Taxes and International Trade: Examples and Exercises Lecture 9 – academic year 2014/15 Introduction to Economics Fabio Landini

2 Index of examples/exercises Lect. 9.1 (taxes and welfare) Lect. 9.2 (taxes, elasticity and welfare) Lect. 9.3 (taxes and welfare, computation) Curiosity: Barbie and the globalization Lect. 9.4 (international trade) Lect. 9.5 Numerical exercise Lect. 9.6 (international trade)

Example.. Taxes in the headings..

Is this a tax that generate fiscal revenue ?

5 Lect. 9.1 a)“If the Government introduced a tax on land, the rich landowners would transfer (at least part of) the tax burden to their poor tenants”. Comment. b)“If the Government introduced a tax on real estate, the rich landlords would transfer (at least part of) the tax burden to their poor tenants”. Comment.

6 a)This statement is wrong. Since the curve of supply is perfectly inelastic the landowners cannot transfer the tax burden to their poor tenants. The latter do not share in the tax burden. b)This statement is correct. The effeect of the tax depends on the elasticity of demand and supply. The cost of the tax will be shared by landlords and tenants. The impact of the tax will be stringer in the long period. Lect. 9.1

7 Let’s consider the market for rubber. a)How would the tax burden be shared if the supply curve is elastic and the demand curve is inelastic? b)What if the reverse holds (i.e. supply is inelastic and demand is elastic)? Lect. 9.2

8 Q* P* Consumer surplus Producer surplus Supply Demand A C B D P PCPC P Q Lect. 9.2

9 a)In this case the tax burden is paid mainly by consumers; since the demand curve is inelastic consumers can hardly change their consumption level following an increase in price. The consumer surplus reduces of the are A + C. Lect. 9.2

10 Q* P* A C B D PPPPPPPP PCPCPCPC P Q Consumer surplus Producer surplus Supply Demand

11 b)In this case the tax burden is paid mainly by the producers; since the supply curve is inelastic they cannot adjust their production following a change in price. The producer surplus diminishes of the area B + D. Lect. 9.2

12 a)The two equations describe the market: Q S = 2P Q D = 300 – P Lect. 9.3

13 a)Find equilibrium price and quantity Q S = Q D 2P = 300 – P  3P = 300  P = 100 Q S = Q D = 200 Lect. 9.3

14 Suppose that a tax T is introduced on consumption a)Compute the price received by producers b)Compute the price paid by consumers c)Compute the new equilibrium quantity d)Compute the fiscal revenue and net loss Lect. 9.3

15 If a new tax T is introduced on consumption the price received by the producers is: Q S = Q D 2P = 300 – (P + T) 2P = 300 – P – T 3P = 300 – T P = 100 – T/3 Lect. 9.3 (a)

16 The price paid by consumers is: P + T = (100 – T/3) + T  da cui P + T = T(– 1/3 +1)  therefore P + T = T/3 Lect. 9.3 (b)

17 The quantity sold is: Q S = 2·P = 2 ·(100 – T/3) = 200 – 2T/3 Comments: as we expected, as a consequence of the tax, the size of the market reduces and the tax burden is shared in by producers and consumers (1/3 is paid by the producers and 2/3 is paid by the consumers). Lect. 9.3 (c)

18 Find the fiscal revenue as a function of T, knowing that it is equal to T· Q: Fiscal revenue = T · Q  T · (200 – 2T/3)  200·T – 2T 2 /3 Lect. 9.3 (d)

19 T T · Q , , Lect. 9.3 (d)

20 Graphically: T 3000 Revenue Lect. 9.3 (d)

21 Derive the net loss as a function of T and draw the graph for T included between 0 and 300. Lect. 9.3 (d)

Supply Demand 100-T/ T/3 Value of the tax T A B D F C E T/3 Lect. 9.3 (d)

23 The net loss is equal to the triangle C + E, whose base is T and height equal to the variation in quantity, i.e. 200 – (200 – 2T/3) = 2T/3. Therefore, the net loss is equal to ½ ( T x 2T/3) = T 2 /3. For algebra addicted: the net loss for values of T included between 0 and 300 increases exponentially. Lect. 9.3 (d)

24 Graficamente: T 3000 Net loss Lect. 9.3 (d)

25 Is T = 200 optimal? No because, as shown by the graph, at that point the fiscal revenue reduces compared to the values of T included between 0 and150. The best decision is to set T = 150 if the objective of the government is to maximize the fiscal revenue, or T = 0 if the objective is to minimize inefficiencies. Lect. 9.3

26 Barbie and the globalization?

27 Barbie is an American product? (1 / 3) Producer: US toys company (Mattel). However, there are no plants in US to produce this doll. Material inputs (rubber for body and hairs) come from Taiwan and Japan. The plate to produce the dolls as well as some colours come from the US.

28 Assembly and decoration of the dolls is realized in the Philippines and Taiwan (more recently Indonesia, Malaysia and China). Also the cotton textile used to produce the doll’s dresses comes from China. Most of the Barbie are sent to the US from Hong Kong. Barbie is an American product? (2 / 3)

29 The value of the doll in 1995 in Hong Kong was $2. The selling price in US was nearly $10, out of which $1 was profit for Mattel and the rest was used to cover transportation costs, distribution, etc. In 2001 the sales of Barbie worldwide were equal to 1,6 billion US dollars. No doubt that the largest part of this profits remain in the US (to Mattel, distributors and so on). The idea of the product is America (and indeed the plates come from there), however can we really call it an American product? Barbie is an American product? (3 / 3)

30 The world price of wine is lower than the one one could get in US in the absence of international trade. Draw the graph of the US wine market with international trade and show in a table the consumer surplus, producer surplus and total surplus. What are the effects of a destruction of harvest on the world price? Show graphically and with a table what happens in the US market. Lect. 9.4

31 D A B C P* Internal supply Internal demand World priceP Import Q S intQ D int Consumer surplus Producer surplus P Q Lect. 9.4

32 Consumer surplus A + B + D Producer Surplus C TOTAL SURPLUS A + B + C + D US wine market in presence of free trade: Lect. 9.4

33 WORLD market: effects of a cold summer Q1Q1Q1Q1 P1P1P1P1 Demand world S 1 world S 2 world P2P2P2P2 Q2Q2Q2Q2 P Q Lect. 9.4

34 D A B C Internal supply Internal demand World price 1 P Import Q S intQ D int Consumer surplus Producer surplus P Q Lect. 9.4 P2P2 World price 2

35 A B C Internal supply Internal demand World price 1 P Q S int Consumer surplus Producer surplus P Q Lect. 9.4 BIBI P2P2 World price 2 B D Q D int

36 Consumer surplus A Producer surplus C + B TOTAL SURPLUS A + B + C Lect. 9.4

37 Following the reduction in the world supply of wine and the consequent increase in world price, the total surplus is decreased. Indeed: A + B +C < A+B+C+D Lect. 9.4

38 BUT: The producer surplus is increased. HOWEVER: This increment is not sufficient to compensate the reduction in consumer surplus. Lect. 9.4

39 In the country of Copperland – whose economy is is completely closed – the price of copper is 10 Eurocent (for 100 Kg.). Lect. 9.5

40 Questions: (a) If the world price of copper is 100 Eurocent (for 100 Kg.), show (even with the help of a graph) what happens to equilibrium price and quantity when the Government of Copperland decides to open the economy to free trade. (b) If the demand for copper is given by equation Q = P, compute the surplus of Copperland’s consumer before and after the opening of the economy. Lect. 9.5

41 Answer: a)The price of copper in Copperland is lower than the world price (10 Eurocent < 100 Eurocent); when the government open the economy the internal price increases until is equal to the world price. In fact no producer has the incentive to accept a price lower than the world price. Lect. 9.5 (a)

42 0 Internal supply Internal demand World price Price under a closed economy Quantitysupplied Export Internal quantity demanded Price of copper Quantity of copper Lect. 9.5 (a)

43 Answer: b1) The surplus of producers before the opening of the economy (in the absence of free trade) was equal to the area included between the internal price and the supply curve, while consumer surplus was equal to the area included between the demand curve and the internal price. b2) With the opening of the economy, the surplus of producers increases, while the surplus of consumers decreases. Total surplus increases. Lect. 9.5 (b)

44 Calculations: if the demand curve is Q = P, then the vertical intercept (Q = 0) is P= 250 Eurocent (2,5 Euro). In fact 0 = 500 – 2·P  P = 500/2 = 250 Lect. 9.5 (b)

45 Therefore the height of the triangle that represents the consumer surplus is Before: 250 – 10 Eurocent = 240, that is the difference with respect to the internal price After: 250 – 100 Eurocent 150, that is the difference with respect to the World price Lect. 9.5 (b)

46 0 Supply Demand Price of copper (Eurocent) Quantity of copper 480 Lect. 9.5 (b)

47 Calculations: the consumer surplus has the following base: Before: 480 = quantity demanded in a closed economy, i.e., with P= 10 Eurocent, Q=480 After: 300 = quantity demanded in an open economy, i.e., with P= 100 Eurocent, Q=300 Lect. 9.5 (b)

48 Results: Before: surplus is (480 x 240)/2 = After: surplus is (300 x 150)/2 = Therefore the consumer surplus has decreased. Lect. 9.5 (b)

49 0 Supply Demand Price of copper (Eurocent) Quantity of copper Lect. 9.5 (b) World price Export

50 French duty on Italian wine import: According to French wine producers a duty on Italian wine import would increase fiscal revenue and increase employment. Lect. 9.6

51 P* Internal supply Internal demand World price P without duty QS1QS1 QD1QD1 P with duty The introduction of the duty increases P P Q Lect. 9.6

52 P* Internal supply Internal demand World price P without duty QS1QS1 QD1QD1 P with duty P Q Lect. 9.6 E A G QO2QO2 QD2QD2 F …Import decreases Producer surplus increases Consumer surplus increases Fiscal revenue B D