Market Interventions: Price Regulation, Taxes & Subsidies

Market Interventions: Price Regulation, Taxes & Subsidies

Outline

  • Effects of a price floor.
  • Effects of a price ceiling.
  • Effects of taxes and subsidies.
    • The incidence of a tax and elasticity.
    • Deadweight loss and elasticity.

Sources of Inefficiency

  • Monopoly
    • Raises price and restricts output relative to a competitive market.
  • Price ceilings and floors
  • Taxes and subsidies
    • With a tax or a subsidy, the amount paid by the consumer (≠)(\neq) amount received by producers/firms.
    • Price signals are no longer consistent.
  • Public goods
    • Goods for which one person's consumption does not detract from another’s consumption or enjoyment of the good.
    • Defence, police, roads (up to a point).
    • Generate a free rider problem.
  • External costs and benefits
    • Costs imposed on agents other than the consumers or producer of the good.
    • Pollution from a factory.
    • Listening to music loudly.
    • Public education.
    • Talking in lectures.
    • Marginal benefit (demand) and marginal cost (supply) curves do not reflect total or society’s benefits/costs.

Price Controls or Regulation

  • Usually enacted when the market price is deemed ‘unfair’.
    • Examples include:
      • Minimum wages.
      • Public housing.
      • Agricultural price support schemes.
  • A price floor (Pf)\text{(Pf)} establishes a minimum price at which a good can be sold.
    • Not binding if set below the equilibrium or market clearing price.
    • Leads to a surplus if it is binding.

Price Floors

  • A binding price floor causes a surplus (excess supply).
  • Non-price rationing means determine who gets to sell the good or service.
  • Examples:
    • Agricultural price supports – wool.
    • Minimum wages – leads to a number of outcomes
      • Unemployment.
      • Time spent searching for scarce jobs.
      • Black markets in jobs.
      • Switching occupations.
  • A binding price floor creates a DWL or a loss of total surplus – some gains from trades that are not realised.
  • Relative to a competitive outcome, consumer surplus (CS) is lower and producer surplus (PS) is higher.
  • The deadweight loss is given by the red triangle.

Price Ceilings

  • A price ceiling (Pc)\text{(Pc)} is a legally established maximum price at which a good can be sold.
  • Price ceiling is not binding if set above the equilibrium or market-clearing price.
  • A binding price ceiling causes a shortage or excess demand.
  • Non-price rationing means determine who gets to buy the good or service.
  • Examples:
    • Rents and housing price controls in the US.
      • Leads to:
        • Queues.
        • Discrimination by sellers or government.
        • Black markets (side payments).
  • A binding price ceiling creates a DWL or a loss of total surplus – some gains from trades that are not realised.
  • Relative to a competitive outcome, CS is higher and PS is lower.
  • The deadweight loss is given by the red triangle.
  • The DWL here could be even higher if it is not the consumers with the highest MB who actually buy the good.

Taxes and Subsidies

  • Drives a wedge between the price paid by buyers and the price received by sellers.
    • If a tax is imposed, buyers pay more than sellers receive (and keep).
    • If a subsidy is imposed, buyers pay less than sellers receive (and keep).
  • Effectively have two prices (signals) when there are taxes
    • Buyers respond to post-tax prices.
    • Sellers respond to pre-tax prices.
  • Why have taxes and subsidies?
    • To raise revenue!
    • Correct market failures, i.e., externalities (e.g., a carbon tax).
    • Income support.
  • Types of taxes
    • Excise taxes or specific.
    • Ad valorem or proportional taxes.
    • Taxes on buyers.
    • Taxes on sellers.

Taxes

  • An excise tax: Tax =(t)= (t)
  • An ad valorem tax
  • Here the tax shifts the supply curve up but by differing amounts depending on the price.

Incidence of Taxation

  • Describes who bears the economic burden of taxation.
    • In general, the economic burden falls partly on the buyer and partly on the seller.
  • The economic burden of taxation is distinct from the legal requirement to pay the tax.
    • This requirement (the legal requirement) may rest with:
      • The seller.
      • The buyer.

Incidence of Taxation

  • The pre-tax outcome
  • Consumer surplus in purple
  • Producer surplus in green

Incidence of Taxation (Tax on Sellers)

  • Tax shifts the supply curve up vertically by the amount of the tax.
  • Initially the equilibrium price was P∗P^*.
  • Imposition of the tax shifts the supply curve up vertically by the amount of the tax.
  • The new post tax supply curve is dashed.
  • The new equilibrium price at which exchange occurs is PTP_T.
  • BUT, the seller only gets to keep P<em>SP<em>S (P</em>T−PSP</em>T - P_S of each unit sold is remitted to the government).
  • Consider what happens to consumer and producer surplus following the imposition of the tax.
    • Consumer surplus is in purple.
    • Producer surplus is in green.
    • Tax revenue raised is in blue
  • The height of the blue area is tax per item, and the width is the quantity sold. Hence, the blue area is total tax revenue.
  • A tax generates a DWL or a loss in total surplus.
  • You can think about this as the lost net surplus or benefit from engaging in trade.
  • Occurs because the quantity traded moves away from what we get in a competitive equilibrium.
  • This red area represents the net loss of CS & PS as a result of the tax. It is generally termed the deadweight loss (DWL). It is that part of the surplus that is lost with the imposition of the tax

Incidence of Taxation (Tax on Buyers)

  • Imposition of the tax shifts the demand curve down vertically by the amount of the tax.
  • This gives a demand curve perceived by sellers.
  • Initially the equilibrium price was P∗P^*.
  • Imposition of the tax shifts the demand curve down vertically by the amount of the tax.
  • The new post tax demand curve is dashed. This is now the demand curve perceived by the sellers.
  • The new equilibrium price at which exchange occurs is PTP_T.
  • BUT, the total paid by the seller for each unit is P<em>B=P</em>T+taxP<em>B = P</em>T + \text{tax}.

Incidence of Taxation

  • The incidence of the tax is unaffected by who must legally pay the tax.
  • Consider:
    • The price of the coffee was $2 pre-tax.
    • A $0.50 tax on sellers resulted in a market price of $2.30 – sellers receive and keep $1.80, buyers pay $2.30.
    • A $0.50 tax on buyers resulted in a market price of $1.80 – sellers receive and keep $1.80, buyers pay $2.30.

Incidence of Taxation Depends on Elasticity

  • The more inelastic the supply, the more the seller pays.
  • The more elastic the supply, the more the buyer pays.
  • The more inelastic the demand, the more the buyer pays.
  • The more elastic the demand, the more the seller pays.
  • In general, the burden of the tax falls on the more inelastic side of the market.

Incidence of Taxation and Supply Elasticity

  • Consider perfectly elastic supply
    • The buyer pays all the tax or bears the full economic burden.
  • Consider perfectly inelastic supply
    • The seller pays all the tax or bears the full economic burden.
  • Perfectly elastic supply: Equilibrium price increases by exactly the amount of the tax.
  • Perfectly inelastic supply: Equilibrium price is unchanged. The new supply curve is coincident with the old supply curve.

Incidence of Taxation and Demand Elasticity

  • Consider perfectly elastic demand
    • The seller pays all the tax or bears the full economic burden.
  • Consider perfectly inelastic demand
    • The buyer pays all the tax or bears the full economic burden.

Incidence of Taxation and Elasticity

  • What happens when neither the supply nor the demand curve are perfectly elastic or perfectly inelastic?
    • The economic burden of the tax is shared
  • Consider a relatively inelastic demand and relatively elastic supply
    • Here price rises by a large amount when the tax is imposed on sellers. That is, the economic burden of the tax is largely borne by buyers.
  • Consider a relatively elastic demand and relatively inelastic supply
    • Here price rises by a small amount when the tax is imposed on sellers. That is, the economic burden of the tax is largely borne by sellers.

The Deadweight Loss from Taxation

  • Consider how a tax creates a deadweight loss
  • Assume that the (legal obligation to pay the) tax is imposed on sellers
  • Worked example:
    • Demand curve: QD=180−2PQ_D = 180 - 2P
    • Supply curve: QS=PQ_S = P
    • Tax of $15

Determinants of Deadweight Loss

  • Size of the deadweight loss will depend on change (decline) in market/equilibrium output that comes about as a result of the tax.
  • This depends on elasticities of supply and demand.
  • In general, the more elastic are supply and demand, the larger the DWL.
  • Relatively inelastic demand: Relatively small DWL.
  • Relatively elastic demand: Relatively large DWL.
  • A tax creates a DWL because it induces buyers and sellers to change their behaviour compared to the market outcome with no tax.
  • The market ‘shrinks’.
  • In general, the DWL increases more rapidly than the tax
    • Doubling the size of the tax leads to a quadrupling of the DWL.

Subsidies

  • Subsidies are really just negative taxes, hence the analysis of them is similar to that of taxes.
    • Drive a wedge between price paid by buyers and price received by sellers.
    • Move the market outcome away from the competitive equilibrium.
    • Create a deadweight loss.
  • Consider a subsidy on production (or a subsidy paid to producers)

Subsidies

  • Post subsidy equilibrium Supply curve is shifted down by the amount of the subsidy Notice that at the new equilibrium that MC > MB
  • The subsidy payments are effectively negative surplus.
    • Just think about where the money for the subsidy comes from!
  • Hence, subsidies create a deadweight loss….