Applications: The Costs of Taxation & International Trade Chapters 8-9

Figure 1 The Effects of a Tax Price Demand Supply Price buyers pay Price sellers receive Quantity with tax Size of tax Price without tax Quantity Quantity Copyright © 2004 South-Western

Tax Revenue If tax is $T per unit, tax revenue equals … TQ

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

Recall … Consumer Surplus: Area under demand curve and above price line. Producer Surplus: Area above supply curve and below price line.

Figure 3 How a Tax Effects Welfare Price Demand Supply = PB Q2 PS Price buyers pay sellers receive A F B D C E = P1 Q1 Price without tax Quantity Copyright © 2004 South-Western

Deadweight Loss The fall in total surplus that results from a market distortion, such as a tax. Buyers have an incentive to consume less and sellers an incentive to produce less.

Figure 4 The Deadweight Loss Price Demand Lost gains from trade Supply PB Q2 PS Size of tax Price without tax Q1 Cost to sellers Value to buyers Quantity Reduction in quantity due to the tax Copyright © 2004 South-Western

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

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 (a) Deadweight Loss Deadweight Loss Tax Size Copyright © 2004 South-Western

Ronald Reagan’s Deadweight Loss I came into the Big Money making pictures during WWII. You could only make four pictures and then you were in the top bracket. So we all quit working after four pictures and went off to the country.

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

Application: International Trade

Export Industries If a country has a comparative advantage in a good or service, the world price will be above the domestic (no-trade) price. The country will export those goods and services for which it has a comparative advantage.

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

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

Welfare effects of an export industry Consumers are worse off—they consume less at higher prices. Producers are better off—they produce more at higher prices. Producers’ gains > consumers’ losses. Net gain from trade.

Imports If a country does not have a comparative advantage, the world price will be below the domestic (no trade) price.

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 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

Tariffs Taxes on imports, used to discourage importing and protect domestic industry.

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 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

Import Quotas Government restricts quantity of imports. Licenses are assigned to exporters.

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

Arguments for Restricting Trade Jobs National Security Infant Industry Unfair competition Protection as a bargaining chip

--Thomas Friedman, NYT 3/4/04 The first era, from the late 1800's to World War I, was driven by falling transportation costs, thanks to the steamship and the railroad. That was Globalization 1.0, and it shrank the world from a size large to a size medium. The second big era, Globalization 2.0, lasted from the 1980's to 2000, was based on falling telecom costs and the PC, and shrank the world from a size medium to a size small. Now we've entered Globalization 3.0, and it is shrinking the world from size small to a size tiny. That's what this outsourcing of white-collar jobs is telling us — and it is going to require some wrenching adjustments for workers and political systems. --Thomas Friedman, NYT 3/4/04

Shaking up trade theory' has some interesting points but reflects confusions in the public debate rather than dissensions in trade theory. The [Paul A.] Samuelson paper is not about offshoring of services through the Internet or other mediums, which created a panic wave, but really about a different and indeed conventional question that has recurred for half a century: Can changes such as productivity increases outside the U.S. hurt the U.S.? Thus, imagine that you are exporting aircraft, and new producers of aircraft emerge abroad. That will lower the price of your aircraft, and your gains from trade will diminish. You have to be naive to believe that this can never happen. But you have to be even more naive to think that the policy response to the reduced gains from trade is to give up the remaining gains as well. The critical policy question we must address is: When external developments, such as the growth of skills in China and India, for instance, do diminish the gains from trade to the U.S., is the harm to the U.S. going to be reduced or increased if the U.S. turns into Fortress America? The answer is: The U.S. will only increase its anguish if it closes its markets. Every trade economist understands this. Jagdish Bhagwati Arvind Panagariya Columbia University, New York

End of Chapter Problems

8:11 Several years ago the British government imposed a “poll tax” that required each person to pay a flat amount to the government independent of his or her income. What is the effect of such a tax on economic efficiency? What is the effect on economic equity? Do you think this was a popular tax?

9:10 When the government of Tradeland decides to impose an import quota on foreign cars, three proposals are suggested: (1) Sell the licenses in an auction. (2) Distribute the licenses in a lottery. (3) Let people wait in line and distribute the licenses on a first-come, first-served basis. Compare the deadweight losses of the three policies.