Chapter 6:
Using Demand and
Supply: Taxation and
Government
Intervention
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Regulating Trade: Institutions,
Government, and Trade

Government provides the institutional
framework that facilitates trade.

Government regulates markets, preventing
trades that are harmful and encouraging
trades that are helpful.
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2
Roles of Government in a Market






Provide a stable institutional framework.
Promote effective and workable competition.
Correct for externalities.
Ensure economic stability and growth.
Provide public goods.
Adjust for undesired market results.
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3
Provide a Stable Set of Institutions
and Rules

Government can create a stable environment
and enforce contracts through its legal
system.

Economic growth is difficult when
government does not provide a stable
environment.
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4
Promote Effective and Workable
Competition

Government promotes competition and
protect against monopolies.

Monopoly power is the ability of individuals or
firms currently in business to prevent other
individuals or firms from entering the same kind of
business
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5
Promote Effective and Workable
Competition

Monopoly power gives existing firms or
individuals the power to raise prices.

Market participants often insist on open
competition except when it comes to
themselves.
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6
Promote Effective and Workable
Competition

Many players in the market insist on open
competition except when it comes to
themselves:

Farmers like competition but still want price
supports.

Lawyers and architects like competition but still
want licensing to prevent others from entering the
market.
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7
Correct for Externalities

An externality is the effect of a decision on a
third party not taken into account by the
decision maker.

Unless they are required to do so, parties to
any exchange are unlikely to take into
account any externality.
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8
Correct for Externalities

A positive externality is one in which society
benefits even more than the two parties – an
example is education.
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9
Correct for Externalities

A negative externality is one in which
society as a whole benefits less than the two
parties – an example is pollution.
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10
Correct for Externalities

When there are externalities, government has
the potential role to change the rules so that
the parties must take into account the effect
of their actions on others.
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11
Correct for Externalities

Government may not effectively assume that
role.


Government generally can only act within its
borders.
Politics and vested interests may prevent
government from acting.
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12
Ensure Economic Stability and
Growth

Most people agree that government should:

Prevent large fluctuations in economic activity.

Maintain a relatively constant price level.

Provide an economic environment conducive to
economic growth.
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13
Ensure Economic Stability and
Growth

Most economists support these goals since
they involve macroeconomic externalities.
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14
Ensure Economic Stability and
Growth

Macroeconomic externalities are
externalities that affect the levels of
unemployment, inflation, or growth in the
economy as a whole.
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15
Provide Public Goods

Public goods are those goods whose
consumption by one individual does not
prevent their consumption by others – an
example is a public park; another is national
defense.
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16
Provide Public Goods

In contrast, a private good is one that, when
consumed by one individual, cannot be
consumed by other individuals – an example
is an apple.
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17
Provide Public Goods

A free rider is a person who participates in
something without having to pay for it.
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18
Provide Public Goods

Since most people would enjoy having public
parks without having to pay for them,
government requires that the public be taxed
to pay for public parks, thereby reducing the
free rider problem.
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19
Adjust for Undesired Market Results

The government, through taxes and
expenditures, redistributes income among
households.
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20
Adjust for Undesired Market Results

In trying to be fair, which type of tax should
the government use?

This issue may be controversial.
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21
Adjust for Undesired Market Results

A progressive tax is one whose rates
increase as a person's income increases.


Canadian income tax is an example.
A regressive tax is one whose effect
decreases as income rises.

Canadian sales tax is an example.
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22
Adjust for Undesired Market Results

A proportional tax is one whose rates are
constant at all income levels, regardless of
the taxpayer's total annual income.
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23
Adjust for Undesired Market Results

Another controversial role for government
involves deciding what is best for people
independently of their desires.

Should government prohibit demerit goods
and activities?
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24
Adjust for Undesired Market Results

Demerit goods and activities are those
considered to be bad for a person, although
one may like them.

Addictive drugs are a demerit good; using
addictive drugs is a demerit activity.
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25
Adjust for Undesired Market Results

Merit goods and activities are things
believed to be good for a person, although
one may not engage in them.

Motorcycle helmets are a merit good; using
helmets while driving a motorcycle is a merit
activity.
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26
Market Failures and Government
Failures

Market failures are reasons for government
intervention.

Market failures are situations where the
market does not lead to a desired result.
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27
Market Failures and Government
Failures

Government intervention, however, need not
improve the outcome.

Government failures are situations where
the government intervenes and makes the
situation worse.
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28
Market Failures and Government
Failures

Real-world policy makers are left with the
choice of selecting that which is least bad –
market failure or government failure.
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29
Producer and Consumer Surplus

Consumer surplus – the value the
consumer gets from buying a product less its
price.

It is the area underneath the demand curve
and above the price an individual pays.
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30
Producer and Consumer Surplus

Producer surplus – the value the producer
sells a product for less the cost of producing
it.

It is the area above the supply curve but
below the price the producer receives.
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31
Producer and Consumer Surplus

The combination of consumer and producer
surplus is as large as it can be at market
equilibrium.
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32
Producer and Consumer Surplus
$10
9
Consumer Surplus
8
7
6
5
4 Producer
3 Surplus
2
1
0
1 2 3 4 5 6 7 8
Quantity
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Supply
Demand
9 10
33
Producer and Consumer Surplus

The combined consumer and producer
surplus falls when price is above market
equilibrium.
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34
Consumer and Producer Surplus
$10
9
Consumer Surplus
8
Lost
7
Surplus
6
5
4 Producer
3 Surplus
2
1
0
1 2 3 4 5 6 7 8
Quantity
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Supply
Demand
9 10
35
Taxation and Government

For government to operate, it must tax.

For the market to work, it needs government.

Tax rates depend on what goods and
services government provides.
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36
How Much Should Government Tax?

To answer this, we must know the costs and
benefits of taxation.
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37
Costs of Taxation

The costs of taxation include:



The direct cost of the revenue paid to government
The loss of consumer and producer surplus
caused by the tax
The administrative costs of collecting the tax.
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38
Costs of Taxation

A tax paid by the supplier shifts the supply
curve up by the amount of the tax.
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39
Costs of Taxation

When government raises taxes, there is a
loss of consumer and producer surplus that is
not gained by government.

This is known as deadweight loss.
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40
Costs of Taxation

Graphically the deadweight loss is shown in a
supply-demand diagram as the welfare loss
triangle.
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41
Costs of Taxation

The welfare loss triangle – a geometric
representation of the welfare loss in terms of
misallocated resources caused by a deviation
from a supply-demand equilibrium.
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42
Costs of Taxation
Consumer
surplus
Price
S1
S0
A
P1
P0
P1–t
B
D
tax
C
E
Deadweight
loss
F
Producer
surplus
Q1
Demand
Q0
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rights reserved.
Quantity
43
Costs of Taxation

The other costs of taxation are the
administrative costs of compliance.

Resources are used by the government to
collect the tax and by citizens and businesses
to comply with it.
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44
Benefits of Taxation

The benefits of taxation are the goods and
services that government provides.
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45
Benefits of Taxation

Some of these benefits are the part of the
basic institutional structure of a market
economy that allows it to function efficiently.

The basic legal system is an example.
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46
Benefits of Taxation

Other goods have the qualities of a public
good – fire and police services are examples.
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47
Benefits of Taxation

Some benefits are provided for reasons of
equity or because they provide positive
externalities. For example, education and
healthcare.
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48
Benefits of Taxation

Measuring the benefits of governmentsupplied goods is difficult because they are
not provided in a market setting.

Because they are not provided in a market
setting, they are often provided at a zero
price.
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49
Two Principles of Taxation

The government follows two general
principles of taxation:

The benefit principle.

The ability-to-pay principle.
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50
Benefit Principle

The benefit principle states that the
individuals who receive the benefit of the
good or service should pay the cost
(opportunity cost) of the resources used to
produce the good.

Examples are gasoline taxes and airport taxes,
both paid by travelers.
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51
Ability-to-Pay Principle

The ability-to-pay principle –individuals
who are most able to bear the burden of the
tax should pay the tax.

The best example of this is a progressive tax,
such as the Canadian income tax.
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52
Applying the Principles of Taxation

The principles of taxation are difficult to
apply.

The two principles often conflict.
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53
Applying the Principles of Taxation

The elasticity concept helps us to understand
the tradeoffs.

The more broadly the good or service is
defined, the more inelastic its demand.
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54
Applying the Principles of Taxation

In the language of consumer and producer
surplus, if the government seeks to minimize
the welfare loss, it should tax goods with
inelastic supplies and demands.
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55
Applying the Principles of Taxation
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56
Burden Depends on Relative Elasticity

The person who physically pays the tax is
not necessarily the person who bears the
burden of the tax.

The burden of the tax depends on relative
elasticity.

The burden of the tax is rarely shared equally
since elasticities are rarely equal.
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57
Burden Depends on Relative Elasticity

The tax burden is greater if a person cannot
easily change their behaviour.

The more inelastic one’s supply or demand,
the larger the tax burden one will bear.
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58
Burden Depends on Relative Elasticity

If demand is more inelastic than supply,
consumers will pay the higher share.

If supply is more inelastic than demand,
suppliers will pay the higher share.
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59
Who Bears the Burden of a Tax?
Demand is inelastic.
Price of luxury boats
S1
$70,000
Consumer pays
60,000
50,000
Supplier pays
40,000
30,000
20,000
10,000
200
400
tax
S0
Demand
590
600 Quantity of luxury boats
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60
Who Bears the Burden of a Tax?
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61
Who Pays Versus Who Bears the
Burden of a Tax

The burden of a tax is independent of who
physically pays the tax.
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62
Who Bears the Burden of a Tax?
Price
Tax levied on the consumer:
$7
6
5
4
3
2
1
S0
Consumer pays
Supplier pays
tax
D0
D1
20
40
60
Quantity
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63
Tax Incidence and Current Policy
Debates

The analysis of tax incidence is helpful when
discussing current policy debates.
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64
Employment Insurance Premiums

Both employer and employee contribute to
the Employment Insurance.

The burden falls mainly on employees
because, on average, labour supply is less
elastic than labour demand.
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65
Burden of the Employment Insurance
Premium
Firms’ share
Workers’ share
Wage
S
wF
w0
wL
t
D0
D1= D0- t
L2 L1
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Labour
66
Price Ceilings

A price ceiling is a government-set
maximum price which the market price
cannot exceed.

Generally, the price ceiling is set below market
equilibrium price.

It is an implicit tax on producers and an implicit
subsidy to consumers.
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67
Price Ceilings

Price ceilings cause a loss in producer and
consumer surpluses that is identical to the
welfare loss from taxation.
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68
Effect of Price Ceiling
Transferred to
consumers
Consumer
surplus
Price
A
Welfare loss
B
P0
P1
D
C
E
F
Excess demand
Supply
Price ceiling
Producer
surplus
Demand
Q1
Q0
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Quantity
69
Price Floors

A price floor is a government-set minimum
price.

Price floors transfer surplus from consumers to
producers.

They can be seen as a tax on consumers and a
subsidy to producers.
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70
Effect of Price Floor
Price
Transferred to
Consumer producers
surplus
Excess supply
P2
Supply
Price Floor
Welfare loss
P0
Producer
surplus
Demand
Q1
Q0
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Quantity
71
Taxes Versus Price Controls

The effects of taxation and price controls are
similar.

Both taxes and price controls create
deadweight losses.
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72
Taxes Versus Price Controls

However, price ceilings create shortages and
taxes do not.

Shortages may create black markets.

Alternative methods of allocation develop
because there is an imbalance between
quantity demanded and quantity supplied.
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73
Rent Seeking, Politics, and Elasticities

Price controls reduce total producer and
consumer surpluses.

Governments institute them because people
care more about their own surplus than they
do about total surplus.
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74
Rent Seeking, Politics, and Elasticities

Individuals lobby government to institute
policies that increase their own surplus.

Others have the incentive to spend money to
counteract that lobbying.
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75
Rent Seeking, Politics, and Elasticities

If consumers hold the balance of political
power, there will be strong pressures to
create price ceilings.

If suppliers hold the political power, there will
be strong pressures to create price floors.
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76
Rent Seeking, Politics, and Elasticities

Rent seeking – activities designed to
transfer surplus from one group to another.
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77
Rent Seeking, Politics, and Elasticities

Public choice economists integrate
economic analysis of politics with their
analysis of the economy.

They argue that often the taxes and the
benefits of government programs offset each
other and do not help society significantly.
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78
Inelastic Demand and Incentives to
Restrict Supply

When demand is inelastic, producers have
incentives to lobby the government to restrict
supply.

Farming is a good example.

Advances in productivity increase supply but
they result in lower prices.
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79
Inelastic Demand and Incentives to
Restrict Supply

Since food has few substitutes, its demand is
inelastic.

Inelastic demand means that prices fall faster
than a rise in quantity sold.

Revenues fall, and farmers are worse off.
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80
Inelastic Demand and Incentives to
Restrict Supply

Because of the increase in supply, and
inelastic demand, farmers are losing revenue.

There is an enormous incentive for farmers to
encourage government to restrict supply or
create a price floor.
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81
Inelastic Demand and Incentives to
Restrict Supply
Price
S2
P2
P1
S1
Revenue gained
A
Revenue lost
Total Revenue
B
Demand
Q2 Q 1
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Quantity
82
Inelastic Supplies and Incentives to
Restrict Prices

Consumers are also rent seekers.

When supply is inelastic, consumers have
incentives to restrict prices.
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83
Inelastic Supplies and Incentives to
Restrict Prices

When supply is inelastic and demand goes
up, prices jump causing consumers to lobby
for price controls.

Rent control is an example.
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84
Long-Run Problems of Price Controls

In the long run, supply and demand tend to
be much more elastic than in the short run.

Therefore, price controls will cause large
shortages or surpluses in the long run.
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85
Long-Run Problems of Price Controls

In the short run there will be small effects
from the price controls.

There will be huge effects in the long run.
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86
Long-Run Problems of Price Controls

In the face of price controls, potential new
competitors hate to enter the market thereby
strangling supply.

Vacancy rates drop as potential new renters
scramble to find affordable housing in a
shrinking market.
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87
Long-Run and Short-Run Effects of
Price Controls
Price
Short run
supply
P1
P2
P0
Long run
supply
Price ceiling
D1
D0
Q0 Q1
Q2
Q3
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Shortage
Quantity
88
Using Demand and Supply:
Taxation and Government
Intervention
End of Chapter 6
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89