Econ 201Ch. 8

Government Policy &

Economic Welfare

Evaluating the Impact of Government Intervention

• Policy Instruments Available– Taxes

• Typically: per-unit tax on output• Others: lump-sum, value added (VAT)

– Subsidies• Rebate on per-unit produced

– Price Floors• Minimum price that can be charged (e.g., minimum wage)

– Price Ceilings• Limit on the maximum price that can be charged (WIN)

– Quotas• Limits on amounts produced/imported • Infant industry/protectionism

How Do We Analyze the Effects of Taxes and Subsidies

• The efficient ideal market– “perfectly competitive” market

• Consumers and suppliers are price-takers, i.e. have no market power

Application: Taxes and Competitive Equilibrium

• Consider a per-unit tax, which adds a fixed dollar amount to each unit of a good sold.

– Graphically, the imposition of the tax is shown by a leftward shift of the supply curve.

Figure 6.4 The Effect of a Per-Unit Tax on Laptop Sales

Deadweight Loss

Price ConsumersPay

Pre-tax price

Price SellersReceive

Reduction inQty sold

Deadweight Loss

Retained CS

Tax RevFrom CS

Tax RevFrom CS

Retained PS

Application: Taxes and Competitive Equilibrium

• This example illustrates three key ideas related to taxes:

– Incidence of a tax on consumers:• The increase in price that consumers pay

– Incidence of a tax on producers:• The decrease in price producers receive

– Deadweight loss:• Losses in consumer and producer surplus that are not

transferred to the government as revenue

Elasticity and Tax Incidence

• The incidence of a tax will be determined by the elasticities of demand and supply.

• Not by who pays the tax!

Figure 6.5(a) Elasticity and Tax Incidence

Figure 6.5(b) Elasticity and Tax Incidence

Tax Incidence and Demand Elasticity

• If demand is inelastic, the majority of the tax incidence falls on consumers.

• If demand is elastic, the majority of the tax incidence falls on producers.

• As demand elasticity increases, the deadweight loss increases.

Figure 6.5(c) Elasticity and Tax Incidence

Figure 6.5(d) Elasticity and Tax Incidence

Tax Incidence and Supply Elasticity

• If supply is inelastic, the majority of the tax incidence falls on producers.

• If supply is elastic, the majority of the tax incidence falls on consumers.

• As supply elasticity increases, the deadweight loss increases.

Deadweight Loss and Tax Revenue

Deadweight Loss and Tax Revenue

Deadweight Loss and Tax Revenue

Deadweight Loss and Tax Revenue

Determinants of the Deadweight Loss

• Price elasticities of supply and demand– Supply curve - more elastic

• Deadweight loss – larger

– Demand curve – more elastic• Deadweight loss – larger

• The greater the elasticities of supply and demand– The greater the deadweight loss of a tax

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How deadweight loss and tax revenue vary with the size of a tax (a, b, c)

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Price

Quantity

0

(a) Small tax

The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue.

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Taxrevenue

Price

Quantity

0

(b) Medium tax

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Taxrevenue

Price

Quantity

0

(c) Large tax

Demand

Supply

Deadweightloss

Q1

PB

PS

Q2

Tax

rev

enue

Balancing DWL and Tax Revenues

• Intuition:– If tax rates are too low or too high, revenue

will be low.– There is an optimal tax rate to be found.

• Later in the course:– The Laffer curve will be discussed.– This is the parabolic relationship between tax

rates and tax revenue.

How deadweight loss and tax revenue vary with the size of a tax (d, e)

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Deadweightloss

Tax size0

(d) From panel (a) to panel (c),deadweight loss continually increases

Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.

(e) From panel (a) to panel (c), taxrevenue first increases, then decreases

TaxRevenue

Tax size0

Laffer curve

• 1974, economist Arthur Laffer– Laffer curve– Supply-side economics– Tax rates were so high

• Reducing them would actually raise tax revenue

• Ronald Reagan - ran for president in 1980– From experience in film industry

• High tax rates - caused less work• Low tax rates - caused more work

The Laffer curve and supply-side economics

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• Ronald Reagan - ran for president in 1980– Argument

• Taxes were so high that they were discouraging hard work• Lower taxes would give people the proper incentive to work

– Raise economic well-being– Perhaps increase tax revenue

• Economists continue to debate Laffer’s argument• General lesson:

– Change in tax revenue from a tax change– Depends on how the tax change affects people’s behavior

The Laffer curve and supply-side economics

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Quotas

• Quota—A maximum quantity of a good or service that can be traded over a specific period of time.

– Used when the government determines the equilibrium quantity would not be in society's best interest

• For example: International trade

Figure 6.9 The Effect of a Quota on the Market for Laptop Computers

Equilibrium Qs

Quota Restriction

DWL from CS

DWL from PS

MV to Consumers

MC of resources

The Effects of a Quota

• Quotas result in:– A transfer of surplus from consumers

to producers– Deadweight loss (DWL)

• DWL is due to less being produced than would be in an unrestricted (competitive) market

• Resources are underutilized and inefficiently allocated

– Consumers place a higher MV on good than MC of using resources to produce the good

The UW and Quotas

• The UW has recently announced that it will not accept any transfers for spring quarter– Restriction on number of students being admitted <->

quota• Assume that the market had previously been

efficient (Qs= Qd at current tuition fee)– A) what would be the economic consequences of the

transfer “freeze”?– B) what would be the impact of raising tuition, instead

of “freezing” transfers– C) In real-life, how are the students admitted to the

UW determined (by what kind(s) of allocation schemes?

Something to Think About

• It is estimated that illegal immigrants account for about 25% of construction labor in the US housing market– A) what would be the impact a ban on illegal

immigrants on the labor market for US housing construction, i.e., hourly wage rates?

– B) what would be the impact of this ban on the price of newly constructed houses?

Total Social Welfare

• Ideally the impact of a program should be evaluated as: {Pareto efficient}

– 1) can at least one person’s welfare be improved– 2) without making anyone worse off– http://en.wikipedia.org/wiki/Pareto_efficiency

• More realistically: Could the winners compensate the losers? {Pigouvian}

– Is the deadweight loss of the taxed good less than the surplus gain from the subsidized good?

– http://en.wikipedia.org/wiki/Pigovian_tax