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Topic 4: Taxes and Welfare 1. Controls on prices Because buyers of any good always want a lower price while sellers want a higher price, the interest of the two groups conflict. Because the price is not allowed to rise above this level, the legislated maximum is called price ceiling. The price ceiling is a legal maximum on the price at which a good can be sold. Because the price cannot fall below this level, the legislated minimum is called a price floor. A price floor is the legal minimum on the price at which a good can be sold.

1.1.

How price ceilings affect market outcomes

When the government imposes a binging price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential buyers. The rationing mechanism in a free, competitive market is both efficient and impersonal. When the market reaches its equilibrium, anyone who wants to pay the market price can get a good. Free markets ration goods with prices.

1.2.

How price floors affect market outcomes

Price floors, like price ceilings, are an attempt by the government to maintain prices at other than equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum. Thus, a binding price floor causes a surplus.

Just as the shortages resulting from the price ceiling can lead to undesirable rationing mechanisms, so can the surpluses resulting from price floors. In the case of a price floor, some sellers are unable to sell all they want at the market. In a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price.

1.3.

Evaluating price controls

One of the Ten Principles of Economics is that the markets are usually a good way to organize economic activity. This principle explains why economists usually oppose price ceilings and price floors. To economists, prices are result of the millions of business and consumer decisions that lie behind the supply and demand curve. They have the crucial job of balancing supply and demand, and, thereby, coordinating economic activity. When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of society’s resources. Another of the Ten principles of Economics is that governments can sometimes improve market outcomes. Price controls are often aimed at helping the poor. Yet price controls often hurt those they are trying to help.

2. Taxes All governments use taxes to raise revenue for public projects such as school, roads or national defense. When the government levies a tax on a good, who actually bears the burden of the tax? The term tax incidence refers to how the burden of a tax is distributed among the various people who make up the economy.

2.1.

Equilibrium without tax

Lets first consider a competitive market without taxes. We will then introduce a sales tax, then a consumption tax, and do some comparative statics to analyze the welfare implications of these policies

2.2.

How taxes on sellers affect market outcomes

We begin by considering a tax levied on sellers of a good. How does this affect the buyers and sellers of that good? To answer this question: 1. Step one: the immediate impact of the tax is on the sellers of the good. Because the tax is not levied on buyers, the quantity demanded at any given price is the same; thus, the demand curve does not change. By contrast, the tax

on sellers makes the business less profitable at any given price, so it shifts the supply curve. 2. Step two: Because the tax on sellers raises the cost of producing and selling the good, it reduces the quantity supplied at every price. The supply curve shifts to the left (upwards). 3. Step three: Having determined how the supply curve shifts, we can now compare the initial and the new equilibriums. Because sellers sell less and buyers buy less in the new equilibrium, the tax reduces the size of the good’s market. 4. Implications: Who pays the tax? Although sellers send the entire tax to the government, buyers and sellers share the burden. To sum up, this analysis yields 2 lessons: 1. Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium. 2. Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less.

What’s happened with a sales tax?  Suppliers now have an additional cost of 15€  The supply curve has shifted upwards by 15€

 At the same time, the quantity demanded has decreased.  In equilibrium  Price has increased. From 23-25 (24€) to 30-33 (31.5€)  Quantity has decreased from 10 to 6  Price paid by buyers: 31.5€  Price received by suppliers: 31.5-15= 16.5€

2.3.

How taxes on buyers affect market outcomes

Now consider a tax levied on buyers of a good. What are the effects of this? 1. Step one: The initial impact of the tax is on the demand for the good. The supply curve is not affected because, for any given price of the good, sellers have the same incentive to provide the good to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buythat good. Thus, the tax shifts the demand curve for the good. 2. Step two: We next determine the direction of the shift. Because the tax on buyers makes buying the good less attractive, buyers demand a smaller quantity of the good at every price. As a result, the demand curve shifts to the left (or, equivalently, downward) 3. Step three: Having determined how the demand curve shifts, we can now see the effect of the tax by comparing the initial equilibrium and the new equilibrium. Once again, the tax on the good reduces the size of the good’s market. And, once again, buyers and sellers share the burden of the tax. Sellers get a lower Price for their product; buyers pay a lower market price to sellers tan they did previously, but the effective price (including the tax buyers have to pay) rises. 4. Implications: Taxes levied on sellers and taxes levied on buyers are equivalent. In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive. The only difference between taxes on sellers and taxes on buyers is who sends the money to the government.

What’s happened with a consumption tax?  Each buyer has to pay an additional 15€ per unit.  The demand curve shifts downwards 15€  For each price, the quantity demanded has gone down  In equilibrium:  Price decreases from 23-25 (24€) to 15-18 (16.5€)  Quantity decreases from 10 to 6  Price paid by buyers: 16.5+15=31.5€  Price paid by sellers: 16.5

3. Taxes and Welfare

Efficiency in competitive markets: The First Welfare Theorem - A result in the market is (Pareto) efficient if the sum of the surpluses obtained by the participants in the market is the highest possible. The competitive market always gives you the maximum amount of producer/consumer surplus, depending on the market. Pareto efficiency means you can’t make anybody better off without making somebody worse off. - A competitive equilibrium is efficient if “there does not exist other price/quantity pair that generates a higher total surplus for the participants in the market”. The supply and demand curves are steeper or flatter depending on the elasticity There are different fiscal policies:  

Taxes Subsidies

What is the effect of taxes/subsidies on the total surplus? (i.e., on the efficiency of the competitive market)? We only need to analyze either a consumption or sales tax. A subsidy is a “negative tax”. If the government pays a 15€ per unit subsidy to demanders, any demander who buys an unit of the good receives his Buyer Value plus the 15€ subsidy. Supplier’s surplus:  Revenue: 24*10=240  Cost: 2*(3+8+13+18+23)=130  Profit: revenue-cost=110 Demander’s surplus:  Willingness to pay= 2*(45+40+35+30+25)=350  Price: 24*10=240  Profit: Willingness to pay-price=110 Total surplus: 110+110= 220

By the First Welfare Theorem, we know that: -

The competitive equilibrium (without intervention) is efficient. It maximizes the total surplus

(for the graopg below, the government introduces a consumption tax of 15€. The demand curve shifts downward in 15€).

Supplier’s surplus:  Revenue: 16.5*6=99  Cost: 2*(3+8+13)=48  Profit: revenue-cost=9948=51 Demander’s surplus:  Willingness to pay: 2*(30+25+20)=150  Price= 16.5*6=99  Surplus= willingness to payprice=150-99=51 Total surplus: 51+51=102 Tax revenue:  Per unit tax=15  Units sold=6  Tax revenue: 15*6=90 (when its represented, the length of the tax is its value). Total surplus with tax=192

Surplus with vs without tax Total surplus without tax=220 Total surplus with tax (consumer’s surplus+ supplier’s surplus+ tax revenue)=192 Dead weight loss (excess burden)= total surplus without tax-total surplus with tax=220192=28 Don’t forget to add also the tax collection which is repaid to all citizens (here buyers and sellers). DWL is represented in the graph with the color green. These are people who got expulsed of the market but still get some revenue because of taxes.

3.1. Dead weight loss The difference between the surplus lost by the market àrticipants (buyers and selelrs) and the tax revenue is called Dead Weight Loss. The reason why a consumption tax leads to DWL is because it provides incentives to consume less, and thus some transactions do not take place. Which are the transactionst that are not hoing to be made? The ones with a total profit of 15€ or less. Look at the sum of the profits of consumers and producers who would have done a transaction without tax=DWL.

4. Smooth demand and supply curves Demand: P=30-Q Supply: P=5+Q The government imposes a sales tax of 10

4.1.

Equilibrium with and without tax

No tax: - Demand=supply-> 30-Q=5+Q Q*=12.5; P*=17.5 With tax: - Demand=new supply-> 30-Q=15+Q Q**=7.5, P**=22.5

Surplus without tax: -

Consumer: ((30-17,5) ×12,5)/2 = 78,125 Producer: ((17,5-5) × 12,5)/2 = 78,125 Total: 78,125 + 78,125 = 156,25

Surplus with tax: -

Consumer: ((30-22,5) × 7,5)/2 = 28,125

-

Producer: ((12,5-5) × 7,5)/2 = 28,125 Government: 10 × 7,5=75 Total: 28,125 + 28,125 + 75 = 131,25

• Dead weight loss(excess buden)=156,25-131,25=25 Dead weight loss In general, when we impose a tax in a competitive market, there will be an efficiency loss.

4.2. Why do we have taxes? We have proved that taxes generate a efficiency loss->why do we have taxes? 1. Pareto Efficiency is not a guarantee of “justice” 2. Markets might not be perfect, i.e. It might be the case that prices are not aggregating the right information. Taxes/subsidies have two objectives:  Correct a market imperfection (for example, when there are externalities).  Make the market allocation more “fair” (redistribute taxes, for example, income taxes). Example of a tax that corrects a market inefficiency: license taxes that vary with the amount of pollution that the car produces. Example of a tax that reduces inequality: Income tax (IRPF)

4.3. Who bears the burden of the tax? The more inelastic, the higher the tax burden. The more elastic, the lower the tax burden.

4.3.1. Extreme cases: a sales tax 1. Perfectly elastic supply curve: Price increase in the amount of the tax: consumers bear all the tax burden. 2. Perfectly inelastic supply curve: Prices decrease in the amount of the tax: producers bear all the tax burden. 3. Perfectly elastic demand: Produces bear the tax burden. 4. Perfectly inelastic demand: Consumers bear the tax burden...