Principles of Microeconomics PowerPoint Presentations for Principles of Microeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

ApplicAtion: the costs of tAxAtion Chapter 8 Copyright © 2014 by Nelson Education Ltd.

ApplicAtion: the costs of tAxAtion To understand fully how taxes affect economic well-being, we must compare the reduced welfare of buyers and sellers to the amount of revenue the government raises. The tools of consumer and producer surplus allow us to make this comparison. Copyright © 2014 by Nelson Education Ltd.

the Deadweight loss of tAxAtion When a tax is levied on buyers, the demand curve shifts downward by the size of the tax. When it is levied on sellers, the supply curve shifts upward by that amount. In either case, when the tax is enacted, the price paid by buyers rises and the price received by sellers falls. In the end, buyers and sellers share the burden of the tax, regardless of how it is levied. Copyright © 2014 by Nelson Education Ltd.

FIGURE 8.1: The Effects of a Tax A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls. Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants Let’s use the tools of welfare economics to measure the gains and losses from a tax on a good. To do this, we must take into account how the tax affects buyers, sellers, and the government. The benefit received by buyers in a market is measured by consumer surplus. The benefit received by sellers in a market is measured by producer surplus. Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants What about the third interested party, the government? If T is the size of the tax and Q is the quantity of the good sold, then the government gets total tax revenue of T x Q. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 8.2: Tax Revenue The tax revenue that the government collects equals T X Q, the size of the tax T times the quantity sold Q. Thus, tax revenue equals the area of the rectangle between the supply and demand curves. Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants Welfare without a Tax To see how a tax affects welfare, we begin by considering welfare before the government has imposed a tax. Without a tax, the price and quantity are found at the intersection of the supply and demand curves. Copyright © 2014 by Nelson Education Ltd.

FIGURE 8.3: How a Tax Affects Welfare A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 8.3 (continued) A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants Welfare with a Tax The price paid by buyers rises from P1 to PB, so consumer surplus now equals only area A. The price received by sellers falls from P1 to PS, so producer surplus now equals only area F. The quantity sold falls from Q1 to Q2, and the government collects tax revenue equal to the area B + D. Total surplus with the tax, we add consumer surplus, producer surplus, and tax revenue. Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants Changes in Welfare We can now see the effects of the tax by comparing welfare before and after the tax is enacted. The change in total welfare includes the change in consumer surplus (which is negative), the change in producer surplus (which is also negative), and the change in tax revenue (which is positive). Video: Canadian taxes http://www.youtube.com/watch?v=xmJS2Vx_cSw Thinkstock Copyright © 2014 by Nelson Education Ltd.

How a Tax Affects Market Participants Changes in Welfare (continued) When we add these three pieces together, we find that total surplus in the market falls by the area C + E. Thus, the losses to buyers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results when a tax distorts a market outcome is called the deadweight loss. The area C + E measures the size of the deadweight loss. Copyright © 2014 by Nelson Education Ltd.

Deadweight Losses and the Gains from Trade Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. The area of the triangle between the supply and demand curves (area C + E in Figure 8.3) measures these losses. This loss can be seen most easily in Figure 8.4. Copyright © 2014 by Nelson Education Ltd.

FIGURE 8.4: The Deadweight Loss When the government imposes a tax on a good, the quantity sold falls from Q1 to Q2. As a result, some of the potential gains from trade among buyers and sellers do not get realized. These lost gains from trade create the deadweight loss. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Draw the supply and demand curves for cookies. If the government imposes a tax on cookies, show what happens to the quantity sold, the price paid by buyers, and the price paid by sellers. In your diagram, show the deadweight loss from the tax. Explain the meaning of the deadweight loss. Copyright © 2014 by Nelson Education Ltd.

Active Learning Analysis of a Tax The market for airplane tickets P Q $ A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S Copyright © 2014 by Nelson Education Limited

Active Learning Answers to A P Q $ The market for airplane tickets CS = ½ x $200 x 100 = $10,000 D S P = PS = ½ x $200 x 100 = $10,000 Total surplus = $10,000 + $10,000 = $20,000 19 Copyright © 2014 by Nelson Education Ltd.

Active Learning Answers to B P Q $ A $100 tax on airplane tickets CS = ½ x $150 x 75 = $5,625 D PB = S PS = $5,625 Tax revenue = $100 x 75 = $7,500 PS = Total surplus = $18,750 DWL = $1,250 Copyright © 2014 by Nelson Education Ltd.

the Determinants of the Deadweight loss What determines whether the deadweight loss from a tax is large or small? The answer is the price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price. Copyright © 2014 by Nelson Education Ltd.

FIGURE 8.5: Tax Distortions and Elasticities In panels (a) and (b), the demand curve and the size of the tax are the same, but the price elasticity of supply is different. Notice that the more elastic the supply curve, the larger the deadweight loss of the tax. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 8.5 (continued) In panels (c) and (d), the supply curve and the size of the tax are the same, but the price elasticity of demand is different. Notice that the more elastic the demand curve, the larger the deadweight loss of the tax. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. The demand for beer is more elastic than the demand for milk. Would a tax on beer or a tax on milk have a larger deadweight loss? Why? Copyright © 2014 by Nelson Education Ltd.

Deadweight loss And tax revenue As taxes vary What happens to the deadweight loss and tax revenue when the size of a tax changes? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 8.6: Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 8.6 (continued) Panels (d) and (e) summarize these conclu- sions. Panel (d) shows that as the size of the tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises then falls. This relationship is sometimes called the Laffer curve. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. If the government doubles the tax on gasoline, can you be sure that revenue from the gasoline tax will rise? Can you be sure that the deadweight loss from the gasoline tax will rise? Explain. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Classroom Activity Labour Taxes Assume you are full-time workers earning $10 per hour, $80 per day, $400 per week, $20,000 per year? Would you quit your job or keep working if the tax rate was 10 percent, 20 percent, 30 percent, … (up to 100 percent)? In your opinion, what is the “best” tax rate is? Activity 1 – Labour Taxes Type” In-class discussion Topics: Deadweight loss, taxation Materials needed: None Time: 10 minutes Class limitations: Works in any size class Purpose: Most students have not spent a great deal of time considering the effects of taxation on labour supply. This in-class exercise gives them the opportunity to consider the effects of proposed tax rates on their own willingness to supply labour. Instructions: Ask students to assume that they are full-time workers earning $10 per hour, $80 per day, $400 per week, $20,000 per year. Ask them if they would quit their jobs or keep working if the tax rate was 10 percent, 20 percent, 30 percent, … (up to 100 percent). Keep a tally as they show hands indicating that they are leaving the labour force. Ask students what they think the “best” tax rate is. Points for Discussion: Many students have no idea that current marginal tax rates are greater than 30 percent for many taxpayers. Students will likely say that a tax rate of zero would be best, but remind them that there would be no roads, libraries, parks, or national defence without at least some revenue raised by the government. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. The end Chapter 8 Copyright © 2014 by Nelson Education Ltd.