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Topic 4 Part 2: Applications of Supply and Demand
4.seven Taxes and Subsidies
Learning Objectives
By the end of this section, you volition be able to:
- Distinguish betwixt legal and economic tax incidence
- Know how to represent taxes past shifting the curve and the wedge method
- Understand the quantity and cost affect from a taxation
- Draw why both taxes and subsidies crusade deadweight loss
Taxes are not the most popular policy, but they are often necessary. We volition wait at two methods to empathise how taxes touch the marketplace: by shifting the curve and using the wedge method. Commencement, we must examine the deviation betwixt legal taxation incidence and economic revenue enhancement incidence.
Legal versus Economic Tax Incidence
When the government sets a tax, it must decide whether to levy the tax on the producers or the consumers. This is calledlegal taxation incidence. The well-nigh well-known taxes are ones levied on the consumer, such as Government Sales Taxation (GST) and Provincial Sales Tax (PST). The authorities also sets taxes on producers, such as the gas tax, which cuts into their profits. The legal incidence of the tax is actually irrelevant when determining who is impacted by the taxation. When the government levies a gas tax, the producers will laissez passer some of these costs on every bit an increased toll. Likewise, a revenue enhancement on consumers will ultimately decrease quantity demanded and reduce producer surplus. This is because the economic tax incidence, or who really pays in the new equilibrium for the incidence of the revenue enhancement, is based on how the market responds to the price modify – non on legal incidence.
Tax – Shifting the Bend
In Topic 3, we adamant that the supply curve was derived from a firm'south Marginal Price and that shifts in the supply curve were caused by any changes in the market that caused an increment in MC at every quantity level. This is no different for a tax. From the producer'southward perspective, whatever tax levied on them is just an increase in the marginal costs per unit. To illustrate the result of a tax, let's look at the oil market again.
If the regime levies a $three gas revenue enhancement on producers (a legal tax incidence on producers), the supply curve will shift up by $3. Every bit shown in Effigy 4.8a below, a new equilibrium is created at P=$5 and Q=2 1000000 barrels. Notation that producers practice non receive $5, they at present merely receive $2, equally $3 has to be sent to the government. From the consumer'southward perspective, this $1 increment in price is no different than a price increment for any other reason, and responds past decreasing the quantity demanded for the college priced good.
What if the legal incidence of the revenue enhancement is levied on the consumers? Since the need bend represents the consumers' willingness to pay, the demand curve will shift down every bit a result of the revenue enhancement. If consumers are only willing to pay $four/gallon for four million gallons of oil but know they volition face a $3/gallon taxation at the till, they will simply purchase 4 million gallons if the ticket toll is $1. This creates a new equilibrium where consumers pay a $2 ticket toll, knowing they will have to pay a $3 revenue enhancement for a full of $5. The producers will receive the $2 paid earlier taxes.
Note that whether the tax is levied on the consumer or producer, the concluding outcome is the same, proving the legal incidence of the tax is irrelevant.
Taxation – The Wedge Method
Another method to view taxes is through the wedge method. This method recognizes that who pays the tax is ultimately irrelevant. Instead, the wedge method illustrates that a tax drives a wedge betwixt the toll consumers pay and the revenue producers receive, equal to the size of the taxation levied.
As illustrated below, to find the new equilibrium, one simply needs to find a $iii wedge betwixt the curves. The offset wedge tested is simply $0.vii, followed by $1.5, until the $iii.0 revenue enhancement is constitute.
Market Surplus
Similar with price and quantity controls, i must compare the market surplus before and after a toll alter to fully understand the furnishings of a tax policy on surplus.
Before
The market place surplus earlier the tax has not been shown, as the process should be routine. Ensure you lot understand how to become the following values:
Consumer Surplus= $iv one thousand thousand
Producer Surplus = $eight million
Market Surplus = $12 one thousand thousand
Later
The market surplus subsequently the policy tin exist calculated in reference to Figure 4.7d
Consumer Surplus (Bluish Surface area) = $1 million
Producer Surplus (Cerise Area)= $2 one thousand thousand
Government Revenue (Green Surface area) = $6 million
Market place Surplus= $ix million
Why is Government Included in Market Surplus
In our previous examples dealing with market surplus, we did not include any give-and-take of authorities revenue, since the government was not engaging in our market place. Remember that marketplace surplus is our metric for efficiency. If government was not included in this metric, it would not be very useful. In this case a million-dollar loss to government would be considered efficient if information technology resulted in a $ane gain to a consumer. To ensure that our metric for efficiency is still useful nosotros must consider government when calculating market surplus.
As with the quota – both consumer and producer surplus decreased because of a reduced quantity. The difference is, since the price is changing, at that place is redistribution. This time, the redistribution is from consumers and producers to the government. Remember, only a modify in quantity causes a deadweight loss. Price changes simply shift surplus around betwixt consumers, producers, and the government.
Transfer and Deadweight Loss
Allow'southward look closely at the revenue enhancement's impact on quantity and price to come across how these components affect the market.
Transfer – The Impact of Toll
Due to the tax's consequence on price, areas A and C are transferred from consumer and producer surplus to authorities revenue.
Consumers to Government – Area A
Consumers originally paid $4/gallon for gas. Now, they are paying $v/gallon. The $1 increase in cost is the portion of the tax that consumers have to bear. Despite the fact that the tax is levied on producers, the consumers have to bear a share of the price change. The size of this share depends on relative elasticity – a concept nosotros will explore in the side by side section. This is because a decrease in cost to producers ways quantity supplied is falling, and in society to maintain equilibrium, quantity demanded must autumn by an equal corporeality. This toll change ways the government collects $1 ten 2 million gallons or $2 meg in tax revenue from the consumers. This is a directly transfer from consumers to authorities and has no consequence on market surplus.
Producers to Government – Area C
Originally, producers received acquirement of $4/gallon for gas. Now, they receive $2/gallon. This $2 decrease is the portion of the revenue enhancement that producers have to bear. This means that the government collects $2 x two 1000000 gallons or $4 meg in tax revenue from the producers. This is a transfer from producers to the government.
Equally calculated, the regime receives a total of $6 million in tax revenue, which is taken from consumers and producers. This has no touch on net market surplus.
Deadweight Loss – The Impact of Quantity
If we simply considered a transfer of surplus, in that location would exist no deadweight loss. In this case, though, nosotros know that price changes come with a alter in quantity. A college price for consumers will cause a subtract in the quantity demanded, and a lower cost for producers will crusade a decrease in quantity supplied. This reduction from equilibrium quantity is what causes a deadweight loss in the market since at that place are consumers and producers who are no longer able to purchase and supply the good.
Consumer Surplus Subtract – Area B
Due to the increment in cost, many consumers will switch away from oil to culling options. This subtract in quantity demand of 1.v 1000000 gallons of oil causes a deadweight loss of $1 1000000.
Producer Surplus Decrease – Surface area D
Producers, who now receive simply $2.00/gallon for their product, will also decrease quantity supplied by 1.five million gallons of oil. It is no coincidence that the size of the decrease is the same. When you create the wedge between consumers and producers, you are finding the quantity where the full amount of the tax is incurred but the market is all the same at equilibrium. Retrieve that quantity demanded must equal quantity supplied or the market volition not be stable. This mirrored decrease in quantity ensures this is all the same the case. Notice, however, that the impact of this quantity drop causes a larger subtract in producer surplus than consumer surplus totalling $ii 1000000. Again, this is due to elasticity, or the relative responsiveness to the cost adventure, which volition be explored in more detail shortly.
Together, these decreases cause a $three million deadweight loss (the difference between the marketplace surplus before and market surplus subsequently).
Subsidy
While a tax drives a wedge that increases the price consumers have to pay and decreases the price producers receive, a subsidy does the opposite. Asubsidy is a benefit given by the government to groups or individuals, commonly in the form of a cash payment or a tax reduction. A subsidy is frequently given to remove some type of burden, and it is frequently considered to be in the overall interest of the public. In economic terms, a subsidy drives a wedge, decreasing the price consumers pay and increasing the price producers receive, with the government incurring an expense.
In Topic three, we looked at a case study of Victoria's competitive housing marketplace where loftier demand drove upwards prices. In response, the authorities has enacted many policies to allow depression-income families to nonetheless become homeowners. Allow's wait at the furnishings of one possible policy. (Note the following policy is unrealistic merely allows for easy comprehension of the result of subsidies).
In the market place above, our efficient equilibrium begins at a cost of $400,000 per home, with 40,000 homes being purchased. The regime wants to essentially increment the number of consumers able to purchase homes, and so it issues a $300,000 subsidy for any consumers purchasing a new home. This drives a wedge betwixt what abode buyers pay ($250,000) and what dwelling house builders receive ($550,000).
With all government policies we have examined so far, we take wanted to determine whether the result of the policy increases or decreases marketplace surplus. With a subsidy, we want to practise the same analysis. Unfortunately, because increases in surplus overlap on our diagram, it becomes more than complicated. To simplify the analysis, the following diagram separates the changes to producers, consumers, and government onto different graphs.
Producers
The producers now receive $550,000 instead of $400,000, increasing quantity supplied to 60,000 homes. This increases producer surplus pastareas A and B.
Consumers
The consumers now pay $250,000 instead of $400,000, increasing quantity demanded to 60,000 homes. This increases consumer surplus pastareas C and D.
Government
The government now has to pay $300,000 per abode to subsidize the sixty,000 consumers buying new homes (this policy would toll the government $eighteen billion!!) Graphically, this is equal to a subtract in government to areas A, B, C, D and East.
Result
Our full gains from the policy (to producers and consumers) are areasA, B, C and D,whereas total losses (the cost to the government) are areasA, B, C, D, and E.To summarize:
AreasA, B, C and D are transferred from the government to consumers and producers.
Area Due east is a deadweight loss from the policy.
In that location are two things to discover nigh this case. First, the policy was successful at increasing quantity from 40,000 homes to 60,000 homes. 2nd, it resulted in a deadweight loss because equilibrium quantity was as well high. Remember,someday quantity is changed from the equilibrium quantity, in the absence of externalities, there is a deadweight loss. This is true for when quantity is decreased and when it is increased.
http://world wide web.investopedia.com/terms/s/subsidy.asp
Summary
Taxes and subsidies are more complicated than a toll or quantity control as they involve a third economic thespian: the government. As we saw, who the tax or subsidy is levied on is irrelevant when looking at how the marketplace ends upward. Notation that the final three sections accept painted a adequately grim picture almost policy instruments. This is considering our model currently does not include the external costs economic players impose to the macro-surround (pollution, affliction, etc.) or attribute any significant to equity. These concepts volition be explored in more detail in later topics.
In our examples above, we see that the legal incidence of the tax does non matter, but what does? To determine which party bears more than of the brunt, we must apply the concept of relative elasticity to our analysis.
Glossary
- Economic Taxation Incidence
- the distribution of tax based on who bears the brunt in the new equilibrium, based on elasticity
- Legal Tax Incidence
- the legal distribution of who pays the tax
- Subsidy
- a benefit given by the government to groups or individuals, usually in the grade of a greenbacks payment or a tax reduction It is often to remove some blazon of brunt, and it is often considered to be in the overall interest of the public
Exercises iv.seven
Refer to the supply and demand curves illustrated below for the post-obit THREE questions. Consider the introduction of a $20 per unit revenue enhancement in this market.
one. Which areas stand for the loss to consumer AND producer surplus as a consequence of this tax?
a) yard + f.
b) j + g.
c) g + j.
d) k + f + j + chiliad.
two.Which areas correspond the gain in government revenue as a outcome of this tax?
a) k + f.
b) j + g.
c) grand + j.
d) yard + f + j + g.
3. Which areas correspond the deadweight loss associated with this revenue enhancement?
a) f + chiliad.
b) thousand – g.
c) j – f.
d) m + f + j + one thousand.
4. Assume that the marginal cost of producing socks is constant for all sock producers, and is equal to $5 per pair. If government introduces a constant per-unit tax on socks, and then which of the following statements is Fake, given the after-taxation equilibrium in the sock market? (Assume a downward-sloping need curve for socks.)
a) Consumers are worse off as a result of the tax.
b) Spending on socks may either increase or decrease as a result of the tax.
c) Producers are worse off equally a upshot of the tax.
d) This tax will result in a deadweight loss.
5. Refer to the supply and demand diagram below.
If an subsidy of $3 per unit of measurement is introduced in this marketplace, the price that consumers pay will equal ____ and the price that producers receive net of the subsidy volition equal _____.
a) $two; $five.
b) $three; $half dozen.
c) $iv; $seven.
d) $5; $8.
6. If a subsidy is introduced in a market, then which of the following statement is True? Assume no externalities
a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all decrease
Use the diagram below to respond the following Ii questions.
7. If a $vi per unit tax is introduced in this market, then the price that consumers pay will equal ____ and the price that producers receive net of the tax will equal _____.
a) $10; $4.
b) $9; $3.
c) $8; $2.
d) $7; $1.
8. If a $6 per unit of measurement revenue enhancement is introduced in this market, then the new equilibrium quantity will be:
a) 20 units.
b) 40 units.
c) 60 units.
d) None of the higher up.
9. Which of the following statements almost the deadweight loss of taxation is Truthful? (Assume no externalities.)
a) If there is a deadweight loss, then the revenue raised by the taxation is greater than the losses to consumer and producers.
b) If in that location is no deadweight loss, and then acquirement raised by the government is exactly equal to the losses to consumers and producers.
c) Both a) and b).
d) Neither a) nor b).
x. Which of the following correctly describes the equilibrium effects of a per-unit tax, in a market with NO externalities?
a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus subtract only social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increment.
d) Consumer surplus, producer surplus, and social surplus all decrease.
eleven. Which of the post-obit correctly describes the equilibrium effects of a per unit subsidy?
a) Consumer toll rises, producer price falls, and quantity increases.
b) Consumer price falls, producer toll falls, and quantity increases.
c) Consumer price rises, producer price rises, and quantity increases.
d) Consumer price falls, producer price rises, and quantity increases.
12. Refer to the supply and demand diagram beneath.
If an output (excise) taxation of $5 per unit of measurement is introduced in this market place, the price that consumers pay will equal ____ and the cost that producers receive net of the taxation will equal _____.
a) $5; $ten.
b) $half-dozen; $eleven.
c) $7; $12.
d) $8; $3.
13. Consider the supply and demand diagram below.
If a $2 per unit subsidy is introduced, what will be the equilibrium quantity?
a) 40 units.
b) 45 units.
c) 50 units.
d) 55 units.
Consider the supply and demand diagram below. Presume that: (i) at that place are no externalities; and (ii) in the absenteeism of government regulation the market place supply curve is the one labeled S1.
14. If a $5 per unit tax is introduced in this market, which area represents the deadweight loss?
a) a.
b) a + b.
c) b + c.
d) a + b + c.
Source: https://pressbooks.bccampus.ca/uvicecon103/chapter/4-6-taxes/
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