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Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is legalized robbery. Calvin Coolidge CHAPTER 8 Copyright © 2010.

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Presentation on theme: "Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is legalized robbery. Calvin Coolidge CHAPTER 8 Copyright © 2010."— Presentation transcript:

1 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

2 Taxation and Government Intervention 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

3 Taxation and Government Intervention 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 $

4 Taxation and Government Intervention 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

5 Taxation and Government Intervention 8 The Burden of Taxation S0S0 D P Q S1S1 P0P0 P1P1 S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 tt Demand is relatively elastic Demand is relatively inelastic P 1-t Q0Q0 Q1Q1 Producers pay more Consumers pay more 8-5

6 Taxation and Government Intervention 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

7 Taxation and Government Intervention 8 S D P Q Application: The Effect of a Price Ceiling P0P0 Q0Q0 A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price ceiling P1P1 An effective price ceiling is set below market equilibrium price Shortage 8-7

8 Taxation and Government Intervention 8 S D P Q Application: The Effect of a Price Floor P0P0 Q0Q0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price floor P1P1 An effective price floor is set above market equilibrium price Surplus 8-8

9 Taxation and Government Intervention 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

10 Taxation and Government Intervention 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

11 Taxation and Government Intervention 8 A C B Inelastic Demand and Incentives to Restrict Supply S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 Revenue gained When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue Revenue lost 8-11

12 Taxation and Government Intervention 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

13 Taxation and Government Intervention 8 Application: Price Floors and Elasticity S D P Q P0P0 P1P1 S D P Q P0P0 Q0Q0 Q1Q1 The surplus created by a price floor is larger if demand and supply are elastic Q0Q0 Q1Q1 Surplus Price floor Surplus P1P1 8-13

14 Taxation and Government Intervention 8 Long-Run and Short-Run Effects on Price Control S short-run D1D1 P Q P0P0 P LR Q0Q0 Q LR Higher long-run elasticity of supply results in smaller price increases when demand increases S long-run D0D0 P SR Q SR 8-14


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