Principles of Microeconomics
7. Taxes, Subsidies, and Introduction
to Welfare Analysis*
Akos Lada
July 29th, 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Lecture 8 - Contents
1. Review of previous lecture
2. More on taxes
3. Willingness to pay and consumer surplus
4. Costs and producer surplus
1. Review
Price controls
•
Binding vs. non-binding
constraints.
•
Binding price ceilings (e.g. rent
control)
• Leads to shortage
• Effect is more severe in the long
run
• Rationing, informal market,
decrease in quality
•
Binding price floors (e.g.
minimum wage)
• Leads to surplus (under the
assumptions of the model
Quiz: Refer to the labor market graph below. The
imposition of an $8 minimum wage would cause
Wage
SL
W = $8
We = $6
DL
65
80
100
Labor hours
1.
tax revenues to increase by $2 per
worker.
2.
unemployment of 35 labor hours.
3.
a labor shortage of 35 labor hours.
4.
no change in the equilibrium wage
and employment because the
minimum wage is not binding.
Do you support minimum wage laws? How do you
think economists would answer this question?
69%
1. support strongly
2. support mildly
3. have mixed feelings
4. oppose mildly
23%
5. oppose strongly
8%
0%
1
0%
2
3
4
5
Do you support minimum wage laws? How do you
think economists would answer this question?
1. support strongly
2. support mildly
3. have mixed feelings
4. oppose mildly
5. oppose strongly
ANSWERS:
1. support strongly – 28.4%
2. support mildly – 18.9%
3. have mixed feelings – 14.4%
4. oppose mildly – 17.8%
5. oppose strongly – 20.5%
SOURCE:
Daniel B. Klein and Charlotta Stern. “Economists’ Policy Views and Voting.” Public Choice
(2006) 126: 331-342.
Taxes
1.
•
•
2.
•
3.
•
•
What shifts?
If imposed on buyers, it is equivalent to a decrease in
income, shifts the demand curve left
If imposed on sellers, it is equivalent to an increase
in input costs, shifts the supply curve left
What is the size of the shift?
The amount of the tax
Tax incidence (who pays for the tax burden)
Whether the tax is charged to the producers or to the
sellers is irrelevant – the tax incidence is the same in both
cases
What matters is the elasticity of Supply and Demand
•
If Supply is more inelastic, the larger share of the burden
falls on the sellers.
•
If Demand is more inelastic, the larger share of the burden
falls on the buyers
2. More on taxes
1. What shifts?
If imposed on buyers, it is
equivalent to a decrease in
income, shifts the demand curve
to the left
P
If imposed on sellers, it is
equivalent to an increase
in input costs, shifts the supply
curve left
S0
P
S0
$10
S0
$10
D0
D0
D1
500
Q
500
Q
2.What is the size of the shift?
~ The amount of the tax! ~
For a $ 1.50 tax imposed on
buyers…
For a $ 1.50 tax imposed on
sellers…
P
P
S0
S1
$13.50
S0
$12
$11.50
$1.5
(tax)
$10
$10
$1.5
(tax)
$8.50
$7.50
D0
$6.00
D0
D1
300
500
900
Q
300
500
900
Q
3.Who pays the tax burden?
Whether the tax is charged to the producers or to the sellers is irrelevant
the tax incidence is the same in both cases
For a $ 1.50 tax imposed on
buyers…
P
For a $ 1.50 tax imposed on
sellers…
Buyers pay
$1.00
P
Buyers pay
$1.00
S0
Total Tax
$1.50
PB= $11.00
S1
Total Tax
$1.50
S0
PB= $11.00
P*= $10
PS= $9.50
P*= $10
PS= $9.50
Sellers pay
$0.50
Sellers pay
$0.50
D0
D0
D1
450 500
Q
450 500
Q
A tax creates a wedge
… between what goes out of the pocket of the buyers, and what goes into the
pocket of the sellers. The wedge is the tax that goes to the government.
S1
P
S0
Amount Buyers pay = PB
P*
Amount Sellers receive = PS
Total Tax
(wedge)
$1.50
D0
D1
Q*` Q*0
Q
Quiz: In the graph below, the after-tax price paid by buyers
and price received by sellers are, respectively,
P
$7.50
S + tax
S
$6.00
$5.00
$4.00
D
$2.50
3
5
7
Price paid by buyers
1. $4.00
2. $5.00
3. $6.00
4. $6.00
Q
Price received by sellers
$6.00
$6.00
$5.00
$4.00
3.Who pays the tax burden?
What matters is the elasticity of Supply and Demand
~ those that are more flexible (adaptive) pay less, those that are less flexible pay more ~
If Supply is more inelastic, the larger
share of the burden falls on the sellers.
P
If Demand is more inelastic, the larger
share of the burden falls on the buyers
Buyers pay
more of the tax
S0
Buyers pay
less of the tax
P
Same
total Tax
Same
total Tax
S0
PB
PB
P*
P*
PS
PS
Sellers pay
more of the tax
Q*1 Q*0
Sellers pay
less of the tax
D0
Q
Q*1 Q*0
D0
Q
Quiz: Suppose the government enacts a tax as shown
in the diagram below. The policy will cause
P
$7.50
S + tax
S
$6.00
$5.00
$4.00
D
$2.50
3
5
7
Q
1.
the equilibrium price to rise by $2.
2.
buyers to bear a higher burden of the
tax than sellers.
3.
buyers and sellers to each bear a $1
burden of the tax.
4.
quantity to fall by 4 units.
3. Willingness to Pay
and Consumer Surplus
Welfare Economics
• Recall, the allocation of resources refers to:
• how much of each good is produced
• which producers produce it
• which consumers consume it
• Welfare economics studies how the allocation of
resources affects economic well-being.
• First, we look at the well-being of consumers.
Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the maximum
amount the buyer will pay for that good.
WTP measures how much the buyer values the good.
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Example:
4 buyers’ WTP
for an iPod
WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod, and
what is quantity demanded?
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
A: Anthony & Flea will buy an iPod,
Chad & John will not.
Hence, Qd = 2
when P = $200.
WTP and the Demand Curve
Derive the
demand
schedule:
P (price
of iPod)
who buys
$301 & up nobody
Qd
0
251 – 300 Flea
1
Anthony $250
176 – 250 Anthony, Flea
2
Chad
175
3
Flea
300
Chad, Anthony,
126 – 175
Flea
John
125
John, Chad,
0 – 125
Anthony, Flea
4
name
WTP
WTP and the Demand Curve
P
$350
$300
P
Qd
$250
$200
$301 & up
0
251 – 300
1
$150
176 – 250
2
$100
$50
126 – 175
3
0 – 125
4
Q
$0
0
1
2
3
4
About the Staircase Shape…
P
This D curve looks like a staircase
with 4 steps – one per buyer.
$350
$300
If there were a huge # of buyers, as
in a competitive market,
$250
$200
there would be a huge #
of very tiny steps,
$150
and it would look
more like a smooth
curve.
$100
$50
Q
$0
0
1
2
3
4
WTP and the Demand Curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Chad’s WTP
John’s
WTP
$150
$100
$50
Q
$0
0
1
2
3
4
At any Q,
the height of
the D curve is the
WTP of the
marginal buyer,
the buyer who
would leave the
market if P were
any higher.
Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing to
pay minus the amount the buyer actually pays:
CS = WTP – P
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
The others get no CS because they
do not buy an iPod at this price.
Total CS = $40.
CS and the Demand Curve
P
Flea’s WTP
$350
$300
P = $260
$250
$200
Flea’s CS =
$300 – 260 = $40
$150
Total CS = $40
$100
$50
$0
Q
0
1
2
3
4
CS and the Demand Curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Instead, suppose
P = $220
Flea’s CS =
$300 – 220 = $80
Anthony’s CS =
$250 – 220 = $30
$150
$100
$50
Total CS = $110
$0
Q
0
1
2
3
4
4. Costs and Producer
Surplus
Cost and the Supply Curve
• Cost is the value of everything a seller must give up
to produce a good (i.e., opportunity cost).
• Includes cost of all resources used to produce good,
including value of the seller’s time.
• Example: Costs of 3 sellers in the lawn-cutting
business.
A
seller
will
produce
and
sell
the
name cost
good/service only if the
Jack
$10
price exceeds his or her cost.
Janet
20
Hence, cost is a measure of
Chrissy
35
willingness to sell.
Cost and the Supply Curve
Derive the supply schedule
from the cost data:
name
cost
Jack
$10
Janet
20
Chrissy
35
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
Cost and the Supply Curve
P
$40
$30
$20
$10
Q
$0
0
1
2
3
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
Cost and the Supply Curve
P
$40
Chrissy’s
cost
$30
Janet’s
cost
$20
Jack’s cost
$10
Q
$0
0
1
2
3
At each Q,
the height of
the S curve
is the cost of the
marginal seller,
the seller who
would leave
the market if
the price were any
lower.
Producer Surplus
P
$40
PS = P – cost
$30
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost
$20
$10
Q
$0
0
1
2
3
Producer Surplus and the S Curve
P
PS = P – cost
$40
Chrissy’s
cost
$30
Janet’s
cost
$20
Jack’s cost
$10
Q
$0
0
1
2
3
Suppose P = $25.
Jack’s PS = $15
Janet’s PS = $5
Chrissy’s PS = $0
Total PS = $20
Total PS equals the area
above the supply curve
under the price, from 0 to
Q.
PS with Lots of Sellers & a Smooth S Curve
Price
per pair
P
The supply of shoes
60
S
50
Suppose P = $40.
At Q = 15(thousand),
the marginal seller’s
cost is $30,
and her producer
surplus is $10.
40
30
1000s of pairs
of shoes
20
10
Q
0
0
5 10 15 20 25 30