Econ 100Lecture 3.04

Government Policy &

Economic Welfare

1-22-09

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

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

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.

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.

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?

A Take Home Problem

• 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?