Econ 201 Ch. 6 & 8

1. Econ 201Ch. 6 & 8 Government Policy & Economic Welfare

2. Evaluating the Impact of Government Intervention • Policy Instruments Available • Taxes • Typically: per-unit tax on output • Others: lump-sum, value added (VAT) • Subsidies • Rebate on per-unit produced • Price Floors • Minimum price that can be charged (e.g., minimum wage) • Price Ceilings • Limit on the maximum price that can be charged (WIN) • Quotas • Limits on amounts produced/imported • Infant industry/protectionism

3. How Do We Analyze the Effects of Taxes and Subsidies • The efficient ideal market • “perfectly competitive” market • Consumers and suppliers are price-takers, i.e. have no market power

4. Application: Taxes and Competitive Equilibrium • Consider a per-unit tax, which adds a fixed dollar amount to each unit of a good sold. • Graphically, the imposition of the tax is shown by a leftward shift of the supply curve.

5. Figure 6.4 The Effect of a Per-Unit Tax on Laptop Sales

6. Deadweight Loss Price Consumers Pay Pre-tax price Price Sellers Receive Reduction in Qty sold

7. Deadweight Loss Retained CS Tax Rev From CS Tax Rev From CS Retained PS

8. Application: Taxes and Competitive Equilibrium • This example illustrates three key ideas related to taxes: • Incidence of a tax on consumers: • The increase in price that consumers pay • Incidence of a tax on producers: • The decrease in price producers receive • Deadweight loss: • Losses in consumer and producer surplus that are not transferred to the government as revenue

9. Elasticity and Tax Incidence • The incidence of a tax will be determined by the elasticities of demand and supply.

10. Figure 6.5(a)Elasticity and Tax Incidence

11. Figure 6.5(b)Elasticity and Tax Incidence

12. Tax Incidence and Demand Elasticity • If demand is inelastic, the majority of the tax incidence falls on consumers. • If demand is elastic, the majority of the tax incidence falls on producers. • As demand elasticity increases, the deadweight loss increases.

13. Figure 6.5(c)Elasticity and Tax Incidence

14. Figure 6.5(d)Elasticity and Tax Incidence

15. Tax Incidence and Supply Elasticity • If supply is inelastic, the majority of the tax incidence falls on producers. • If supply is elastic, the majority of the tax incidence falls on consumers. • As supply elasticity increases, the deadweight loss increases.

16. Deadweight Loss and Tax Revenue

17. 6 How deadweight loss and tax revenue vary with the size of a tax (a, b, c) (b) Medium tax (a) Small tax (c) Large tax Price Price Price PB PB PB Deadweight loss Deadweight loss Deadweight loss Tax revenue Tax revenue Tax revenue PS PS PS Q2 Q2 Q2 Q1 Q1 Q1 0 0 0 The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the amount of the tax times the amount of the good sold. In panel (a), a small tax has a small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very large tax has a very large deadweight loss, but because it has reduced the size of the market so much, the tax raises only a small amount of revenue. Demand Demand Demand Quantity Quantity Quantity Supply Supply Supply

18. Balancing DWL and Tax Revenues • Intuition: • If tax rates are too low or too high, revenue will be low. • There is an optimal tax rate to be found. • The Laffer curve (Arthur Laffer, USC) • This is the parabolic relationship between tax rates and tax revenue. • Underlying rational for supply-side economics and cutting taxes to promote economic growth

19. 6 How deadweight loss and tax revenue vary with the size of a tax (d, e) Deadweight loss Tax Revenue (d) From panel (a) to panel (c), deadweight loss continually increases (e) From panel (a) to panel (c), tax revenue first increases, then decreases Laffer curve 0 0 Tax size Tax size Panels (d) and (e) summarize these conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is sometimes called the Laffer curve.

20. The Laffer curve and supply-side economics • 1974, economist Arthur Laffer • Laffer curve • Supply-side economics • Tax rates were so high • Reducing them would actually raise tax revenue • Ronald Reagan - ran for president in 1980 • From experience in film industry • High tax rates - caused less work • Low tax rates - caused more work

21. The Laffer curve and supply-side economics • Ronald Reagan - ran for president in 1980 • Argument • Taxes were so high that they were discouraging hard work • Lower taxes would give people the proper incentive to work • Raise economic well-being • Perhaps increase tax revenue • Economists continue to debate Laffer’s argument • General lesson: • Change in tax revenue from a tax change • Depends on how the tax change affects people’s behavior

22. Quotas • Quota—A maximum quantity of a good or service that can be traded over a specific period of time. • Used when the government determines the equilibrium quantity would not be in society's best interest • For example: International trade

23. Figure 6.9 The Effect of a Quota on the Market for Laptop Computers MV to Consumers DWL from CS DWL from PS MC of resources Quota Restriction Equilibrium Qs

24. The Effects of a Quota • Quotas result in: • A transfer of surplus from consumers to producers • Deadweight loss (DWL) • DWL is due to less being produced than would be in an unrestricted (competitive) market • Resources are underutilized and inefficiently allocated • Consumers place a higher MV on good than MC of using resources to produce the good

25. The UW and Quotas • The UW has recently announced that it will not accept any transfers for spring quarter • Restriction on number of students being admitted <-> quota • Assume that the market had previously been efficient (Qs= Qd at current tuition fee) • A) what would be the economic consequences of the transfer “freeze”? • B) what would be the impact of raising tuition, instead of “freezing” transfers • C) In real-life, how are the students admitted to the UW determined (by what kind(s) of allocation schemes?

26. Something to Think About • It is estimated that illegal immigrants account for about 25% of construction labor in the US housing market • A) what would be the impact a ban on illegal immigrants on the labor market for US housing construction, i.e., hourly wage rates? • B) what would be the impact of this ban on the price of newly constructed houses?

27. Total Social Welfare • Ideally the impact of a program should be evaluated as: {Pareto efficient} • 1) can at least one person’s welfare be improved • 2) without making anyone worse off • http://en.wikipedia.org/wiki/Pareto_efficiency • More realistically: Could the winners compensate the losers? {Pigouvian} • Is the deadweight loss of the taxed good less than the surplus gain from the subsidized good? • http://en.wikipedia.org/wiki/Pigovian_tax