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Taxation and Government Intervention
8
Taxation and Government Intervention
Collecting more taxes than is absolutely necessary is legalized robbery.
— Calvin Coolidge
CHAPTER
8
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Taxation and Government Intervention
8
Producer and Consumer Surplus
• Consumer surplus is the value the consumer gets from buying a product, less its price
• It is the area above the supply curve but below the price the producer receives
• Producer surplus is the value the producer sells a product for less the cost of producing it
• It is the area below the demand curve and above the price
8-2
Taxation and Government Intervention
8
S
D
P
Q
Consumer surplus = area of red triangle =
½($5)(5) = $12.5
Producer surplus = area of green triangle =
½($5)(5) = $12.5
Producer and Consumer Surplus
The combination of producer and consumer surplus is maximized at
market equilibrium
CS
PS
$10987654321
0 1 2 3 4 5 6 7 8
8-3
Taxation and Government Intervention
8
The Burden of Taxation
The costs of taxation include:
• The administrative costs of compliance which are the resources used by the government to administer the tax and individuals and businesses to comply with it
• The deadweight loss which is the loss of consumer and producer surplus that is not gained by the government
• Direct cost of the tax paid to the government by consumers and producers
8-4
Taxation and Government Intervention
8
The Burden of Taxation
S0
D
P
Q
S1
P0
P1
S0
D
P
Q
S1
P0
P1
Q0Q1
tt
Demand is relatively elastic Demand is relatively inelastic
P1-t
P1-t
Q0Q1
Producers pay more
Consumers pay more
8-5
Taxation and Government Intervention
8
Government Intervention as Implicit Taxation
• An effective price floor is a government set price above the market equilibrium
• An effective price ceiling is a government set price below the market equilibrium price
• Government intervention in the form of price controls can be viewed as a combination tax and subsidy
• It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation
• It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers
8-6
Taxation and Government Intervention
8
S
D
P
Q
Application: The Effect of a Price Ceiling
P0
Q0
A price ceiling transfers surplus from producers to consumers,
generates deadweight loss, and reduces equilibrium quantity
Q1
Price ceilingP1
An effective price ceiling is set below market equilibrium price
Shortage
8-7
Taxation and Government Intervention
8
S
D
P
Q
Application: The Effect of a Price Floor
P0
Q0
A price floor transfers surplus from consumers to producers,
generates deadweight loss, and reduces equilibrium quantity
Q1
Price floorP1
An effective price floor is set above market equilibrium price
Surplus
8-8
Taxation and Government Intervention
8
The Difference Between Taxes and Price Controls
• Taxes leave people free to choose how much to supply and consume as long as they pay the tax
• Price ceilings create shortages and taxes do not
• Shortages may also create black markets
8-9
Taxation and Government Intervention
8
Rent Seeking, Politics, and Elasticities
• Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus
• Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior
• 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
• Rent-seeking activities are activities designed to transfer surplus from one group to another
8-10
Taxation and Government Intervention
8
A
C
B
Inelastic Demand and Incentives to Restrict Supply
S0
D
P
Q
S1
P0
P1
Q0Q1
Revenue gained When demand is relatively
inelastic, suppliers have incentive to restrict quantity
to increase total revenue
Revenue lost
8-11
Taxation and Government Intervention
8
Inelastic Supplies and Incentives to Restrict Prices
• When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls
• When supply is inelastic, consumers have incentives to restrict prices
• Rent control in New York City is an example
8-12
Taxation and Government Intervention
8
Application: Price Floors and Elasticity
S
D
P
Q
P0
P1
S
D
P
Q
P0
Q0Q1
The surplus created by a price floor is larger if demand and supply are elastic
Q0Q1
Surplus
Price floor
Surplus
P1
8-13
Taxation and Government Intervention
8
Long-Run and Short-Run Effects on Price Control
Sshort-run
D1
P
Q
P0
PLR
Q0 QLR
Higher long-run elasticity of supply results in smaller
price increases when demand increases
Slong-run
D0
PSR
QSR
8-14