1. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. TAXATION AND GOVERNMENT INTERVENTION TAXATION AND GOVERNMENT INTERVENTION Chapter 7

2. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-2 Today’s lecture will: Show how equilibrium maximizes consumer and producer surplus. Demonstrate the burden of taxation to consumers and producers. Explain why the person who physically pays the tax is not necessarily the person who bears the burden of the tax.

3. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-3 Today’s lecture will: Demonstrate how an effective price ceiling is the equivalent of a tax on producers and a subsidy to consumers. Define rent seeking and show how it is related to elasticity. State the general rule of political economy.

4. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-4 Producer and Consumer Surplus Consumer surplus - 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 – 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.

5. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-5 Producer and Consumer Surplus Price S D Quantity 0 $10 9 8 7 6 5 4 3 2 1 10987654321 Producer Surplus Consumer Surplus CS = ½(5x5) = 12.5 = Area of blue triangle PS = ½(5x5) = 12.5 = Area of orange triangle The combination of producer and consumer surplus is maximized at market equilibrium.

6. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-6 Producer and Consumer Surplus Price S D Quantity 0 $10 9 8 7 6 5 4 3 2 1 10987654321 Producer Surplus gains 2x4 = 8 units of lost consumer surplus If price is $6, Consumer Surplus: CS = 1/2 ($4x4) = $8 Combined consumer and producer surplus decreases when price is above equilibrium. Lost surplus = ½($2x1) = $1

7. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-7 Costs of Taxation S1S1 P 1 –t Quantity Price P0P0 Q0Q0 P1P1 Q1Q1 Producer surplus S0S0 D Consumer surplus Deadweight loss tax A per unit tax t shifts supply from S 0 to S 1 and increases price to P 1 and decreases quantity to Q 1. Consumer surplus is A+B+C before the tax and A after the tax. Producer surplus is D+E+F before the tax and F after the tax. Government revenue=B+D Deadweight loss=C+E F E D C B A

8. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-8 The Costs of Taxation  Direct cost of revenue paid to the government  Deadweight loss - loss of consumer and producer surplus that is not gained by the government  Administrative costs of compliance – resources used by the government to administer the tax and individuals and businesses to comply with it

9. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-9 Tax Burden The person who physically pays the tax is not necessarily the person who bears the burden of the tax. The more inelastic one’s relative demand and supply, the larger the tax burden one will bear.  If demand is more inelastic than supply, consumers will pay the higher share.  If supply is more inelastic than demand, suppliers will pay the higher share.

10. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-10 Who Bears the Tax Burden? Equal elasticity Equal burden Price of luxury boats Quantity of luxury boats 0 510 S1S1 D S0S0 60 $70 600 50 Price of luxury boats Quantity of luxury boats 0 500 S1S1 D S0S0 60 $70 600 50 tax Demand is more inelastic Larger consumer burden 590

11. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-11 Who Bears the Tax Burden Fraction of tax borne by demander Fraction of tax borne by supplier

12. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-12 Who Bears the Tax Burden? Supplier pays the tax- Supply shifts Price of luxury boats Quantity of luxury boats 0 510 S1S1 D S0S0 60 $70 600 50 tax Price of luxury boats Quantity of luxury boats 0 510 D0D0 S 60 $70 600 50 tax D1D1 Consumer pays the tax- Demand shifts Tax burden is independent of who pays the tax.

13. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-13 Social Security Taxes Both employer and employee contribute the same percentage of before-tax wages to the Social Security fund. Although the employer and employee contribute the same percentage, they do not share the burden equally. On average, labor supply tends to be less elastic than labor demand, so the Social Security tax burden is primarily on employees.

14. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-14 Sales Taxes Sales taxes are paid by retailers on the basis of their sales revenue. Since sales taxes are broadly defined to include most goods and services, consumers find it hard to substitute to avoid the tax. Demand is inelastic so consumers bear the greater burden of the tax. As consumers increase purchases on the Internet where sales are not taxed, retail stores will bear a greater burden of the sales tax.

15. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-15 Government Intervention as Implicit Taxation Government intervention in the form of price controls can be viewed as a combination tax and subsidy. A price ceiling is an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation. A price floor is a tax on consumers and a subsidy for producers that transfers consumer surplus to producers.

16. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-16 Effect of a Price Ceiling P0P0 Q0Q0 Quantity Price Q1Q1 S D Producer surplus (F) Consumer surplus (A+B+D) Welfare loss (C+E) P1P1 Price ceiling Transferred to consumers (D) F D C E B A

17. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-17 Effect of a Price Floor P0P0 Q0Q0 Quantity Price Q1Q1 S D Consumer surplus (A) Welfare loss (C+E) Transferred to producers (B) F D C E B A P1P1 Price floor Producer surplus (B+D+F)

18. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-18 The Difference Between Taxes and Price Controls Price ceilings create shortages and taxes do not unless people try to evade them. Taxes leave people free to choose how much to supply and consume as long as they pay the tax. Shortages also create black markets.

19. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-19 Rent Seeking and Politics Price controls, which transfer surplus from one group to another are 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.

20. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-20 Inelastic Demand and Incentives to Restrict Supply S0S0 P1P1 Q1Q1 P0P0 Q0Q0 D S1S1 Quantity Price Total Revenue Revenue lost Revenue gained

21. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-21 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.

22. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-22 Price Floors and Elasticity of Demand and Supply The surplus created by a price floor is larger if demand and supply are elastic. PFPF PEPE QDQD QSQS S D Q P P Q S D PFPF PEPE QDQD QSQS surplus

23. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-23 Long-Run and Short-Run Elasticities P0P0 Q0Q0 P1P1 Q1Q1 P2P2 Q2Q2 Q3Q3 Short run supply D0D0 Q P Long run supply D1D1 Larger long-run elasticities result in smaller price increases when demand increases.

24. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-24Summary Consumer surplus is the net benefit a consumer gets from purchasing a good. Producer surplus is the net benefit a producer gets from selling a good. Equilibrium maximizes the combination of consumer and producer surplus. Taxes create a loss of consumer and producer surplus known as deadweight loss, which is graphically represented by the welfare loss triangle.

25. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-25Summary The cost of taxation to consumers and producers includes the actual tax paid, the deadweight loss, and the costs of administering the tax. Relative elasticities determine who bears the burden of the tax. The more inelastic one’s demand or supply, the larger the burden of the tax. Price ceilings and floors, like taxes, result in loss of consumer and producer surplus.

26. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-26Summary Price ceilings transfer producer surplus to consumers; they are a tax on producers and a subsidy to consumers. Price floors transfer consumer surplus to producers; they are a tax on consumers and a subsidy to producers. The more elastic supply and/or demand is, the greater the surplus with an effective price floor and the greater the shortage is with an effective price ceiling.

27. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-27 Review Question 7-1 Given the following demand and supply of pizza, find consumer and producer surplus. $4 $10 $9 $8 $7 $6 $5 50100300250200150 Consumer surplus: ½ x ($10-6) x 100 = $200 Producer surplus: ½ x ($6-4) x 100 = $100 S D Quantity Price

28. McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 7-28 Review Question 7-2 Given the following demand and supply of pizza, show the effects of a price floor at $8. $4 $10 $9 $8 $7 $6 $5 50100300250200150 Price floor Consumer surplus Deadweight loss Producer surplus S D Price Quantity