1. CH 8: Taxation and Government Intervention (Consumer and Producer Surplus)

2. Consumer Surplus
Consumer surplus is the value the consumer gets from buying a product, less its price (paying less than you are willing to pay)
It is the area below the demand curve and above the price
Example: I was willing to pay $1.75 for a water but I only paid $1.50
8-2

3. Draw the Graph: Consumer Surplus
Consumer surplus= area below the demand curve and above price CS P1 D Q Q1

4. Producer Surplus
Producer surplus is the value the producer sells a product for less the cost of producing it (receiving more than the price you are willing to sell the good for)
It is the area above the supply curve but below the price the producer receives
Example: The producer was willing to sell blue t-shirts for $10 but people were willing to pay $12 for them

5. Draw the Graph: Producer Surplus
Producer surplus= area above the supply curve and below price S P1 PS D Q Q1

6. Calculating CS and PS
To calculate the CS and PS use the formula for the area of a triangle
½(base x height)

7. Producer and Consumer Surplus
Consumer surplus = area of blue triangle = ½(5)($5) = $12.50
Producer surplus = area of red triangle = ½(5)($5) = $12.50
The combination of producer and consumer surplus is maximized at market equilibrium S D P Q CS PS
$10 9 8 7 6 5 4 3 2 1

8. Producer and Consumer Surplus
Suppose P increases to $6 P
Consumer surplus decreases = area of blue triangle = ½(5)($4) = $10
Producer surplus increases = areas of red triangle and rectangle =
½(5)($4)+(5)(2)= $20
The combination of producer and consumer surplus decreases when price is greater than equilibrium price
Lost surplus (deadweight loss) = ½($2)(1)
$10 9 8 7 6 5 4 3 2 1 S CS PS D Q

9. The Burden of Taxation
A tax paid by the supplier decreases supply by the amount of the tax
Taxes result in deadweight loss: the loss of consumer and producer surplus from a tax (that is not gained by the government)
This is shown graphically by the welfare loss triangle

10. The Burden of Taxation CS PS DWL Both producer and
consumer surplus decrease
A tax paid by the supplier shifts the supply curve up by the amount of the tax (t)
Positive government revenue exists
Deadweight loss exists P S2 S1 CS
DWL P2 t P1 P3 PS D Q Q2 Q1
The amount of the tax is the distance between the supply curves

11. Draw the Graph: A $2 Tax Begin with S+D
Graph a decrease in S to represent the tax S1 P2 P1 D Q Q2 Q1

12. The amount of the tax is the distance between the supply curves
Draw the Graph: A $2 Tax S1 D P Q 4 5 6 Q1 Q2 S2 t
The amount of the tax is the distance between the supply curves
The distance between the supply curves is $2—the amount of the tax.
Extend your dotted line from S2 until it touches demand
Add numbers to show the $2 tax

13. The amount of the tax is the distance between the supply curves
Draw the Graph: A $2 Tax S1 D P Q 4 5 6 Q1 Q2 S2 t
The amount of the tax is the distance between the supply curves
Label CS and PS
Label DWL CS
DWL PS

14. The amount of the tax is the distance between the supply curves
Draw the Graph: A $2 Tax S1 D P Q 4 5 6 Q1 Q2 S2
The amount of the tax is the distance between the supply curves
The distance between the supply curves is $2.
The new equilibrium price is $6.
The orange triangle represents DWL as a result of the tax.
Both CS and PS decrease as a result of the tax
(Write the above info in your notes to the right of your graph) CS
DWL PS

15. Revenue Box S1 D P Q $4 $5 $6 10 8 S2 CS PS
DWL
The revenue box is created by the distance between the supply curves and by drawing a line from each point to the price axis
This results in a smaller area of CS and PS
Using the graph, what is the amount of tax revenue?
The amount of tax revenue is $2(8) =$16

16. What price do buyers pay and sellers keep as a result of a $2 tax?Q $4 $5 $6 10 8 S2
What price do buyers pay?
They pay $6 (were paying $5 before the tax; an increase of $1)
What is the price sellers keep?
$4 (the new price is $6 but they have to pay the $2 tax) CS
DWL PS

17. Who Bears the Burden of Taxation?
The tax burden (or tax incidence):
The person who physically pays the tax is not necessarily the person who bears the burden of the tax

18. Who Bears the Burden of Taxation?
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

19. Who Bears the Burden of Taxation?P Q D 14 12 11 8 10
Stax
Calculate the following:
1. Tax per unit
2. Total tax revenue
3. Amount of tax paid by consumers
4. Amount of tax paid by producers
5. Total expenditures
6. Total revenue for firms
7. Who bears the greater tax burden? Why?

20. Who Bears the Burden of Taxation?P Q D 14 12 11 8 10
Stax
Calculate the following:
1. Tax per unit $3
2. Total tax revenue
$3(10)=$30
3. Amount of tax paid by consumers
$2(10)=$20
4. Amount of tax paid by producers
$1(10)=$10
5. Total expenditures
$14(10)=$140
6. Total revenue for firms
$11(10)=$110
7. Who bears the greater tax burden? Why?
Demanders; Demand is relatively
inelastic compared to supply

21. Who Bears the Burden of Taxation?P Q D 14 13 12 11 10
Stax
Calculate the following:
1. Tax per unit
2. Total tax revenue
3. Amount of tax paid by consumers
4. Amount of tax paid by producers
5. Total expenditures
6. Total revenue for firms
7. Who bears the greater tax burden? Why?

22. Who Bears the Burden of Taxation?P Q D 14 13 12 11 10
Stax
Calculate the following:
1. Tax per unit $3
2. Total tax revenue
$3(10)=$30
3. Amount of tax paid by consumers
$1(10)=$10
4. Amount of tax paid by producers
$2(10)=$20
5. Total expenditures
$14(10)=$140
6. Total revenue for firms
$11(10)=$110
7. Who bears the greater tax burden? Why?
Suppliers; supply is relatively inelastic
compared to demand

23. The Burden of Taxation
How to calculate the fraction of the tax borne by consumers and producers:
Fraction of tax borne
by demander
Fraction of tax borne
by supplier

24. Example Price elasticity of supply is 4
Price elasticity of demand is 1
Fraction of tax borne by demander
4/1+4= 4/5
Fraction of tax borne by supplier
1/1+4= 1/5

25. Government Intervention: Price Ceiling
An effective price ceiling is a government-set price below the market equilibrium price
A price ceiling acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation
A price ceiling redistributes surplus from producers to consumers

26. Government Intervention: Price Ceiling
An effective price ceiling is set below market equilibrium price P
A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity S CS P1
DWL Pc
Price ceiling PS
Shortage D Q QS Q1 QD

27. Government Intervention: Price Floor
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

28. Government Intervention: Price Floor
An effective price floor is set above market equilibrium price P
Surplus S
A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity CS Pf
Price floor P1 PS
DWL D Q QD Q1 QS

29. Tariffs, Quotas, and World Price
S Domestic D P Q
$25 PW
$50
100 50 A B C E
The market price is $50 but the world price with trade is $25. How does this affect CS and PS?
120

30. Tariffs, Quotas, and World Price
1. CS before trade A
2. PS before trade BC
3. CS after trade
ABDE
4. PS after trade C
5. Net gain from trade
DE (will import 70
units from another
country)
S Domestic D P Q
$25 PW
$50
100 50 A B C E
120

31. Tariffs, Quotas, and World Price
$25 Pw
$50
100 50
120
$30 Pt
Now, the government places a $5 tariff on this good and the price becomes $30.
1. What happens to CS?
2. What happens to PS?
3. Where is the tariff revenue? (How would you calculate it?)

32. Tariffs, Quotas, and World Price
$25 Pw
$50
100 50
Now, the government places a $5 tariff on this good and the price becomes $30.
1. What happens to CS?
Decreases CS
$30 Pt
120

33. Tariffs, Quotas, and World Price
$25 Pw
$50
100 50
Now, the government places a $5 tariff on this good and the price becomes $30.
2. What happens to PS?
Increases CS
$30 Pt PS
120

34. Tariffs, Quotas, and World Price
$25 Pw
$50
100 50
Now, the government places a $5 tariff on this good and the price becomes $30.
3. Where is the tariff revenue? (How would you calculate it?)
Located in grey box; $5 (amount of tariff) times the difference between QS and QD CS QS QD
Tariff revenue
$30 Pt PS
120

35. Tariffs, Quotas, and World Price
$25 Pw
$50
100 50
What if there was a quota?
At the world price of $25 we would be importing 70 units. The government imposes a quota because that quantity is too high. We would import the difference between QS and QD. (There would be no tariff revenue)
$30 Pt QS QD
120

36. Tariffs, Quotas, and World Price: Summary
With international trade total surplus gets bigger (CS and PS both increased)
Consumers benefit from a lower world price
Domestic producers do not benefit

37. Chapter Summary
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

38. Chapter Summary
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

39. Chapter Summary
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