1. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 6: Using Demand and Supply: Taxation and Government Intervention Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

2. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Regulating Trade: Institutions, Government, and Trade Government provides the institutional framework that facilitates trade. Government regulates markets, preventing trades that are harmful and encouraging trades that are helpful.

3. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Roles of Government in a Market Provide a stable institutional framework. Promote effective and workable competition. Correct for externalities. Ensure economic stability and growth. Provide public goods. Adjust for undesired market results.

4. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Provide a Stable Set of Institutions and Rules Government can create a stable environment and enforce contracts through its legal system. Economic growth is difficult when government does not provide a stable environment.

5. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Promote Effective and Workable Competition Government promotes competition and protect against monopolies.  Monopoly power is the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business

6. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Promote Effective and Workable Competition Monopoly power gives existing firms or individuals the power to raise prices. Market participants often insist on open competition except when it comes to themselves.

7. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Promote Effective and Workable Competition Many players in the market insist on open competition except when it comes to themselves:  Farmers like competition but still want price supports.  Lawyers and architects like competition but still want licensing to prevent others from entering the market.

8. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Correct for Externalities An externality is the effect of a decision on a third party not taken into account by the decision maker. Unless they are required to do so, parties to any exchange are unlikely to take into account any externality.

9. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Correct for Externalities A positive externality is one in which society benefits even more than the two parties – an example is education.

10. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Correct for Externalities A negative externality is one in which society as a whole benefits less than the two parties – an example is pollution.

11. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Correct for Externalities When there are externalities, government has the potential role to change the rules so that the parties must take into account the effect of their actions on others.

12. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Correct for Externalities Government may not effectively assume that role.  Government generally can only act within its borders.  Politics and vested interests may prevent government from acting.

13. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Ensure Economic Stability and Growth Most people agree that government should:  Prevent large fluctuations in economic activity.  Maintain a relatively constant price level.  Provide an economic environment conducive to economic growth.

14. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Ensure Economic Stability and Growth Most economists support these goals since they involve macroeconomic externalities.

15. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Ensure Economic Stability and Growth Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, or growth in the economy as a whole.

16. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Provide Public Goods Public goods are those goods whose consumption by one individual does not prevent their consumption by others – an example is a public park; another is national defense.

17. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Provide Public Goods In contrast, a private good is one that, when consumed by one individual, cannot be consumed by other individuals – an example is an apple.

18. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Provide Public Goods A free rider is a person who participates in something without having to pay for it.

19. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Provide Public Goods Since most people would enjoy having public parks without having to pay for them, government requires that the public be taxed to pay for public parks, thereby reducing the free rider problem.

20. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Adjust for Undesired Market Results The government, through taxes and expenditures, redistributes income among households.

21. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Adjust for Undesired Market Results In trying to be fair, which type of tax should the government use?  This issue may be controversial.

22. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Adjust for Undesired Market Results A progressive tax is one whose rates increase as a person's income increases. Canadian income tax is an example. A regressive tax is one whose effect decreases as income rises. Canadian sales tax is an example.

23. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Adjust for Undesired Market Results A proportional tax is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.

24. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 Adjust for Undesired Market Results Another controversial role for government involves deciding what is best for people independently of their desires. Should government prohibit demerit goods and activities?

25. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Adjust for Undesired Market Results Demerit goods and activities are those considered to be bad for a person, although one may like them.  Addictive drugs are a demerit good; using addictive drugs is a demerit activity.

26. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Adjust for Undesired Market Results Merit goods and activities are things believed to be good for a person, although one may not engage in them.  Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity.

27. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 Market Failures and Government Failures Market failures are reasons for government intervention. Market failures are situations where the market does not lead to a desired result.

28. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Market Failures and Government Failures Government intervention, however, need not improve the outcome. Government failures are situations where the government intervenes and makes the situation worse.

29. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 Market Failures and Government Failures Real-world policy makers are left with the choice of selecting that which is least bad – market failure or government failure.

30. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 Producer and Consumer Surplus Consumer surplus – the value the consumer gets from buying a product less its price. It is the area underneath the demand curve and above the price an individual pays.

31. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 31 Producer and Consumer Surplus 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.

32. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 32 Producer and Consumer Surplus The combination of consumer and producer surplus is as large as it can be at market equilibrium.

33. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Producer and Consumer Surplus Price Supply Demand Quantity 0 $10 9 8 7 6 5 4 3 2 1 10987654321 Producer Surplus Consumer Surplus

34. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Producer and Consumer Surplus The combined consumer and producer surplus falls when price is above market equilibrium.

35. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Consumer and Producer Surplus Price Supply Demand Quantity 0 $10 9 8 7 6 5 4 3 2 1 10987654321 Producer Surplus Consumer Surplus Lost Surplus

36. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Taxation and Government For government to operate, it must tax. For the market to work, it needs government. Tax rates depend on what goods and services government provides.

37. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 How Much Should Government Tax? To answer this, we must know the costs and benefits of taxation.

38. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Costs of Taxation The costs of taxation include:  The direct cost of the revenue paid to government  The loss of consumer and producer surplus caused by the tax  The administrative costs of collecting the tax.

39. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Costs of Taxation A tax paid by the supplier shifts the supply curve up by the amount of the tax.

40. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Costs of Taxation When government raises taxes, there is a loss of consumer and producer surplus that is not gained by government. This is known as deadweight loss.

41. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Costs of Taxation Graphically the deadweight loss is shown in a supply-demand diagram as the welfare loss triangle.

42. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 42 Costs of Taxation The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.

43. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 43 Costs of Taxation S1S1 P 1–t Quantity Price P0P0 Q0Q0 P1P1 Q1Q1 Producer surplus S0S0 Demand Consumer surplus Deadweight loss tax A B C D E F

44. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 44 Costs of Taxation The other costs of taxation are the administrative costs of compliance. Resources are used by the government to collect the tax and by citizens and businesses to comply with it.

45. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 45 Benefits of Taxation The benefits of taxation are the goods and services that government provides.

46. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 46 Benefits of Taxation Some of these benefits are the part of the basic institutional structure of a market economy that allows it to function efficiently.  The basic legal system is an example.

47. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 47 Benefits of Taxation Other goods have the qualities of a public good – fire and police services are examples.

48. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 48 Benefits of Taxation Some benefits are provided for reasons of equity or because they provide positive externalities. For example, education and healthcare.

49. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 49 Benefits of Taxation Measuring the benefits of government- supplied goods is difficult because they are not provided in a market setting. Because they are not provided in a market setting, they are often provided at a zero price.

50. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 50 Two Principles of Taxation The government follows two general principles of taxation:  The benefit principle.  The ability-to-pay principle.

51. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 51 Benefit Principle The benefit principle states that the individuals who receive the benefit of the good or service should pay the cost (opportunity cost) of the resources used to produce the good.  Examples are gasoline taxes and airport taxes, both paid by travelers.

52. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 52 Ability-to-Pay Principle The ability-to-pay principle –individuals who are most able to bear the burden of the tax should pay the tax.  The best example of this is a progressive tax, such as the Canadian income tax.

53. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 53 Applying the Principles of Taxation The principles of taxation are difficult to apply. The two principles often conflict.

54. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 54 Applying the Principles of Taxation The elasticity concept helps us to understand the tradeoffs. The more broadly the good or service is defined, the more inelastic its demand.

55. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 55 Applying the Principles of Taxation In the language of consumer and producer surplus, if the government seeks to minimize the welfare loss, it should tax goods with inelastic supplies and demands.

56. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 56 Applying the Principles of Taxation

57. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 57 Burden Depends on Relative Elasticity The person who physically pays the tax is not necessarily the person who bears the burden of the tax. The burden of the tax depends on relative elasticity. The burden of the tax is rarely shared equally since elasticities are rarely equal.

58. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 58 Burden Depends on Relative Elasticity The tax burden is greater if a person cannot easily change their behaviour. The more inelastic one’s supply or demand, the larger the tax burden one will bear.

59. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 59 Burden Depends on Relative Elasticity 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.

60. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 60 Who Bears the Burden of a Tax? 590 Price of luxury boats $70,000 60,000 50,000 40,000 30,000 20,000 10,000 Quantity of luxury boats600200400 S1S1 S0S0 Demand is inelastic. Demand tax Consumer pays Supplier pays

61. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 61 Who Bears the Burden of a Tax?

62. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 62 Who Pays Versus Who Bears the Burden of a Tax The burden of a tax is independent of who physically pays the tax.

63. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 63 Who Bears the Burden of a Tax? Tax levied on the consumer: Price $7 6 5 4 3 2 1 Quantity602040 D0D0 S0S0 tax Consumer pays Supplier pays D1D1

64. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 64 Tax Incidence and Current Policy Debates The analysis of tax incidence is helpful when discussing current policy debates.

65. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 65 Employment Insurance Premiums Both employer and employee contribute to the Employment Insurance. The burden falls mainly on employees because, on average, labour supply is less elastic than labour demand.

66. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 66 Burden of the Employment Insurance Premium Wage Labour L1L1 w0w0 wLwL S D0D0 wFwF L2L2 t Firms’ share Workers’ share D 1 = D 0 - t

67. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 67 Price Ceilings A price ceiling is a government-set maximum price which the market price cannot exceed.  Generally, the price ceiling is set below market equilibrium price.  It is an implicit tax on producers and an implicit subsidy to consumers.

68. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 68 Price Ceilings Price ceilings cause a loss in producer and consumer surpluses that is identical to the welfare loss from taxation.

69. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 69 Effect of Price Ceiling P0P0 Q0Q0 Quantity Price Q1Q1 Supply Demand Producer surplus Consumer surplus Welfare loss P1P1 Price ceiling Transferred to consumers Excess demand A B D F C E

70. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 70 Price Floors A price floor is a government-set minimum price.  Price floors transfer surplus from consumers to producers.  They can be seen as a tax on consumers and a subsidy to producers.

71. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 71 Effect of Price Floor Q1Q1 Supply Demand Producer surplus Consumer surplus Welfare loss Transferred to producers Quantity Price Excess supply P2P2 Price Floor P0P0 Q0Q0

72. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 72 Taxes Versus Price Controls The effects of taxation and price controls are similar. Both taxes and price controls create deadweight losses.

73. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 73 Taxes Versus Price Controls However, price ceilings create shortages and taxes do not. Shortages may create black markets. Alternative methods of allocation develop because there is an imbalance between quantity demanded and quantity supplied.

74. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 74 Rent Seeking, Politics, and Elasticities Price controls reduce total producer and consumer surpluses. Governments institute them because people care more about their own surplus than they do about total surplus.

75. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 75 Rent Seeking, Politics, and Elasticities Individuals lobby government to institute policies that increase their own surplus. Others have the incentive to spend money to counteract that lobbying.

76. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 76 Rent Seeking, Politics, and Elasticities If consumers hold the balance of political power, there will be strong pressures to create price ceilings. If suppliers hold the political power, there will be strong pressures to create price floors.

77. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 77 Rent Seeking, Politics, and Elasticities Rent seeking – activities designed to transfer surplus from one group to another.

78. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 78 Rent Seeking, Politics, and Elasticities Public choice economists integrate economic analysis of politics with their analysis of the economy. They argue that often the taxes and the benefits of government programs offset each other and do not help society significantly.

79. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 79 Inelastic Demand and Incentives to Restrict Supply When demand is inelastic, producers have incentives to lobby the government to restrict supply. Farming is a good example. Advances in productivity increase supply but they result in lower prices.

80. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 80 Inelastic Demand and Incentives to Restrict Supply Since food has few substitutes, its demand is inelastic. Inelastic demand means that prices fall faster than a rise in quantity sold. Revenues fall, and farmers are worse off.

81. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 81 Inelastic Demand and Incentives to Restrict Supply Because of the increase in supply, and inelastic demand, farmers are losing revenue. There is an enormous incentive for farmers to encourage government to restrict supply or create a price floor.

82. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 82 Inelastic Demand and Incentives to Restrict Supply S2S2 P1P1 Q1Q1 P2P2 Q2Q2 Demand S1S1 Quantity Price Total Revenue Revenue gained Revenue lost A B

83. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 83 Inelastic Supplies and Incentives to Restrict Prices Consumers are also rent seekers. When supply is inelastic, consumers have incentives to restrict prices.

84. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 84 Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand goes up, prices jump causing consumers to lobby for price controls. Rent control is an example.

85. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 85 Long-Run Problems of Price Controls In the long run, supply and demand tend to be much more elastic than in the short run. Therefore, price controls will cause large shortages or surpluses in the long run.

86. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 86 Long-Run Problems of Price Controls In the short run there will be small effects from the price controls. There will be huge effects in the long run.

87. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 87 Long-Run Problems of Price Controls In the face of price controls, potential new competitors hate to enter the market thereby strangling supply. Vacancy rates drop as potential new renters scramble to find affordable housing in a shrinking market.

88. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 88 Long-Run and Short-Run Effects of Price Controls P0P0 Q0Q0 P1P1 Q1Q1 P2P2 Q2Q2 Q3Q3 Short run supply D0D0 Quantity Price Long run supply D1D1 Price ceiling Shortage

89. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.89 Using Demand and Supply: Taxation and Government Intervention End of Chapter 6