Which Factor Probably Caused The Change Shown In The Graphs?
Topic 4 Office 2: Applications of Supply and Demand
4.7 Taxes and Subsidies
Learning Objectives
By the end of this section, you lot volition be able to:
- Distinguish between legal and economic tax incidence
- Know how to stand for taxes by shifting the curve and the wedge method
- Sympathize the quantity and price affect from a tax
- Describe why both taxes and subsidies cause deadweight loss
Taxes are non the most popular policy, just they are often necessary. We will look at two methods to understand how taxes affect the market: by shifting the bend and using the wedge method. First, we must examine the difference between legal revenue enhancement incidence and economic revenue enhancement incidence.
Legal versus Economic Revenue enhancement Incidence
When the regime sets a tax, it must decide whether to levy the tax on the producers or the consumers. This is calledlegal tax incidence. The almost well-known taxes are ones levied on the consumer, such as Authorities Sales Taxation (GST) and Provincial Sales Tax (PST). The government likewise sets taxes on producers, such equally the gas tax, which cuts into their profits. The legal incidence of the tax is actually irrelevant when determining who is impacted by the tax. When the regime levies a gas tax, the producers volition laissez passer some of these costs on as an increased toll. Likewise, a tax on consumers will ultimately decrease quantity demanded and reduce producer surplus. This is because the economic revenue enhancement incidence, or who actually pays in the new equilibrium for the incidence of the taxation, is based on how the market place responds to the price modify – not on legal incidence.
Tax – Shifting the Curve
In Topic 3, we adamant that the supply curve was derived from a firm'due south Marginal Toll and that shifts in the supply curve were caused by any changes in the market that acquired an increase in MC at every quantity level. This is no different for a tax. From the producer's perspective, any revenue enhancement levied on them is simply an increment in the marginal costs per unit. To illustrate the effect of a tax, let's await at the oil market again.
If the authorities levies a $3 gas tax on producers (a legal taxation incidence on producers), the supply curve will shift upwardly by $3. As shown in Figure iv.8a below, a new equilibrium is created at P=$5 and Q=two million barrels. Note that producers practice non receive $v, they now but receive $ii, as $3 has to be sent to the government. From the consumer'southward perspective, this $ane increase in price is no different than a price increase for whatsoever other reason, and responds by decreasing the quantity demanded for the college priced good.
What if the legal incidence of the revenue enhancement is levied on the consumers? Since the demand curve represents the consumers' willingness to pay, the demand curve will shift downwards equally a result of the revenue enhancement. If consumers are only willing to pay $iv/gallon for iv million gallons of oil but know they will face a $3/gallon taxation at the till, they will only buy 4 1000000 gallons if the ticket price is $1. This creates a new equilibrium where consumers pay a $ii ticket price, knowing they volition accept to pay a $three tax for a total of $5. The producers will receive the $2 paid before taxes.
Notation that whether the revenue enhancement is levied on the consumer or producer, the final outcome is the same, proving the legal incidence of the tax is irrelevant.
Tax – The Wedge Method
Another method to view taxes is through the wedge method. This method recognizes that who pays the tax is ultimately irrelevant. Instead, the wedge method illustrates that a revenue enhancement drives a wedge between the price consumers pay and the revenue producers receive, equal to the size of the tax levied.
As illustrated below, to discover the new equilibrium, one merely needs to find a $3 wedge between the curves. The first wedge tested is only $0.seven, followed past $i.5, until the $3.0 tax is institute.
Market Surplus
Similar with price and quantity controls, one must compare the market surplus before and afterwards a price change to fully sympathise the effects of a tax policy on surplus.
Before
The market surplus earlier the taxation has not been shown, as the process should be routine. Ensure you understand how to become the following values:
Consumer Surplus= $iv million
Producer Surplus = $viii meg
Marketplace Surplus = $12 million
Afterward
The market surplus after the policy can be calculated in reference to Figure 4.7d
Consumer Surplus (Blue Area) = $1 1000000
Producer Surplus (Red Area)= $2 one thousand thousand
Government Revenue (Green Area) = $6 million
Marketplace Surplus= $9 one thousand thousand
Why is Government Included in Market Surplus
In our previous examples dealing with market surplus, we did non include whatsoever word of regime revenue, since the government was not engaging in our market. Remember that market surplus is our metric for efficiency. If authorities was non included in this metric, it would not be very useful. In this case a one thousand thousand-dollar loss to government would exist considered efficient if information technology resulted in a $1 gain to a consumer. To ensure that our metric for efficiency is nevertheless useful we must consider regime when calculating market place surplus.
Equally with the quota – both consumer and producer surplus decreased because of a reduced quantity. The departure is, since the price is changing, there is redistribution. This time, the redistribution is from consumers and producers to the regime. Recollect, but a change in quantity causes a deadweight loss. Toll changes simply shift surplus around between consumers, producers, and the government.
Transfer and Deadweight Loss
Permit's look closely at the tax'south impact on quantity and cost to come across how these components affect the market.
Transfer – The Impact of Price
Due to the tax's effect on price, areas A and C are transferred from consumer and producer surplus to government revenue.
Consumers to Government – Area A
Consumers originally paid $four/gallon for gas. Now, they are paying $5/gallon. The $ane increase in price is the portion of the revenue enhancement that consumers accept to acquit. Despite the fact that the tax is levied on producers, the consumers have to deport a share of the price change. The size of this share depends on relative elasticity – a concept we will explore in the adjacent section. This is because a decrease in price to producers ways quantity supplied is falling, and in order to maintain equilibrium, quantity demanded must fall by an equal amount. This price change means the government collects $one ten 2 one thousand thousand gallons or $2 million in tax revenue from the consumers. This is a directly transfer from consumers to regime and has no upshot on market surplus.
Producers to Government – Area C
Originally, producers received revenue of $iv/gallon for gas. At present, they receive $2/gallon. This $ii decrease is the portion of the tax that producers have to acquit. This ways that the government collects $2 ten 2 million gallons or $4 million in tax acquirement from the producers. This is a transfer from producers to the government.
As calculated, the regime receives a full of $6 million in tax revenue, which is taken from consumers and producers. This has no impact on net market surplus.
Deadweight Loss – The Impact of Quantity
If we just considered a transfer of surplus, there would be no deadweight loss. In this case, though, nosotros know that price changes come with a change in quantity. A higher toll for consumers volition cause a subtract in the quantity demanded, and a lower price for producers will cause a subtract in quantity supplied. This reduction from equilibrium quantity is what causes a deadweight loss in the market place since there are consumers and producers who are no longer able to buy and supply the good.
Consumer Surplus Decrease – Area B
Due to the increase in toll, many consumers will switch away from oil to alternative options. This subtract in quantity demand of 1.5 meg gallons of oil causes a deadweight loss of $1 million.
Producer Surplus Decrease – Area D
Producers, who now receive only $2.00/gallon for their product, will as well decrease quantity supplied past one.5 million gallons of oil. It is no coincidence that the size of the subtract is the same. When you create the wedge between consumers and producers, yous are finding the quantity where the total amount of the tax is incurred but the marketplace is withal at equilibrium. Think that quantity demanded must equal quantity supplied or the market volition not exist stable. This mirrored decrease in quantity ensures this is still the case. Detect, however, that the bear upon of this quantity drop causes a larger subtract in producer surplus than consumer surplus totalling $2 million. Again, this is due to elasticity, or the relative responsiveness to the toll adventure, which will be explored in more detail soon.
Together, these decreases crusade a $3 million deadweight loss (the departure between the market surplus before and market surplus subsequently).
Subsidy
While a tax drives a wedge that increases the toll consumers have to pay and decreases the cost producers receive, a subsidy does the reverse. Asubsidy is a benefit given by the government to groups or individuals, ordinarily in the class of a cash payment or a tax reduction. A subsidy is often given to remove some type of burden, and it is often considered to be in the overall interest of the public. In economic terms, a subsidy drives a wedge, decreasing the cost consumers pay and increasing the cost producers receive, with the government incurring an expense.
In Topic 3, we looked at a instance study of Victoria's competitive housing market where loftier need drove up prices. In response, the government has enacted many policies to allow low-income families to still become homeowners. Let'due south expect at the furnishings of i possible policy. (Notation the post-obit policy is unrealistic just allows for easy comprehension of the effect of subsidies).
In the marketplace to a higher place, our efficient equilibrium begins at a price of $400,000 per home, with 40,000 homes existence purchased. The government wants to essentially increase the number of consumers able to purchase homes, so it issues a $300,000 subsidy for any consumers purchasing a new home. This drives a wedge betwixt what abode buyers pay ($250,000) and what home builders receive ($550,000).
With all government policies nosotros take examined so far, we have wanted to determine whether the event of the policy increases or decreases market surplus. With a subsidy, we want to practice the same assay. Unfortunately, because increases in surplus overlap on our diagram, it becomes more complicated. To simplify the analysis, the following diagram separates the changes to producers, consumers, and authorities onto different graphs.
Producers
The producers now receive $550,000 instead of $400,000, increasing quantity supplied to 60,000 homes. This increases producer surplus pastareas A and B.
Consumers
The consumers now pay $250,000 instead of $400,000, increasing quantity demanded to lx,000 homes. This increases consumer surplus byareas C and D.
Government
The government at present has to pay $300,000 per home to subsidize the 60,000 consumers ownership new homes (this policy would cost the regime $18 billion!!) Graphically, this is equal to a decrease in government to areas A, B, C, D and Eastward.
Consequence
Our total gains from the policy (to producers and consumers) are areasA, B, C and D,whereas total losses (the toll to the regime) are areasA, B, C, D, and E.To summarize:
AreasA, B, C and D are transferred from the regime to consumers and producers.
Expanse Due east is a deadweight loss from the policy.
In that location are two things to discover about this example. First, the policy was successful at increasing quantity from 40,000 homes to sixty,000 homes. 2nd, it resulted in a deadweight loss because equilibrium quantity was too high. Remember,anytime quantity is changed from the equilibrium quantity, in the absence of externalities, in that location is a deadweight loss. This is truthful for when quantity is decreased and when information technology is increased.
http://world wide web.investopedia.com/terms/due south/subsidy.asp
Summary
Taxes and subsidies are more complicated than a cost or quantity command every bit they involve a third economical histrion: the government. Every bit nosotros saw, who the tax or subsidy is levied on is irrelevant when looking at how the marketplace ends up. Note that the last three sections have painted a fairly grim picture nigh policy instruments. This is because our model currently does non include the external costs economic players impose to the macro-environment (pollution, disease, etc.) or aspect whatever pregnant to equity. These concepts will be explored in more detail in later topics.
In our examples above, nosotros see that the legal incidence of the tax does not thing, but what does? To decide which political party bears more of the burden, nosotros must apply the concept of relative elasticity to our assay.
Glossary
- Economic Tax Incidence
- the distribution of revenue enhancement based on who bears the brunt in the new equilibrium, based on elasticity
- Legal Tax Incidence
- the legal distribution of who pays the tax
- Subsidy
- a benefit given by the government to groups or individuals, usually in the form of a cash payment or a tax reduction It is oft to remove some type of burden, and information technology is frequently considered to exist in the overall interest of the public
Exercises iv.7
Refer to the supply and demand curves illustrated below for the following THREE questions. Consider the introduction of a $20 per unit tax in this marketplace.
ane. Which areas represent the loss to consumer AND producer surplus as a event of this taxation?
a) chiliad + f.
b) j + g.
c) k + j.
d) k + f + j + g.
2.Which areas represent the gain in government revenue as a issue of this tax?
a) k + f.
b) j + g.
c) k + j.
d) thou + f + j + g.
3. Which areas represent the deadweight loss associated with this tax?
a) f + g.
b) k – g.
c) j – f.
d) k + f + j + m.
4. Assume that the marginal cost of producing socks is abiding for all sock producers, and is equal to $5 per pair. If government introduces a abiding per-unit tax on socks, then which of the post-obit statements is Imitation, given the afterward-tax equilibrium in the sock market? (Assume a downward-sloping need curve for socks.)
a) Consumers are worse off as a result of the tax.
b) Spending on socks may either increase or decrease equally a result of the revenue enhancement.
c) Producers are worse off as a result of the tax.
d) This tax volition event in a deadweight loss.
5. Refer to the supply and demand diagram below.
If an subsidy of $3 per unit is introduced in this market, the toll that consumers pay volition equal ____ and the toll that producers receive cyberspace of the subsidy will equal _____.
a) $2; $five.
b) $3; $6.
c) $4; $7.
d) $5; $eight.
6. If a subsidy is introduced in a market place, and so which of the following argument is Truthful? Assume no externalities
a) Consumer and producer surplus increase but social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all subtract
Use the diagram below to reply the following Two questions.
seven. If a $six per unit of measurement tax is introduced in this market, then the price that consumers pay volition equal ____ and the price that producers receive net of the taxation volition equal _____.
a) $ten; $4.
b) $9; $3.
c) $8; $2.
d) $7; $i.
8. If a $six per unit of measurement tax is introduced in this marketplace, so the new equilibrium quantity volition exist:
a) 20 units.
b) 40 units.
c) sixty units.
d) None of the above.
9. Which of the post-obit statements about the deadweight loss of taxation is Truthful? (Presume no externalities.)
a) If there is a deadweight loss, and then the acquirement raised by the tax is greater than the losses to consumer and producers.
b) If there is no deadweight loss, then revenue raised by the government is exactly equal to the losses to consumers and producers.
c) Both a) and b).
d) Neither a) nor b).
10. Which of the following correctly describes the equilibrium effects of a per-unit revenue enhancement, in a market place with NO externalities?
a) Consumer and producer surplus increase simply social surplus decreases.
b) Consumer and producer surplus decrease but social surplus increases.
c) Consumer surplus, producer surplus, and social surplus all increase.
d) Consumer surplus, producer surplus, and social surplus all subtract.
eleven. Which of the following correctly describes the equilibrium effects of a per unit subsidy?
a) Consumer price rises, producer toll falls, and quantity increases.
b) Consumer price falls, producer price falls, and quantity increases.
c) Consumer cost rises, producer price rises, and quantity increases.
d) Consumer price falls, producer price rises, and quantity increases.
12. Refer to the supply and demand diagram below.
If an output (excise) tax of $5 per unit of measurement is introduced in this market place, the price that consumers pay will equal ____ and the price that producers receive cyberspace of the revenue enhancement volition equal _____.
a) $5; $ten.
b) $vi; $11.
c) $7; $12.
d) $8; $iii.
thirteen. Consider the supply and demand diagram below.
If a $2 per unit subsidy is introduced, what will be the equilibrium quantity?
a) 40 units.
b) 45 units.
c) l units.
d) 55 units.
Consider the supply and demand diagram below. Presume that: (i) there are no externalities; and (ii) in the absenteeism of government regulation the market supply curve is the one labeled S1.
14. If a $5 per unit of measurement tax is introduced in this market, which expanse represents the deadweight loss?
a) a.
b) a + b.
c) b + c.
d) a + b + c.
Source: https://pressbooks.bccampus.ca/uvicecon103/chapter/4-6-taxes/
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