Econ 201
Ch. 6 & 8
Government Policy &
Economic Welfare
Evaluating the Impact of
Government Intervention
• Policy Instruments Available
– Taxes
• Typically: per-unit tax on output
• Others: lump-sum, value added (VAT)
– Subsidies
• Rebate on per-unit produced
– Price Floors
• Minimum price that can be charged (e.g., minimum wage)
– Price Ceilings
• Limit on the maximum price that can be charged (WIN)
– Quotas
• Limits on amounts produced/imported
• Infant industry/protectionism
How Do We Analyze the Effects of
Taxes and Subsidies
• The efficient ideal market
– “perfectly competitive” market
• Consumers and suppliers are price-takers, i.e. have no
market power
Application:
Taxes and Competitive Equilibrium
• Consider a per-unit tax, which adds a fixed
dollar amount to each unit of a good sold.
– Graphically, the imposition of the tax is shown
by a leftward shift of the supply curve.
Figure 6.4 The Effect of a Per-Unit
Tax on Laptop Sales
Deadweight Loss
Price Consumers
Pay
Pre-tax price
Price Sellers
Receive
Reduction in
Qty sold
Deadweight Loss
Retained CS
Tax Rev
From CS
Tax Rev
From CS
Retained PS
Application:
Taxes and Competitive Equilibrium
• This example illustrates three key ideas related
to taxes:
– Incidence of a tax on consumers:
• The increase in price that consumers pay
– Incidence of a tax on producers:
• The decrease in price producers receive
– Deadweight loss:
• Losses in consumer and producer surplus that are not
transferred to the government as revenue
Elasticity and Tax Incidence
• The incidence of a tax will be determined
by the elasticities of demand and supply.
Figure 6.5(a)
Elasticity and Tax Incidence
Figure 6.5(b)
Elasticity and Tax Incidence
Tax Incidence and Demand
Elasticity
• If demand is inelastic, the majority of
the tax incidence falls on consumers.
• If demand is elastic, the majority of the tax
incidence falls on producers.
• As demand elasticity increases, the
deadweight loss increases.
Figure 6.5(c)
Elasticity and Tax Incidence
Figure 6.5(d)
Elasticity and Tax Incidence
Tax Incidence and Supply
Elasticity
• If supply is inelastic, the majority of the tax
incidence falls on producers.
• If supply is elastic, the majority of the tax
incidence falls on consumers.
• As supply elasticity increases, the
deadweight loss increases.
Deadweight Loss and Tax Revenue
6
How deadweight loss and tax revenue vary with the
size of a tax (a, b, c)
(b) Medium tax
(a) Small tax
Price
Price
Deadweight
loss
Deadweight
loss
Supply
Supply
PB
PB
Tax
revenue
Tax
revenue
PS
Deadweight
loss
Demand
Demand P
S
Supply
Tax revenue
Price
PB
(c) Large tax
Demand
PS
0
Q2 Q1
Quantity
0
Q2
Quantity
Q1
0 Q2
Q1
Quantity
The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount
of the tax times the amount of the good sold. In panel (a), a small tax has a small deadweight
loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger
deadweight loss and raises a larger amount of revenue. In panel (c), a very large tax has a
very large deadweight loss, but because it has reduced the size of the market so much, the
tax raises only a small amount of revenue.
17
Balancing DWL and Tax
Revenues
• Intuition:
– If tax rates are too low or too high, revenue
will be low.
– There is an optimal tax rate to be found.
• The Laffer curve (Arthur Laffer, USC)
– This is the parabolic relationship between
tax rates and tax revenue.
– Underlying rational for supply-side economics
and cutting taxes to promote economic growth
6
How deadweight loss and tax revenue vary with the
size of a tax (d, e)
(d) From panel (a) to panel (c),
deadweight loss continually increases
Deadweight
loss
(e) From panel (a) to panel (c), tax
revenue first increases, then decreases
Tax
Revenue
Laffer curve
0
Tax size
0
Tax size
Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax
grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises
and then falls. This relationship is sometimes called the Laffer curve.
19
The Laffer curve and supply-side
economics
• 1974, economist Arthur Laffer
– Laffer curve
– Supply-side economics
– Tax rates were so high
• Reducing them would actually raise tax
revenue
• Ronald Reagan - ran for president in 1980
– From experience in film industry
• High tax rates - caused less work
• Low tax rates - caused more work
20
The Laffer curve and supplyside economics
• Ronald Reagan - ran for president in 1980
– Argument
• Taxes were so high that they were discouraging hard work
• Lower taxes would give people the proper incentive to work
– Raise economic well-being
– Perhaps increase tax revenue
• Economists continue to debate Laffer’s argument
• General lesson:
– Change in tax revenue from a tax change
– Depends on how the tax change affects people’s behavior
21
Quotas
• Quota—A maximum quantity of a good or
service that can be traded over a specific
period of time.
– Used when the government determines
the equilibrium quantity would not be in
society's best interest
• For example: International trade
Figure 6.9 The Effect of a Quota
on the Market for Laptop
Computers
MV to Consumers
DWL from CS
DWL from PS
MC of resources
Quota Restriction
Equilibrium Qs
The Effects of a Quota
• Quotas result in:
– A transfer of surplus from consumers
to producers
– Deadweight loss (DWL)
• DWL is due to less being produced than would be
in an unrestricted (competitive) market
• Resources are underutilized and inefficiently
allocated
– Consumers place a higher MV on good than MC of using
resources to produce the good
The UW and Quotas
• The UW has recently announced that it will not
accept any transfers for spring quarter
– Restriction on number of students being admitted <->
quota
• Assume that the market had previously been
efficient (Qs= Qd at current tuition fee)
– A) what would be the economic consequences of the
transfer “freeze”?
– B) what would be the impact of raising tuition, instead
of “freezing” transfers
– C) In real-life, how are the students admitted to the
UW determined (by what kind(s) of allocation
schemes?
Something to Think About
• It is estimated that illegal immigrants
account for about 25% of construction
labor in the US housing market
– A) what would be the impact a ban on illegal
immigrants on the labor market for US
housing construction, i.e., hourly wage rates?
– B) what would be the impact of this ban on
the price of newly constructed houses?
Total Social Welfare
•
Ideally the impact of a program should be
evaluated as: {Pareto efficient}
–
–
–
•
1) can at least one person’s welfare be improved
2) without making anyone worse off
http://en.wikipedia.org/wiki/Pareto_efficiency
More realistically: Could the winners
compensate the losers? {Pigouvian}
–
–
Is the deadweight loss of the taxed good less than
the surplus gain from the subsidized good?
http://en.wikipedia.org/wiki/Pigovian_tax