© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 6: Using Demand and Supply: Taxation and Government Intervention Prepared by: Kevin Richter,

© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 1

Chapter 6:Using Demand and Supply: Taxation and Government InterventionPrepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology


Regulating Trade: Institutions, Government, and Trade Government provides the institutional

framework that facilitates trade.

Government regulates markets, preventing trades that are harmful and encouraging trades that are helpful.


Roles of Government in a Market Provide a stable institutional framework. Promote effective and workable competition. Correct for externalities. Ensure economic stability and growth. Provide public goods. Adjust for undesired market results.


Provide a Stable Set of Institutions and Rules Government can create a stable environment

and enforce contracts through its legal system.

Economic growth is difficult when government does not provide a stable environment.


Promote Effective and Workable Competition Government promotes competition and

protect against monopolies.

Monopoly power is the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business


Promote Effective and Workable Competition Monopoly power gives existing firms or

individuals the power to raise prices.

Market participants often insist on open competition except when it comes to themselves.


Promote Effective and Workable Competition Many players in the market insist on open

competition except when it comes to themselves: Farmers like competition but still want price

supports.

Lawyers and architects like competition but still want licensing to prevent others from entering the market.


Correct for Externalities

An externality is the effect of a decision on a third party not taken into account by the decision maker.

Unless they are required to do so, parties to any exchange are unlikely to take into account any externality.



A positive externality is one in which society benefits even more than the two parties – an example is education.



A negative externality is one in which society as a whole benefits less than the two parties – an example is pollution.



When there are externalities, government has the potential role to change the rules so that the parties must take into account the effect of their actions on others.



Government may not effectively assume that role.

Government generally can only act within its borders.

Politics and vested interests may prevent government from acting.


Ensure Economic Stability and Growth Most people agree that government should:

Prevent large fluctuations in economic activity.

Maintain a relatively constant price level.

Provide an economic environment conducive to economic growth.


Ensure Economic Stability and Growth Most economists support these goals since

they involve macroeconomic externalities.


Ensure Economic Stability and Growth Macroeconomic externalities are

externalities that affect the levels of unemployment, inflation, or growth in the economy as a whole.


Provide Public Goods

Public goods are those goods whose consumption by one individual does not prevent their consumption by others – an example is a public park; another is national defense.



In contrast, a private good is one that, when consumed by one individual, cannot be consumed by other individuals – an example is an apple.



A free rider is a person who participates in something without having to pay for it.



Since most people would enjoy having public parks without having to pay for them, government requires that the public be taxed to pay for public parks, thereby reducing the free rider problem.


Adjust for Undesired Market Results The government, through taxes and

expenditures, redistributes income among households.


Adjust for Undesired Market Results In trying to be fair, which type of tax should

the government use?

This issue may be controversial.


Adjust for Undesired Market Results A progressive tax is one whose rates

increase as a person's income increases. Canadian income tax is an example.

A regressive tax is one whose effect decreases as income rises.

Canadian sales tax is an example.


Adjust for Undesired Market Results A proportional tax is one whose rates are

constant at all income levels, regardless of the taxpayer's total annual income.


Adjust for Undesired Market Results Another controversial role for government

involves deciding what is best for people independently of their desires.

Should government prohibit demerit goods and activities?


Adjust for Undesired Market Results Demerit goods and activities are those

considered to be bad for a person, although one may like them.

Addictive drugs are a demerit good; using addictive drugs is a demerit activity.


Adjust for Undesired Market Results Merit goods and activities are things

believed to be good for a person, although one may not engage in them.

Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity.


Market Failures and Government Failures Market failures are reasons for government

intervention.

Market failures are situations where the market does not lead to a desired result.


Market Failures and Government Failures Government intervention, however, need not

improve the outcome.

Government failures are situations where the government intervenes and makes the situation worse.


Market Failures and Government Failures Real-world policy makers are left with the

choice of selecting that which is least bad – market failure or government failure.


Producer and Consumer Surplus Consumer surplus – the value the

consumer gets from buying a product less its price.

It is the area underneath the demand curve and above the price an individual pays.


Producer and Consumer Surplus Producer surplus – the value the producer

sells a product for less the cost of producing it.

It is the area above the supply curve but below the price the producer receives.


Producer and Consumer Surplus The combination of consumer and producer

surplus is as large as it can be at market equilibrium.


Producer and Consumer Surplus

Pric

e

Supply

Demand

Quantity

0

$10987654321

10987654321

Producer Surplus

Consumer Surplus


Producer and Consumer Surplus The combined consumer and producer

surplus falls when price is above market equilibrium.


Consumer and Producer Surplus

Pric

e

Supply

Demand

Quantity

0

$10987654321

10987654321

Producer Surplus

Consumer Surplus

Lost Surplus


Taxation and Government

For government to operate, it must tax.

For the market to work, it needs government.

Tax rates depend on what goods and services government provides.


How Much Should Government Tax? To answer this, we must know the costs and

benefits of taxation.


Costs of Taxation

The costs of taxation include: The direct cost of the revenue paid to government The loss of consumer and producer surplus

caused by the tax The administrative costs of collecting the tax.


Costs of Taxation

A tax paid by the supplier shifts the supply curve up by the amount of the tax.


Costs of Taxation

When government raises taxes, there is a loss of consumer and producer surplus that is not gained by government.

This is known as deadweight loss.


Costs of Taxation

Graphically the deadweight loss is shown in a supply-demand diagram as the welfare loss triangle.


Costs of Taxation

The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.


Costs of Taxation

S1

P1–t

Quantity

Price

P0

Q0

P1

Q1

Producer surplus

S0

Demand

Consumer surplus

Deadweight loss

tax

A

B C

D E

F


Costs of Taxation

The other costs of taxation are the administrative costs of compliance.

Resources are used by the government to collect the tax and by citizens and businesses to comply with it.


Benefits of Taxation

The benefits of taxation are the goods and services that government provides.



Some of these benefits are the part of the basic institutional structure of a market economy that allows it to function efficiently.

The basic legal system is an example.



Other goods have the qualities of a public good – fire and police services are examples.



Some benefits are provided for reasons of equity or because they provide positive externalities. For example, education and healthcare.



Measuring the benefits of government-supplied goods is difficult because they are not provided in a market setting.

Because they are not provided in a market setting, they are often provided at a zero price.


Two Principles of Taxation

The government follows two general principles of taxation:

The benefit principle.

The ability-to-pay principle.


Benefit Principle

The benefit principle states that the individuals who receive the benefit of the good or service should pay the cost (opportunity cost) of the resources used to produce the good.

Examples are gasoline taxes and airport taxes, both paid by travelers.


Ability-to-Pay Principle

The ability-to-pay principle –individuals who are most able to bear the burden of the tax should pay the tax.

The best example of this is a progressive tax, such as the Canadian income tax.


Applying the Principles of Taxation

The principles of taxation are difficult to apply.

The two principles often conflict.


Applying the Principles of Taxation The elasticity concept helps us to understand

the tradeoffs.

The more broadly the good or service is defined, the more inelastic its demand.



In the language of consumer and producer surplus, if the government seeks to minimize the welfare loss, it should tax goods with inelastic supplies and demands.




Burden Depends on Relative Elasticity The person who physically pays the tax is

not necessarily the person who bears the burden of the tax.

The burden of the tax depends on relative elasticity.

The burden of the tax is rarely shared equally since elasticities are rarely equal.


Burden Depends on Relative Elasticity The tax burden is greater if a person cannot

easily change their behaviour.

The more inelastic one’s supply or demand, the larger the tax burden one will bear.


Burden Depends on Relative Elasticity 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.


Who Bears the Burden of a Tax?

590

Pric

e of

luxu

ry b

oats $70,000

60,000

50,000

40,000

30,000

20,000

10,000

Quantity of luxury boats 600200 400

S1

S0

Demand is inelastic.

Demand

taxConsumer pays

Supplier pays


Who Bears the Burden of a Tax?


Who Pays Versus Who Bears the Burden of a Tax The burden of a tax is independent of who

physically pays the tax.


Who Bears the Burden of a Tax? Tax levied on the consumer:

Pric

e

$7

6

5

4

3

2

1

Quantity6020 40

D0

S0

tax

Consumer pays

Supplier pays

D1


Tax Incidence and Current Policy Debates The analysis of tax incidence is helpful when

discussing current policy debates.


Employment Insurance Premiums Both employer and employee contribute to

the Employment Insurance.

The burden falls mainly on employees because, on average, labour supply is less elastic than labour demand.


Burden of the Employment Insurance Premium

Wage

LabourL1

w0

wL

S

D0

wF

L2

t

Firms’ share

Workers’ share

D1= D0- t


Price Ceilings

A price ceiling is a government-set maximum price which the market price cannot exceed.

Generally, the price ceiling is set below market equilibrium price.

It is an implicit tax on producers and an implicit subsidy to consumers.


Price Ceilings

Price ceilings cause a loss in producer and consumer surpluses that is identical to the welfare loss from taxation.


Effect of Price Ceiling

P0

Q0 Quantity

Price

Q1

Supply

DemandProducer surplus

Consumer surplus

Welfare loss

P1Price ceiling

Transferred to consumers

Excess demand

A

B

D

F

CE


Price Floors

A price floor is a government-set minimum price.

Price floors transfer surplus from consumers to producers.

They can be seen as a tax on consumers and a subsidy to producers.


Effect of Price Floor

Q1

Supply

DemandProducer surplus

Consumer surplus

Welfare loss

Transferred to producers

Quantity

Price

Excess supply

P2Price Floor

P0

Q0


Taxes Versus Price Controls

The effects of taxation and price controls are similar.

Both taxes and price controls create deadweight losses.


Taxes Versus Price Controls

However, price ceilings create shortages and taxes do not.

Shortages may create black markets.

Alternative methods of allocation develop because there is an imbalance between quantity demanded and quantity supplied.


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 they do about total surplus.


Rent Seeking, Politics, and Elasticities Individuals lobby government to institute

policies that increase their own surplus.

Others have the incentive to spend money to counteract that lobbying.


Rent Seeking, Politics, and Elasticities If consumers hold the balance of political

power, there will be strong pressures to create price ceilings.

If suppliers hold the political power, there will be strong pressures to create price floors.


Rent Seeking, Politics, and Elasticities Rent seeking – activities designed to

transfer surplus from one group to another.


Rent Seeking, Politics, and Elasticities Public choice economists integrate

economic analysis of politics with their analysis of the economy.

They argue that often the taxes and the benefits of government programs offset each other and do not help society significantly.


Inelastic Demand and Incentives to Restrict Supply When demand is inelastic, producers have

incentives to lobby the government to restrict supply.

Farming is a good example.

Advances in productivity increase supply but they result in lower prices.


Inelastic Demand and Incentives to Restrict Supply

Since food has few substitutes, its demand is inelastic.

Inelastic demand means that prices fall faster than a rise in quantity sold.

Revenues fall, and farmers are worse off.



Because of the increase in supply, and inelastic demand, farmers are losing revenue.

There is an enormous incentive for farmers to encourage government to restrict supply or create a price floor.



S2

P1

Q1

P2

Q2

Demand

S1

Quantity

Price

Total Revenue

Revenue gained

Revenue lostA

B


Inelastic Supplies and Incentives to Restrict Prices

Consumers are also rent seekers.

When supply is inelastic, consumers have incentives to restrict prices.


Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand goes

up, prices jump causing consumers to lobby for price controls.

Rent control is an example.


Long-Run Problems of Price Controls

In the long run, supply and demand tend to be much more elastic than in the short run.

Therefore, price controls will cause large shortages or surpluses in the long run.


Long-Run Problems 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.


Long-Run Problems 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 affordable housing in a shrinking market.


Long-Run and Short-Run Effects of Price Controls

P0

Q0

P1

Q1

P2

Q2 Q3

Short run supply

D0

Quantity

Price

Long run supply

D1

Price ceiling

Shortage


Using Demand and Supply: Taxation and Government Intervention

End of Chapter 6

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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 6: Using Demand and Supply: Taxation and Government Intervention Prepared by: Kevin Richter,