Market Interventions chapter 15 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives Describe the effects of a tax or subsidy in a competitive market. Explain what determines who bears the burden of tax and the difference between the statutory and economic incidence of the tax. Compare the results of price floors, price supports, production quotas, and voluntary production reduction programs. Show the effects of a price ceiling. Define domestic aggregate surplus and determine the effects of import tariffs and quotas. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Overview Government interventions usually alter market outcomes. We will focus on: Taxes and subsidies Policies designed to raise or decrease prices Import tariffs and quotas Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Taxes Governments tax goods to raise the revenue needed to pay public expenditures There are different kinds of taxes. We will focus on two: Specific tax: a fixed dollar amount that must be paid on each unit bought or sold Ad valorem tax: a tax that is stated as a percentage on the good’s price Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Effects of a Specific Tax Point A shows the market equilibrium Point B shows the increase in the price paid by consumers due to the tax Point C shows the decrease in the price received by producers due to the tax P0 + T S1 Increase in consumers’ cost per gallon S Price paid by buyers ($/gallon) Pb QT B P0 Q0 A Decrease in gas stations’ receipts per gallon PS = Pb - T C D Gallons of gas per month Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-5

Incidence of a Specific Tax Incidence: how much of the tax burden is borne by various market participants Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Incidence of a Specific Tax Sellers bear the entire burden of the tax Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-7

Incidence of a Specific Tax Buyers bear the entire burden of the tax Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-8

Incidence of a Specific Tax The more elastic demand is, and the less elastic supply is, more of the tax is borne by seller For small taxes: Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Effects of a Specific Tax: Shifting the Demand Curve Point A shows the market equilibrium Point B shows the increase in the consumer’s cost due to the tax Point C shows the decrease in the producer’s profit due to the tax Regardless of who is taxed by the government, the incidence remains the same Increase in consumers’ cost per gallon S Pb = PS - T QT B Price paid by buyers ($/gallon) P0 + T DT T P0 Q0 A Decrease in gas stations’ receipts per gallon PS C D Gallons of gas per month Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-10

Welfare Effects of a Specific Tax Deadweight loss of taxation: lost aggregate surplus due to a tax DWL Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-11

Welfare Effects of a Specific Tax Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-12

Which Goods should the Government Tax? Tax goods for which the deadweight loss of taxation will be low Deadweight loss of taxation will be low if either the demand or the supply curve is very inelastic Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Taxation with No Deadweight Loss Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-14

Subsidies Subsidy: payment that reduces the amount that buyers pay for a good or increases the amount that sellers receive In competitive markets, subsidies create deadweight loss Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-15

Policies that Raise Prices Price floors Price supports Production quotas Voluntary production reduction Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Floors Price floor: establishes a minimum price that sellers can charge Quantity traded Price floor Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-17

Price Supports Price support: raises the market price by making purchases of the good, thereby increasing demand Quantity traded Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-18

Production Quota Production quota: imposes limits on the quantity that individual firms can produce Quantity traded Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-19

Voluntary Production Reductions Voluntary production reduction: offers firms inducements to reduce their production voluntarily Quantity traded Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-20

Policies that Raise Prices and their Welfare Effects Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-21

Policies that Lower Prices Price ceiling: establishes a maximum price that sellers can charge Quantity traded Price ceiling Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-22

Tariffs Tariff: tax on imports Equilibrium with and without tariff Sd Domestic price ($/ton) PT = PW + T QT ST P0 = PW Q0 S0 Tons of sugar per year Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Welfare Effects of a Tariff Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-24

Quotas Quota: limits the total quantity of a good that can be imported Quota = (QT - ) Sd D SQ Domestic price ($/ton) PT = PW + T QT P0 = PW Q0 S0 Tons of sugar per year Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 15-25

Beneficial Trade Barriers When the import supply curve is upward sloping, a government can reduce the price received by foreign firms by imposing a tariff. Sometimes the domestic benefit from this effect may exceed the deadweight loss created by the tariff, increasing the aggregate domestic surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Review The effects of a tax are independent of who is legally required to pay it, whether buyers or sellers. The economic incidence of a tax depends on the elasticities of demand and supply. The more elastic demand is and the less elastic supply is, the smaller the share of the tax is borne by consumers. Policies designed to raise or lower competitive prices create deadweight loss. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Looking Forward Until now we have studied markets one at a time. But what are the ripple effects on other markets? General equilibrium analysis studies the simultaneous competitive equilibrium in multiple markets, and it will allow us to understand the consequences of interdependence between markets. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.