Policy Levers: Taxes & Subsidies

Policy Levers: Taxes & Subsidies

Course Information

  • Course Code: ECO 2023

  • Course Title: Introductory Microeconomics

  • Instructor: Viviana Rodriguez

  • Semester: Fall 2025

Prologue

  • Introduction to key concepts regarding the role of policy levers such as taxes and subsidies in microeconomics.

Housekeeping

  • Midterm 1 Grades: Posted and available on Canvas.

  • Grades include all adjustments:

    1. Denominator change

    2. Extra credit points for participation in Pit Market activity

  • Plan for the Class:

    • Discuss policy tools: taxes, subsidies, price controls

    • Learn from data: Introduction to causal inference

    • Explore market failures and game theory

Market Efficiency

  • Definition of Efficiency (Market-specific):

    • The outcome that maximizes mutual benefits from voluntary trade, known as total surplus.

  • General Definition of Efficiency:

    • The absence of waste.

  • Definition of Pareto Efficiency:

    • The state in which no person can be made better off without harming someone else.

Efficient Markets

Conditions for Market Efficiency

  1. Well-defined property rights.

  2. No market power.

  3. Symmetric information.

Results of Conditions

  • If all three conditions hold, an unregulated market maximizes total surplus.

Implications

  1. Government intervention can lead to inefficient outcomes when all three conditions hold.

  2. At least one condition failing can cause unregulated markets to be inefficient.

  3. Well-designed government interventions can address these inefficiencies.

Markets Yielding Efficient Outcomes

  • Characteristics:

    1. Transactions that do not affect third parties (externalities).

    2. Presence of many buyers and sellers.

    3. Goods with easily observable quality.

  • Examples needed to elucidate these points.

Taxes

  • Quote by Benjamin Franklin:

    • “In this world, nothing can be said to be certain, except death and taxes.”

Purposes of Taxes

  1. Raise revenue for public goods.

  2. Discourage undesirable behaviors.

  3. Redistribute income or wealth.

Purposes of Subsidies

  1. Provide economic stimulus.

  2. Encourage desirable behaviors.

  3. Redistribute income or wealth.

Q: Why do governments levy taxes and provide subsidies?

  • To achieve economic objectives, regulate behavior, and fund public services.

Examples of Taxes

  1. Per-unit taxes:

    • Sin taxes on tobacco, cannabis, alcohol.

    • Excise taxes on lodging, gasoline, other goods.

    • Historical example: UK’s window tax (1696-1851).

  2. Ad valorem taxes (percentage of value):

    • Sales taxes.

    • Payroll and income taxes.

    • Property taxes.

  3. Lump-sum taxes:

    • License registration fees.

    • Poll-tax/head-tax.

Price Elasticities of Demand and Supply

Price Elasticity of Demand

  • Definition:

    • A measure of the responsiveness of quantity demanded to changes in price:
      ϵd=% change in quantity demanded% change in price\epsilon_d = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}

Types of Elasticity of Demand

  1. Perfectly Inelastic:

    • ϵd=0\epsilon_d = 0

  2. Perfectly Elastic:

    • ϵd=−∞\epsilon_d = - \infty

Price Elasticity of Supply

  • Definition:

    • A measure of the responsiveness of quantity supplied to changes in price:
      ϵs=% change in quantity supplied% change in price\epsilon_s = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}

Types of Elasticity of Supply

  1. Perfectly Inelastic:

    • ϵs=0\epsilon_s = 0

  2. Perfectly Elastic:

    • ϵs=∞\epsilon_s = \infty

Effects of Taxes

Q: Impact of a Per-Unit Tax on Producers

  • Scenario:

    • Without tax:

      • Equilibrium Price (PMarket): $5.50, Quantity (QMarket): 4.5

    • With a $3.00 tax:

      • Price Consumer: $7.00

      • Price Producer: $4.00

      • Quantity: 3

    • Result: Price wedge created due to the tax.

Q: Impact on Total Surplus in an Efficient Market

  • Without tax:

    • Consumer Surplus (CS): $10.125

    • Producer Surplus (PS): $10.125

    • Total Surplus (TS): $20.25

  • With tax:

    • CS: $4.50

    • PS: $4.50

    • Government Revenue (GR): $9.00

    • TS: $18.00

  • Reduction in total surplus due to tax considered.

Deadweight Loss

  • Definition:

    • The decrease in total surplus caused by market distortions.

Effects of Taxes on Consumers

Q: Impact of Per-Unit Tax on Consumers

  • Scenario:

    • Impact similar to producers. Adjustments in prices lead to a price wedge.

Implications for Total Surplus

  • Analysis follows same structure as for producers. Measurement of surplus against tax burdens and revenue.

Tax Incidence

Statutory Incidence

  • The group of individuals who must remit a specific tax to the government.

Tax Incidence

  • The distribution of the burden of a tax among consumers and producers (i.e., who really pays the tax).

Key Points

  • Tax incidence is unchanged regardless of whether the government levies the tax on producers or consumers. The burden distribution hinges on relative price elasticities of demand and supply.

Tax Revenue and Rates

Dynamic of Tax Rate Changes

  • Q: Does an increase in the tax rate always lead to an increase in tax revenue?

    • The relationship can vary based on the interplay between tax revenue gained and loss from decreased market quantity.

  • Example Outcomes:

    1. Revenue gains outweigh losses.

    2. Revenue gains equal losses.

    3. Revenue losses outweigh gains.

  • Laffer Curve: Theory presents an optimal tax rate that maximizes revenue without discouraging economic activity excessively.

Tax Elasticity and Consumer Behavior

  • Distinction between taxing goods with inelastic demand versus elastic demand for optimal revenue generation and efficiency.

Government Concerns

  • Governments may avoid taxing necessities due to political consequences, as taxes on inelastic goods are often unpopular.

Efficiency and Equity Trade-offs

Concept of The Leaky Bucket

  • Efficiency isn’t always the primary goal; perceptions of equity can lead to less efficient outcomes.

  • Redistribution efforts can introduce inefficiencies (deadweight loss), leading to reductions in total surplus available for redistribution.

Land Tax Exploration

  • A land tax is posited as efficient (no deadweight loss) and progressive; however, practical implementation poses challenges.

Subsidies

Producer Subsidy Impact

  • Investigate particular cases to determine how per-unit subsidies for producers influence equilibrium price and quantity. Examples and calculations needed for clarity.

Creating Efficient Outcomes

  • Assessing total surplus calculations following producer subsidies, emphasizing the effectiveness in addressing market failures.