1. Market Interventions chapter 15
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2. 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.
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3. 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
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4. 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
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5. 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 ($/gallon) Pb QT B P0 Q0 A
Decrease in gas stations’ receipts per gallon
PS = Pb - T C D
Gallons of gas per month
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6. Incidence of a Specific Tax
Incidence: how much of the tax burden is borne by various market participants
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7. Incidence of a Specific Tax
Sellers bear the entire burden of the tax
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8. Incidence of a Specific Tax
Buyers bear the entire burden of the tax
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9. Incidence of a Specific Tax
The more elastic demand is, and the less elastic supply is, more of the tax is borne by seller
For small taxes:
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10. Effects of a Specific Tax: Shifting the Demand Curve
Point A shows the market equilibrium
Point B shows the increase in the consumer’s cost due to the tax
Point C shows the decrease in the producer’s profit due to the tax
Regardless of who is taxed by the government, the incidence remains the same
Increase in consumers’ cost per gallon S
Pb = PS - T QT B
Price paid by buyers ($/gallon)
P0 + T DT T P0 Q0 A
Decrease in gas stations’ receipts per gallon PS C D
Gallons of gas per month
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11. Welfare Effects of a Specific Tax
Deadweight loss of taxation: lost aggregate surplus due to a tax
DWL
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12. Welfare Effects of a Specific Tax
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13. 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
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14. Taxation with No Deadweight Loss
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15. 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
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16. Policies that Raise Prices
Price floors
Price supports
Production quotas
Voluntary production reduction
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17. Price Floors
Price floor: establishes a minimum price that sellers can charge
Quantity traded
Price floor
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18. Price Supports
Price support: raises the market price by making purchases of the good, thereby increasing demand
Quantity traded
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19. Production Quota
Production quota: imposes limits on the quantity that individual firms can produce
Quantity traded
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20. Voluntary Production Reductions
Voluntary production reduction: offers firms inducements to reduce their production voluntarily
Quantity traded
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21. Policies that Raise Prices and their Welfare Effects
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22. Policies that Lower Prices
Price ceiling: establishes a maximum price that sellers can charge
Quantity traded
Price ceiling
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23. Tariffs Tariff: tax on imports Equilibrium with and without tariff Sd
Domestic price ($/ton)
PT = PW + T QT ST
P0 = PW Q0 S0
Tons of sugar per year
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24. Welfare Effects of a Tariff
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25. Quotas Quota: limits the total quantity of a good that can be imported
Quota = (QT ) Sd D SQ
Domestic price ($/ton)
PT = PW + T QT
P0 = PW Q0 S0
Tons of sugar per year
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26. 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
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27. 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.
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28. 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.
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