Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is...

Taxation and Government Intervention

8


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


8

Producer and Consumer Surplus

• Consumer surplus is the value the consumer gets from buying a product, less its price

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

• Producer surplus is the value the producer sells a product for less the cost of producing it

• It is the area below the demand curve and above the price

8-2


8

S

D

P

Q

Consumer surplus = area of red triangle =

½($5)(5) = $12.5

Producer surplus = area of green triangle =

½($5)(5) = $12.5

Producer and Consumer Surplus

The combination of producer and consumer surplus is maximized at

market equilibrium

CS

PS

$10987654321

0 1 2 3 4 5 6 7 8

8-3


8

The Burden of Taxation

The costs of taxation include:

• The administrative costs of compliance which are the resources used by the government to administer the tax and individuals and businesses to comply with it

• The deadweight loss which is the loss of consumer and producer surplus that is not gained by the government

• Direct cost of the tax paid to the government by consumers and producers

8-4


8

The Burden of Taxation

S0

D

P

Q

S1

P0

P1

S0

D

P

Q

S1

P0

P1

Q0Q1

tt

Demand is relatively elastic Demand is relatively inelastic

P1-t

P1-t

Q0Q1

Producers pay more

Consumers pay more

8-5


8

Government Intervention as Implicit Taxation

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

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

• Government intervention in the form of price controls can be viewed as a combination tax and subsidy

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

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

8-6


8

S

D

P

Q

Application: The Effect of a Price Ceiling

P0

Q0

A price ceiling transfers surplus from producers to consumers,

generates deadweight loss, and reduces equilibrium quantity

Q1

Price ceilingP1

An effective price ceiling is set below market equilibrium price

Shortage

8-7


8

S

D

P

Q

Application: The Effect of a Price Floor

P0

Q0

A price floor transfers surplus from consumers to producers,

generates deadweight loss, and reduces equilibrium quantity

Q1

Price floorP1

An effective price floor is set above market equilibrium price

Surplus

8-8


8

The Difference Between Taxes and Price Controls

• Taxes leave people free to choose how much to supply and consume as long as they pay the tax

• Price ceilings create shortages and taxes do not

• Shortages may also create black markets

8-9


8

Rent Seeking, Politics, and Elasticities

• Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus

• Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior

• Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public

• Rent-seeking activities are activities designed to transfer surplus from one group to another

8-10


8

A

C

B

Inelastic Demand and Incentives to Restrict Supply

S0

D

P

Q

S1

P0

P1

Q0Q1

Revenue gained When demand is relatively

inelastic, suppliers have incentive to restrict quantity

to increase total revenue

Revenue lost

8-11


8

Inelastic Supplies and Incentives to Restrict Prices

• When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls

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

• Rent control in New York City is an example

8-12


8

Application: Price Floors and Elasticity

S

D

P

Q

P0

P1

S

D

P

Q

P0

Q0Q1

The surplus created by a price floor is larger if demand and supply are elastic

Q0Q1

Surplus

Price floor

Surplus

P1

8-13


8

Long-Run and Short-Run Effects on Price Control

Sshort-run

D1

P

Q

P0

PLR

Q0 QLR

Higher long-run elasticity of supply results in smaller

price increases when demand increases

Slong-run

D0

PSR

QSR

8-14

Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is...

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