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
KEY ASSUMPTIONS
No Market Failure
 No externalities
 i.e., benefits or costs that are not accounted for in the marketplace (e.g., no free
riders, no pollution costs that aren’t captured in the product’s price)
 Perfectly competitive markets
 Large # of suppliers and buyers
Evaluate Market Efficiency
 Look at losses/gains in consumer/producer surplus
EFFECT OF A TAX ON THE SUPPLY
CURVE
To the supplier: increases per-unit costs
 Shifts supply curve to the left
Reduces amount supplied and raises the market clearing price
How do we measure the effects of the tax?
 Efficiency or deadweight losses are losses in consumer and producer surplus
relative to the “ideal” market
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
EFFECT OF A TAX ON THE SUPPLY
CURVE
DEADWEIGHT LOSS
HOW DO WE EVALUATE
THE IMPACT OF THE TAX?
Two Parts:
 Tax Incidence
 Who pays for it more?
 Consumers or Producers?
 Will depend on relative demand/supply elasticities
 Economic welfare analysis
 Does the tax (revenue) improve social welfare?
 Will depend on relative elasticities of:
 a) good taxed
 B) good or program financed by the tax
TAX INCIDENCE
Essential question is: how much of the tax can be passed on to consumers?
 Suppliers will be able to a higher proportion of the tax onto consumers when
 Demand is relatively inelastic
 Supply is relatively elastic
 Under these conditions
 Consumer surplus losses >> producer surplus losses
ECONOMIC WELFARE ANALYSIS
Framework for analysis is comparing benefits and costs
 Costs of the tax
 Reduction in equilibrium quantity
 Increase in price paid
 Costs can be calculated as the deadweight loss in $ if demand and supply curves
are known
WHAT ARE THE BENEFITS?
Depends on what we do with the tax revenues
Suppose we use it to subsidize another good
 Subsidy appears as a reduction in per-unit costs to the firm
getting the subsidy
Figure A-1.
The Deadweight Loss from a Price Subsidy
SOURCE: Congressional Budget Office.
EVALUATING THE IMPACT
Costs:
 Deadweight loss: sum of reduction in consumer and
producer surplus for the taxed good
 Reflects reduction in Qd and higher price paid
Benefits
 Gain in CS and PS from subsidized cost
Will Benefits > Tax?
 Depends on the relative demand elasticities for the 2
goods
EVALUATING THE IMPACT
Distributional Consequences)
“A Positive Analysis” (
 Who gains/loses from the tax and subsidy?
 Both producers and consumers of the taxed good lose (in terms of lost surpluses)
 Relative demand/elasticities determine who loses more
 More inelastic demand -> greater is CS loss
 Producers and Consumers of subsidized good win (lower price and more Q)
 Relative demand supply elasticities determine who benefits most
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
SO DO THEY DO THIS
IN THE REAL WORLD?
The Senate has approved a bill that would
require gasoline producers to blend 36 billion
gallons of ethanol into gasoline by 2022, an
increase from the current standard of 7.5
billion gallons by 2012. The House did not
include such a provision in the version it
passed, and it is uncertain whether any final
legislation will emerge this year and what it
will say about ethanol if it does.
What would be the impact of such legislation on
the demand for ethanol? For corn-based food
prices?
PRICE FLOORS
A price floor is a government or group imposed limit on
how low a price can be charged for a product.
 For a price floor to be effective, it must be greater than the
equilibrium price.
EXAMPLES OF PRICE FLOORS
Minimum wage
 Can create a surplus of labor
Agricultural price supports
 Every year, farmers produce and sell a certain product at a certain
price that is determined by the market. If the market price is lower
than that price at which the farmers want to sell, the farmers are in
a deficit. Therefore, in order to assist American farmers, our
government gives price supports for some crops and dairy
products. So in a case where the market price is lower that the
target price for farmers, farmers receive a "deficiency payment", or
price support, from the government in order to make up for the
difference.
 Has created a surplus of cheese and milk products
 Some released to low-income/poverty households
 Can exacerbate the effect by increasing supply
AN ECONOMIST’S PERSPECTIVE
Cato Institute
 http://www.cato.org/pubs/tbb/tbb_0707_47.pdf
The federal government has subsidized and regulated
the dairy industry since the 1930s. A system of
“marketing order” regulations was enacted in 1937. A
dairy price support program was added in 1949. An
income support program for dairy farmers was added
in 2002.
As part of this year’s farm bill, Congress may reauthorize
dairy programs, but they are among the most illogical
of all farm programs.1 The government spends billions
of dollars reducing food costs through programs such
as food stamps, yet dairy programs increase milk
prices.
PRICE CEILINGS
A price ceiling is a government-imposed limit on
how high a price can be charged on a product.
For a price ceiling to be effective, it must differ
from the free market price
 Example:
 New York City rent control
 Landlords are not allowed to raise rental prices
 Gerald Ford’s Whip Inflation Now (WIN)
 World War II
 Somewhat effective (resulted in blackmarkets, rationing)
 Impact:
 Shortages and higher costs
WELFARE EFFECTS OF RATIONING
QUOTAS
A restriction of limit on:
 The number of migrant workers that can be legally employed in the US
 The amount of a good or resource that can be imported to the US, or exported from
the US
 The amount of a resource that can be “harvested” during a period of time (e.g., fish
or mining)
 The amount of a pollutant that can be emitted
 The number of taxi cabs that can be licensed
TRADE QUOTAS
Import quotas are limitations on the quantity of goods that can be imported
into the country during a specified period of time. An import quota is
typically set below the free trade level of imports. In this case it is called
a binding quota. If a quota is set at or above the free trade level of
imports then it is referred to as a non-binding quota. Goods that are
illegal within a country effectively have a quota set equal to zero. Thus
many countries have a zero quota on narcotics and other illicit drugs.
There are two basic types of quotas: absolute quotas and tariff-rate quotas.
Absolute quotas limit the quantity of imports to a specified level during a
specified period of time. Sometimes these quotas are set globally and
thus affect all imports while sometimes they are set only against
specified countries. Absolute quotas are generally administered on a
first-come first-served basis. For this reason, many quotas are filled
shortly after the opening of the quota period. Tariff-rate quotas allow a
specified quantity of goods to be imported at a reduced tariff rate during
the specified quota period.
In the US in 1996, milk, cream, brooms, ethyl alcohol, anchovies, tuna,
olives and durum wheat were subject to tariff-rate quotas. Other quotas
exist on peanuts, cotton, sugar and syrup.
USEFUL WEBSITES
http://www.sjsu.edu/faculty/watkins/taximpact.html
Economic Welfare Analysis
Price Controls
Monopoly
Monopsony
Taxes and Subsidies
Oligopoly
Marginal Cost Pricing
Price Discrimination
Trade
Externality Tax
WEEKEND’S PROBLEM
# 1: Congress is currently considering an energy
bill which would mandate that all gasoline
producers use include at least 10% ethanol in
each gallon of gas
 1. What would be the impact of this on the gasoline
market?
 2. What would be the impact of this on the ethanol
market?
 3. Impact on the corn market (for both food and
gasoline)?
 4. Impact on the food products containing corn
market?
WEEKEND’S PROBLEM
#2 The US provides price supports (minimum
price) to the producers of milk.
 Assuming that the support is effective, what would be
the economic welfare impact on the milk market?
 The US government also provides food stamps to
subsidize food purchases. What is the impact of the
food stamp program (alone) on economic welfare?
 What can you say about the combined impact of both
the price support and food stamp programs on
economic welfare?