The market price is $50 but the world price with trade is $25. How does this affect CS and PS?




1. CS before tradeA

2. PS before tradeBC

3. CS after tradeABDE

4. PS after tradeC

5. Net gain from tradeDE (will import 70 units from another country)

S

D

P

Q

$50

10050

8-26

120

A

B

C

D E$25 PW




Now, the government places a $5 tariff on this good.Now, the price becomes $30.1. What happens to CS?2. What happens to PS?3. Where is the tariff

revenue? (How would you calculate it?)

S

D

P

Q

$25 Pw

$50

10050 120

$30 Pt




S

D

P

Q

$25 Pw

$50

10050 120

Now, the government places a $5 tariff on this good.Now the price becomes $30.1. What happens to CS?

Decreases

$30 Pt

CS




S

D

P

Q

$25 Pw

$50

10050 120

Now, the government places a $5 tariff on this good.Now the price becomes $30.2. What happens to PS?

Increases

$30 Pt

CS

PS




S

D

P

Q

$25 Pw

$50

10050 120

Now, the government places a $5 tariff on this good.Now the price becomes $30.3. Where is the tariff

revenue? (How would you calculate it?)

Located in grey box; $5 (amount of tariff) times the difference between QS and QD

$30 Pt

CS

PS

QS QD

Tariff revenue




S

D

P

Q

$25 Pw

$50

10050 120

What if there was a quota?

At the world price of $25 we would be importing 70 units. The government imposes a quota because that quantity is too high. We would import the difference between QS and QD. (There would be no tariff revenue)

$30 Pt

QS QD


Tariffs, Quotas, and World Price: Summary

• With international trade total surplus gets bigger (CS and PS both increased)

• Consumers benefit from a lower world price

• Domestic producers do not benefit



Chapter 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

8-33


Chapter Summary • The cost of taxation to consumers and

producers includes the actual tax paid, the deadweight loss, and the costs of administering the tax

• 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

8-34


Chapter Summary • 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

8-35

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