Taxation and Government Intervention

CHAPTER 8

Taxation and Government Intervention

Collecting more taxes than is absolutely necessary is legalized robbery.

Calvin Coolidge

McGraw-Hill/Irwin

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

Taxation and Government Intervention

Producer and Consumer Surplus

Consumer surplus is the value the consumer gets from buying a product, less its price It is the area below the demand curve and above the price Producer surplus is 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

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Taxation and Government Intervention

Producer and Consumer Surplus

P $10 9 8 7 6 5 4 3 2 1
Consumer surplus = area of red triangle = ($5)(5) = $12.5

CS

Producer surplus = area of green triangle = ($5)(5) = $12.5 The combination of producer and consumer surplus is maximized at market equilibrium

PS
D 0 1 2 3 4 5 6 7 8 Q

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Taxation and Government Intervention

The Burden of Taxation

The costs of taxation include: Direct cost of the tax paid to the government by consumers and producers The deadweight loss which is the loss of consumer and producer surplus that is not gained by the government 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

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Taxation and Government Intervention

The Burden of Taxation

Demand is relatively elastic Demand is relatively inelastic

P
Producers pay more S1

Consumers pay more

S1
S0 P1 P0 P1-t

t
P1

S0

P0
P1-t

Q1

Q0

D Q1 Q0

Q
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Taxation and Government Intervention

Government Intervention as Implicit Taxation

Government intervention in the form of price controls can be viewed as a combination tax and subsidy An effective price ceiling is a government set price below the market equilibrium price

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
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
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Taxation and Government Intervention

Application: The Effect of a Price Ceiling

An effective price ceiling is set below market equilibrium price

A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity

P0 P1
Shortage

Price ceiling D Q

Q1

Q0

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Taxation and Government Intervention

Application: The Effect of a Price Floor

An effective price floor is set above market equilibrium price

Surplus

S
Price floor
A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity

P1 P0

Q1

Q0

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Taxation and Government Intervention

The Difference Between Taxes and Price Controls

Price ceilings create shortages and taxes do not
Taxes leave people free to choose how much to supply and consume as long as they pay the tax Shortages may also create black markets

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Taxation and Government Intervention

Rent Seeking, Politics, and Elasticities

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

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

Inelastic Demand and Incentives to Restrict Supply

P

Revenue gained

S1
S0

P1 P0

When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue

A
B
D Q 1 Q0

Revenue lost

Q
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Taxation and Government Intervention

Inelastic Supplies and Incentives to Restrict Prices

When supply is inelastic, consumers have incentives to restrict prices
When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls Rent control in New York City is an example

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Taxation and Government Intervention

Application: Price Floors and Elasticity

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

P
Surplus
P1
P0 D S

P
Surplus
P1
P0

Price floor

D Q1 Q0

Q1 Q0

Q
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Taxation and Government Intervention

Long-Run and Short-Run Effects on Price Control

P
Higher long-run elasticity of supply results in smaller price increases when demand increases

Sshort-run
PSR PLR P0 D1 D0 Q0 QSR QLR

Slong-run

Q
8-14