1. Chapter 15 Market Interventions McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Main Topics The effect of a tax or subsidy Policies designed to raise prices Import tariffs and quotas 15-2

3. Taxes A specific tax is a fixed dollar amount that must be paid on each unit bought or paid An ad valorem tax is a tax that is stated as a percentage of the good’s price The incidence of a tax indicates how much of the tax burden is borne by various market participants 15-3

4. Taxes In studying the effects of taxes it’s important to distinguish between the amount a consumer pays for a good and the amount a firm receives Use P b for the amount a consumer pays, P s for the amount a firm receives If the tax is T per unit, then P s = P b – T 15-4

5. The Burden of a Tax Consider the effect of a specific tax of T dollars per gallon paid by gas stations on their sales of gasoline Graphically, there are three ways to determine the tax’s effect: Shift the supply curve up by T Shift the demand curve down by T Use a wedge between the amounts consumers pay and firms receive All three methods yield the same results Makes no difference whether the tax is levied on consumers or producers 15-5

6. Effects of a Specific Tax Shifting the supply curve is one way to determine a specific tax’s effects Demand curve remains unchanged For any price paid by consumers, firms now receive less than when there is no tax Won’t be willing to supply as much as before Supply curve with the tax is a distance T above the original supply curve New equilibrium price paid by consumers is price at which the demand curve and new supply curve cross Amount bought and sold falls Price paid by consumers rises; price received by firms falls In a competitive market the burden of a tax is shared by consumers and firms 15-6

7. Figure 15.1: Effects of a Specific Tax – Shifting the Supply Curve Gallons of Gas per Month Price Paid by Consumers ($/gallon) QTQT QoQo P s = P b - T PoPo PbPb Increase in Consumer Cost per Gallon Decrease in Firms’ Receipts per Gallon A B T D S STST P o + T 15-7

8. Tax Incidence Incidence of a tax depends on the shapes of the demand and supply curves In general, the more elastic is demand and less elastic is supply, the more of the tax is borne by firms Consumers bear the larger share of the tax when demand is less elastic than supply 15-8

9. Figure 15.2: Incidence of a Specific Tax – Two Special Cases 15-9 Who bears the burden of the tax?

10. Figure 15.3: Effects of a Specific Tax – Shifting the Demand Curve 15-10

11. Welfare Effects of a Tax Use the no-tax demand and supply curve to measure aggregate surplus in the absence of a tax The tax reduces the amount bought and sold to the quantity at which the distance between the supply and demand curves is T Since quantity bought and sold is higher without the tax, so is aggregate surplus To see the welfare effect of the tax, compute the difference in aggregate surplus at the quantities with and without the tax The deadweight loss of taxation is the lost aggregate surplus due to a tax 15-11

12. Welfare Effects of a Tax Welfare effects can be used to assess winners and losers from a tax or other policy Graphical analysis of a tax shows: Consumers and producers both lose, government gains tax revenue Society overall loses (deadweight loss) Taxation can be used to move resources from the private sector to the government But the government receives less than private parties give up Effect of a tax on welfare depends on what is done with the revenue Use algebra to compute the value of deadweight loss from a tax 15-12

13. Figure 15.6: Welfare Effects of a Specific Tax 15-13

14. Example Problem 15.1 Market demand for corn is Qd=15-2P and Mkt supply is Qs=5P-2.5. What happens if the govt. imposes a $.70 tax? What is aggregate/consumer/producer surplus? Step 1: Find mkt equil. without tax: $2.50 and 10 bil. bushels with an agg. Surplus of $35B, Consumer is $25B Step 2: Find the new equil. with the tax: Qs=5(Pb-.70)-2.5=5Pb-6 Find equil. with 15-2Pb=5Pb-6 = $3 What will the seller receive? What are the changes? What is the govt. tax revenue? Step 3: Calculate the new levels of surplus 15-14

15. Example Problem 15.1 15-15

16. Which Goods Should be Taxed? Size of the deadweight loss from taxation of a good depends on the shapes of the demand and supply curves If supply or demand is perfectly inelastic, for example, there is no deadweight loss The tax doesn’t change the quantity bought and sold If either supply or demand is very inelastic, deadweight loss caused by a tax will be low Implies the government should aim to tax goods for which the deadweight loss from taxation will be low. If two goods have equal and constant marginal cost, the good with less elastic demand should face a larger tax Distributional considerations can also affect the choice of goods to tax Why wouldn’t we want to tax milk? Why might we want to tax cigarettes? 15-16

17. Figure 15.8: Taxation with No Deadweight Loss 15-17 Who bears the burden of the tax?

18. Subsidies and Their Effects A subsidy is a payment that reduces the amount that buyers pay for a good or increases the amount that sellers receive Subsidies can be either specific or ad valorem (like taxes) Often result from lobbying efforts Unlike taxes, subsidies usually increase sales of the affected goods Cause deadweight loss…why? 15-18

19. Subsidies and Their Effects Consider the effect of a government subsidy of T dollars for each gallon of ethanol produced Can find the equilibrium with the subsidy by: Shifting supply curve down by T Shifting demand curve up by T Looking for the quantity at which the demand curve lies a distance of T below the no-subsidy supply curve Consumers pay T dollars less than firms receive (directly from the mkt) Subsidy increases the amount bought and sold 15-19

20. Welfare Effects of Subsidies Welfare analysis of a subsidy shows consumers and producers both gain The sum of the reduction in price to consumers and the increase in price to firms exactly equals the size of the subsidy The side of the market whose demand or supply is less elastic has a larger price change Aggregate surplus falls This is because the government incurs an expense, the per-unit subsidy times the number of units sold 15-20

21. Figure 15.9: Deadweight Loss of a Subsidy 15-21

22. Policies Designed to Raise Prices Governments often attempt to manipulate markets to benefit a particular group When they want to help sellers in a market, they turn to policies meant to raise prices A price floor establishes a minimum price that sellers can charge A price support program raises the market price by making purchases of the good, increasing demand Production quotas impose limits on the quantity that individual firms can produce Voluntary production reduction programs offer firms inducements to decrease their output voluntarily 15-22

23. Figure 15.12 (a): Price Floor A price floor establishes a minimum price that sellers can charge With minimum price of P, quantity bought and sold is Q 1 15-23

24. Figure 15.12 (b): Price Support A price support program raises the market price by making purchases of the good, increasing demand Here, total sales are Q 2 : Government purchases Q 2 -Q 1 Private buyers purchase Q 1 Price is P Common Price Support products are….agricultural goods…! 15-24

25. Figure 15.12 (c): Production Quota Production quotas impose limits on the quantity that individual firms can produce Total sales of Q 1 are achieved through a production quota Could also be achieved through a voluntary reduction program Can be either voluntary or involuntary. 15-25

26. Welfare Effects of Policies for Raising Prices Compare all four policies, each raising the price of milk from P 0 to P 1 All create deadweight loss Price support program is least efficient Causes unused milk to be produced Other three policies create equal deadweight loss Price floor and production quota have same effects 15-26

27. Figure 15.13: Welfare Effects of Policies for Raising Prices 15-27

28. Figure 15.13: Welfare Effects of Policies for Raising Prices 15-28

29. In-Text Problem 15.2 Market demand for corn is Qd=15-2P and Mkt supply is Qs=5P-2.5. What happens if the govt. wants to raise the price per bushel to $3? How could it do this with a price ceiling, a price support program, a quota and a voluntary production reduction program? 15-29

30. In-Text Problem 15.2 Price ceiling: State that corn cannot be old for less than $3 Price support program: Govt. purchase a great quantity that will drive the price up to $3 Quota: Dist. X amount of quotas to the farmers and prohibit them from producing more. Voluntary production reduction program: Pay farmers to reduce production to the equil. Level required for $3. Which is the best? Worst? 15-30

31. Policies that Lower Prices Sometimes governments adopt policies that are designed to lower prices To improve the well-being of buyers Example: rent control laws Reduces amount of the good available for purchase Creates deadweight loss Because buyers can’t purchase all they want at the ceiling price, they may behave inefficiently Increases deadweight loss Example: extreme searching for rent-controlled apartments Sellers have an incentive to inefficiently degrade the quality of their products 15-31

32. Figure 15.16: Price Ceiling 15-32 If the govt. imposes a price ceiling on apt. equal to P (line), the # of avail. Apts and # rented falls to Q1.

33. Import Tariffs and Quotas Many countries use tariffs or quotas to discourage imports Example: the U.S. imposes a tariff on frozen orange juice A tariff is a tax on imports A tariff is a tax on sellers in a market But only on foreign sellers A quota directly limits the total quantity of a good that can be imported In some cases governments use a mix of tariffs and quotas 15-33

34. Tariffs Analyzing the effects of a tariff, T, assume that the country consumes a small share of the world’s production of the good Doesn’t affect world price, P w Import supply curve is horizontal at P w Tariff shifts the import supply curve upward by the distance T Foreign firms must now sell their goods for P w + T Price to domestic consumers rises, domestic consumption falls Amount sold by domestic producers increases Imports decline 15-34

35. Figure 15.17: Effects of a Tariff 15-35

36. Welfare Effects of Tariff The domestic government is concerned with domestic aggregate surplus: the sum of consumer surplus, domestic producer surplus, and government revenue Under the tariff: Consumers are worse off Domestic consumers are better off Government receives revenue equal to the quantity of imports times the amount of the tariff Domestic deadweight loss arises from reduction in total consumption The tariff allocates production inefficiently away from foreign producers to domestic producers 15-36

37. Figure 15.18: Welfare Effects of a Tariff 15-37

38. Quotas A quota limits the supply of imports to some maximum quantity The government can use either a quota or a tariff to achieve a desired outcome of imports and domestic price Consumers and domestic firms are both as well off with the quota as with the tariff Difference is that government revenue is zero under the quota Instead, revenue is earned by foreign firms lucky enough to import their goods Quota has lower domestic aggregate surplus than tariff If government allocates import rights to domestic firms, domestic firm’s producer surplus would increase Domestic aggregate surplus would be the same for quota and tariff 15-38

39. Figure 15.19: Effects of a Quota 15-39

40. Beneficial Trade Barriers…? Although we have talked about the effects of deadweight loss, can a trade barrier bring about positive results? (Assumes non-perfectly elastic supply…upward sloping supply cure) Consider a situation with no domestic producers Domestic Agg. Surplus = C+D+ without a tariff and C+D+F with a tariff. 15-40 Can also work even if there are some domestic producers. The key point is that there is an upwards sloping supply curve.