Economic Analysis for Business Session X: Consumer Surplus, Producer Surplus and Market Efficiency-2 Instructor Sandeep Basnyat

How do taxes affect the economic well-being of market participants?

Tax Effect Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive Government’s tax revenue = T  Q; where T = the size of the tax Q = the quantity of the good sold CS PS ??

How a Tax Effects Welfare?: Deadweight Loss ! A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax.

Tax Wedge PEPE P D Q S Price sellers get Price buyers pay

Welfare Effect of a Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue

Consumer Surplus Before Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue A + B + C

Producer Surplus Before Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue A + B + C D + E + F A + B+ C+ D + E + F 0

Consumer Surplus After Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue A + B + C D + E + F A + B+ C+ D + E + F 0 A-(B + C)

Producer Surplus After Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix F Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue A + B + C D + E + F A + B+ C+ D + E + F 0 A-(B + C) -(D + E)

Revenue After Tax PEPE P D Q S A B C D E F Price sellers get Price buyers pay

Welfare Matrix B + D A + B + D + F Consumer Surplus Producer Surplus Total Surplus Before TaxAfter Tax Net  Tax Revenue A + B + C D + E + F A + B+ C+ D + E + F 0 A F -(B + C) -(D + E) B + D -(C + E)

PEPE P D Q S A B C D E F Triangle: Deadweight Loss

Is there any relationship between Elasticity and Deadweight Loss?

Tax Distortions and Elasticities (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

Tax Distortions and Elasticities (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

Tax Distortions and Elasticities Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

Tax Distortions and Elasticities (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

DETERMINANTS OF THE DEADWEIGHT LOSS The greater the elasticities of demand and supply: ◦ the larger will be the decline in equilibrium quantity and, ◦ the greater the deadweight loss of a tax. Policy makers should be careful before imposing Taxes on Products !!

Is there any relationship between DEADWEIGHT LOSS and TAX REVENUE as Taxes very?

Revenue and Tax Size Q P D S Small Tax P Q D S Medium Tax P D Q S Large Tax Tax RevenueDeadweight Loss

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (a) Deadweight Loss Deadweight Loss 0 Tax Size

How Deadweight Loss and Tax Revenue Vary with the Size of a Tax (b) Revenue (the Laffer curve) Tax Revenue 0 Tax Size

Numerical Problems Consider the previous market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kg. and p is in dollars per kg.). Imagine that the government imposes a $0.60 per-unit tax on the prices that buyers pay. 1. Calculate the Change in Consumer surplus, Change in Producer surplus and Government Revenue. Calculate the deadweight loss due to imposition of tax in this market. (Hint: To find the Consumer surplus and Producer surplus, find the Prices when Quantity demanded and Quantity Supplied is zero)

Numerical Problems Consider the previous market with Demand curve q = 16 − 10p and Supply curve q = −8 + 20p. (Here q is in millions of kg. and p is in dollars per kg.). Imagine that the government imposes a $0.60 per-unit tax on the prices that buyers pay. 1. Change in Consumer surplus = $2.4 Change in Producer surplus = $1.2 Government Revenue = $2.4 million 2. Deadweight loss= $1.2 million

Application: International Trade A. Free Trade Determinants of Imports and Exports B. Restricted Trade 1. Impact of Tariff 2. Impact of Quota C. Arguments for Imposing Restrictions

The Equilibrium without International Trade Consumer surplus Producer surplus Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Equilibrium price Equilibrium quantity

Assume that the country is opened to FREE TRADE 3 Primary Impacts: 1.Domestic Consumers can buy from world markets 2.Domestic producers face competitions from the international producers 3.Eventually domestic price equals the world price

Case 1: World Price Higher than Domestic Equilibrium Price Price of Steel 0 Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Domestic quantity demanded Domestic quantity supplied Does Free Trade benefit exporting countries?

How Free Trade Affects Welfare in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Consumer surplus before trade

Welfare Matrix Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+B

How Free Trade Affects Welfare in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Consumer surplus after trade

Welfare Matrix Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA- B

How Free Trade Affects Welfare in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Producer surplus before trade

Welfare Matrix Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA- B C

How Free Trade Affects Welfare in an Exporting Country D C B A Price of Steel 0Quantity of Steel Domestic supply Price after trade World price Domestic demand Exports Price before trade Producer surplus after trade

Welfare Matrix Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA- B CB+C+D + (B+D)

Welfare Matrix Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA- B CB+C+D + (B+D) A+B+C A+B+C+D +D Gains from trade for Exporting Country

Overall Impact of the Trade?

Trade creates winners and losers

Winners and Losers in Exporting Country Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA - B CB+C+D + (B+D) A+B+C A+B+C+D +D Consumers lose

Winners and Losers in Exporting Country Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA - B CB+C+D + (B+D) A+B+C A+B+C+D +D Producers Gain

Winners and Losers in Exporting Country Consumer Surplus Producer Surplus Before TradeAfter Trade Net  Total Surplus A+BA - B CB+C+D + (B+D) A+B+C A+B+C+D +D Country as whole benefit

Case 2: World Price lower than domestic equilibrium price Price of Steel 0 Quantity Price after trade World price of Steel Domestic supply Domestic demand Imports Domestic quantity supplied Domestic quantity demanded Price before trade Does Free Trade benefit importing countries?

How Free Trade Affects Welfare in an Importing Country C B A Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price after trade World price Price before trade Consumer surplus before trade Producer surplus before trade

Figure 5 How Free Trade Affects Welfare in an Importing Country C B D A Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price after trade World price Imports Price before trade Producer surplus after trade Consumer surplus after trade

How Free Trade Affects Welfare in an Importing Country

Trade creates winners and losers for importing countries 1. Consumers gain 2. Producers lose 3. Country as a whole benefit

The Effects of a Tariff A tariff is a tax on goods produced abroad and sold domestically. Tariffs raise the price of imported goods above the world price by the amount of the tariff.

The Effects of a Tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Equilibrium without trade Price without tariff World price Imports with tariff Q S Q S Q D Q D

Welfare before Tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Imports without tariff Equilibrium without trade Price without tariff World price Q S Q D Producer surplus before tariff Consumer surplus before tariff

Welfare Effects of a Tariff A B Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Price with tariff Tariff Imports without tariff Q S Q S Q D Q D Consumer surplus with tariff Domestic supply C G Price without tariff World price Producer surplus after tariff E Tariff Revenue Deadweight Loss with tariff Imports Terms of Trade Gain

The Effects of an Import Quota An import quota is a limit on the quantity of a good that can be produced abroad and sold domestically.

The Effects of an Import Quota Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand Price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S

The Effects of an Import Quota Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off. License holders are better off because they make a profit from buying at the world price and selling at the higher domestic price.

The Effects of an Import Quota A E' C B G D E" F Price of Steel 0 Quantity of Steel Domestic supply Domestic supply + Import supply Domestic demand price with quota Imports without quota Equilibrium with quota Equilibrium without trade Quota Imports with quota Q D World price World price Price without quota = Q S Q D Q S Terms of Trade Gain

The Effects of an Import Quota

With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. The quota can potentially cause an even larger deadweight loss, if a mechanism such as lobbying is employed to allocate the import licenses.

The Lessons for Trade Policy Both tariffs and import quotas... ◦ raise domestic prices. ◦ reduce the welfare of domestic consumers. ◦ increase the welfare of domestic producers. ◦ cause deadweight losses.

The Lessons for Trade Policy Other Benefits of International Trade ◦ Increased variety of goods ◦ Lower costs through economies of scale ◦ Increased competition ◦ Enhanced flow of ideas

THE ARGUMENTS FOR RESTRICTING TRADE Jobs National Security Infant Industry Unfair Competition Protection-as-a-Bargaining Chip

CASE STUDY: Trade Agreements and the World Trade Organization Unilateral Unilateral: when a country removes its trade restrictions on its own. Multilateral Multilateral: a country reduces its trade restrictions while other countries do the same.

CASE STUDY: Trade Agreements and the World Trade Organization NAFTA ◦ The North American Free Trade Agreement (NAFTA) is an example of a multilateral trade agreement. ◦ In 1993, NAFTA lowered the trade barriers among the United States, Mexico, and Canada.

CASE STUDY: Trade Agreements and the World Trade Organization GATT/WTO ◦ The General Agreement on Tariffs and Trade (GATT) refers to a continuing series of negotiations among many of the world’s countries with a goal of promoting free trade. ◦ GATT/WTO has successfully reduced the average tariff among member countries from about 40 percent after WWII to about 5 percent today.

Thank you