TAXES, SUBSIDIES, AND INSURANCE Microeconomics Made Easy by William Yacovissi Mansfield University ©William Yacovissi All Rights Reserved INSURANCE Insurance is generally a system in which the consumer prepays for some event. When the event occurs the consumer pays no money or some specified small amount instead of the full amount INSURANCE Mostly we insure against bads so we’re not encouraged to consume the item even though it’s already paid for. Still, insurance companies notice increased consumption when insurance is present. That is, people with fire insurance have more fires. INSURANCE We can examine the impact of insurance or any prepaid plan using a market diagram. On the diagram on the next slide, the market would be in equilibrium at P1 and Q1. With insurance the price of the item to the consumer drops to P2 and consumption increases to Q2 In order to get Q2 of output, the insurance company ahs to pay P3. INSURANCE INSURANCE Keep in mind that the diagram is drawn in a way that exaggerates the quantity impact of the price change. In the real world, insurance, taxes, and subsidies can only be applied in situations that will have a manageable quantity impact SUBSIDIES A subsidy is when a third party pays for all or part of the price of something. For example, your college education is subsidized by the state and federal governments and by Alumni and other donors to the University. SUBSIDIES The impact of a subsidy is the same as insurance in that both involve a third party payer. As the price to the consumer is lower from P1 to P2, the quantity demanded increases from Q1 to Q2 To produce Q2 of the good, suppliers must receive P3 for that amount of output. So, my salary is higher as a result of your education being subsidized. The subsidy increase the demand for college professors. TAXES A is the opposite of a subsidy. A person is required to pay more for the item than the market would charge. Looking at the diagram on the next slide, the tax increases the price from P1 to P2 and reduces the quantity demanded from Q1 to Q2 Suppliers only need a price of P3 to produce Q2 of the good. TAXES TAXES Payment of the tax is split between consumers and producers in proportion to the relative strengths of the demand and supply. In the diagram the tax is P1 – P3 with consumers paying P2 – P1 of the tax and producers paying P1 – P3 of the tax.