Applications of Welfare ETP Economics 101

TOPICS Cost of Taxation International Trade

Cost of Taxation

Deadweight Loss Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as government regulations on prices and tax.

TAX ON A GOOD Levied on buyers Demand curve shifts downward by the size of tax Levied on sellers Supply curve shifts upward by the size of tax Same outcome: price wedge Price paid by buyers – rises Price received by sellers – falls Lower quantity sold

TAX ON A GOOD-CONTINUED Tax burden Distributed between producers and consumers Determined by elasticities of supply and demand Market for the good - smaller

The effects of a tax Price Demand Price buyers pay Supply Quantity with tax Size of tax Price without tax Quantity without tax Price sellers receive Quantity A tax on a good places a wedge between the price that buyers pay and the price that sellers receive. The quantity of the good sold falls.

Tax Wedge A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks.

The Deadweight Loss of Taxation How a tax affects market participants Gains and losses from a tax on a good Buyers: consumer surplus Sellers: producer surplus Government: total tax revenue Tax times quantity sold Public benefit from the tax

Figure 2 Tax Revenue Price Demand Supply Quantity with tax Price buyers pay Price sellers receive Tax revenue (T × Q) Size of tax (T) Quantity without tax Quantity sold (Q) Quantity Copyright © 2004 South-Western

How a tax affects welfare Price Demand Price buyers pay =PB Supply A A tax on a good reduces consumer surplus (by the area B + C) and producer surplus (by the area D + E). Because the fall in producer and consumer surplus exceeds tax revenue (area B + D), the tax is said to impose a deadweight loss (area C + E). Q2 C B Price without tax =P1 E Q1 D Price sellers receive =PS F Quantity The area C + E shows the fall in total surplus and is the deadweight loss of the tax Without Tax With Tax Change Consumer Surplus Producer Surplus Tax Revenue Total Surplus A+B+C D+E+F None A+B+C+D+E+F A F B+D A+B+D+F -(B+C) -(D+E) +(B+D) -(C+E)

The Deadweight Loss of Taxation Losses of surplus to buyers and sellers from a tax Exceed the revenue raised by the government Deadweight loss Fall in total surplus that results from a market distortion, such as a tax Taxes distort incentives Markets allocate resources inefficiently

Determinants of Deadweight Loss What determines whether the deadweight loss from a tax is large or small? The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. That, in turn, depends on the price elasticities of supply and demand.

Determinants of 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.

Figure 5 Tax Distortions and Elasticities (a) Inelastic Supply Price Demand Supply When supply is relatively inelastic, the deadweight loss of a tax is small. Size of tax Quantity Copyright © 2004 South-Western

Figure 5 Tax Distortions and Elasticities (b) Elastic Supply Price Demand When supply is relatively elastic, the deadweight loss of a tax is large. Size of tax Supply Quantity Copyright © 2004 South-Western

Figure 5 Tax Distortions and Elasticities (c) Inelastic Demand Price Supply Demand Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small. Quantity Copyright © 2004 South-Western

Figure 5 Tax Distortions and Elasticities (d) Elastic Demand Price Supply Demand Size of tax When demand is relatively elastic, the deadweight loss of a tax is large. Quantity Copyright © 2004 South-Western

Deadweight Loss and Tax Rate With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

Tax Revenue and Tax Rate For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (a) Small Tax Price Demand Deadweight loss Supply PB Q2 PS Tax revenue Q1 Quantity Copyright © 2004 South-Western

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (b) Medium Tax Price Demand Deadweight loss PB Q2 PS Tax revenue Supply Q1 Quantity Copyright © 2004 South-Western

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes (c) Large Tax Price PB Q2 PS Demand Tax revenue Deadweight loss Supply Q1 Quantity Copyright © 2004 South-Western

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Tax Size Copyright © 2004 South-Western

Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax Tax Size Copyright © 2004 South-Western

Deadweight Loss & Tax Revenue as Taxes Vary As the tax increases Deadweight loss increases Even more rapidly than the size of the tax Tax revenue Increases initially Then decreases Higher tax – drastically reduces the size of the market

Laffer Curve and Supply-side economics The Laffer curve depicts the relationship between tax rates and tax revenue. Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues.

International Trade

Equilibrium Without Trade Assume: A country is isolated from rest of the world and produces steel. The market for steel consists of the buyers and sellers in the country. No one in the country is allowed to import or export steel.

Figure 1The Equilibrium without International Trade Price of Steel Domestic demand Consumer surplus Domestic supply Equilibrium price quantity Producer surplus Quantity of Steel Copyright © 2004 South-Western

Importer or Exporter? If the country decides to engage in international trade, will it be an importer or exporter of steel? The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the price that prevails in the world market for that good.

Exporter If a country has a comparative advantage, then the domestic price will be below the world price, and the country will be an exporter of the good.

Figure 2 International Trade in an Exporting Country Price of Steel Domestic demand Domestic supply Price after trade World price Domestic quantity demanded Domestic quantity supplied Price before trade Exports Quantity of Steel Copyright © 2004 South-Western

Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel Domestic demand Domestic supply Price after trade World price Exports D C B A Price before trade Quantity of Steel Copyright © 2004 South-Western

Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel Domestic demand Consumer surplus before trade Domestic supply Price after trade World price Exports D C B A Price before trade Producer surplus before trade Quantity of Steel Copyright © 2004 South-Western

Winners and Losers The analysis of an exporting country yields two conclusions: Domestic producers of the good are better off, and domestic consumers of the good are worse off. Trade raises the economic well-being of the nation as a whole.

Importer If the country does not have a comparative advantage, then the domestic price will be higher than the world price, and the country will be an importer of the good.

Figure 4 International Trade in an Importing Country Price of Steel Domestic demand Domestic supply Price before trade Price after trade World price Domestic quantity supplied Domestic quantity demanded Imports Quantity of Steel Copyright © 2004 South-Western

Figure 5 How Free Trade Affects Welfare in an Importing Country Price Domestic demand of Steel Domestic supply C B D A Price before trade Price after trade World price Imports Quantity of Steel Copyright © 2004 South-Western

Figure 5 How Free Trade Affects Welfare in an Importing Country Price A Domestic demand of Steel Consumer surplus before trade Domestic supply Price before trade C B Producer surplus before trade Price after trade World price Quantity of Steel Copyright © 2004 South-Western

Figure 5 How Free Trade Affects Welfare in an Importing Country Price Domestic demand of Steel Consumer surplus after trade Domestic supply C B D A Price before trade Price after trade World price Imports Producer surplus after trade Quantity of Steel Copyright © 2004 South-Western

Winners and Losers How Free Trade Affects Welfare in an Importing Country The analysis of an importing country yields two conclusions: Domestic producers of the good are worse off, and domestic consumers of the good are better off. Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers

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.

Figure 6 The Effects of a Tariff Price of Steel Domestic demand Domestic supply Equilibrium without trade Price with tariff Q S Q D Tariff Price without tariff World price Q S Q D Imports with tariff Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Figure 6 The Effects of a Tariff Price of Steel Domestic demand Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price without tariff World price Q S Q D Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Figure 6 The Effects of a Tariff Price of Steel A B Domestic demand Consumer surplus with tariff Domestic supply Equilibrium without trade Price with tariff Q S Q D Tariff Price without tariff World price Q S Q D Imports with tariff Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Figure 6 The Effects of a Tariff Price of Steel Domestic demand Domestic supply Producer surplus after tariff Equilibrium without trade Price with tariff C G Imports with tariff Q S D Tariff Price without tariff World price Q S Q D Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Figure 6 The Effects of a Tariff Price of Steel Domestic demand Domestic supply Tariff Revenue Price with tariff Imports with tariff Q S D E Tariff Price without tariff World Q S Q D price Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Figure 6 The Effects of a Tariff Price of Steel A Domestic demand Domestic supply Deadweight Loss B Price with tariff C G D F Q S E Q D Tariff Price without tariff World Q S Q D Imports with tariff price Quantity Imports without tariff of Steel Copyright © 2004 South-Western

Effects of Tariff A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade. With a tariff, total surplus in the market decreases by an amount referred to as a deadweight loss.

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

Figure 7 The Effects of an Import Quota Price of Steel Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota Isolandian price with quota Equilibrium with quota Q S Q D World price Price without quota = Q S Q D Imports with quota Quantity Imports without quota of Steel Copyright © 2004 South-Western

Effects of 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.

Figure 7 The Effects of an Import Quota Price of Steel A Domestic demand Domestic supply Equilibrium without trade Domestic supply + Import supply Quota B Isolandian price with quota Equilibrium with quota D Q S E' Q D C F World price Price without quota = E" Q S Q D G Imports with quota Quantity Imports without quota of Steel Copyright © 2004 South-Western

Deadweight Loss of 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.

Lessons from 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.