Study Guide on Government Intervention in Free Markets
Chapter 4: Government Intervention in Free Markets
Section 2: Ways Government Can Intervene to Change Free Market Equilibrium Outcome (P, Q)
A. Fight the Market
Government interventions aimed at preventing the market from reaching equilibrium price include:
Price Ceilings: A maximum price that can be charged for a good or service.
Price Floors: A minimum price that must be paid for a good or service.
B. Manipulate the Market
The government may manipulate market equilibrium outcomes through:
Taxes
Goal of Taxes: Collect revenue to:
Provide public goods/services.
Meet payroll of government workers.
Correct inequalities in wealth distribution.
Impact: Taxes distort the free-market outcomes (P, Q).
Types of Taxes:
Focus on Excise Tax:
A specific tax applied to a particular good or service, not a general sales tax.
Example: Cigarette tax is collected from the seller.
Understanding Tax Burden
Statutory Burden: The burden on the party responsible for sending payment to the government.
Economic Burden (Tax Incidence): The real burden in reduced resources resulting from a tax on either the buyer or the seller.
Difference Between Statutory and Economic Burden:
Statutory burden is about the responsibility of payment, while economic burden reflects the actual impact on market prices.
Key Insight: The economic burden is the same regardless of which side of the market the tax is collected from.
Example of Excise Tax on Gasoline
A. Tax on Sellers
Consider an excise tax on sellers, for example, $0.60 per unit sold.
Impact on Supply: The supply curve is shifted upwards by the amount of the tax due to higher costs of production.
Price Analysis:
If the pre-tax price was $3.00 per gallon, the new price after tax would shift to:
After tax price = $3.60 (due to the $0.60 tax added to the initial price).
This change will lead to an economic burden on both buyers and sellers:
Economic burden on seller: $3.00 - $2.80 = $0.20.
Economic burden on buyer: $3.40 - $3.00 = $0.40.
B. Tax on Buyers
Now consider the same excise tax ($0.60) but collected from buyers.
Impact on Demand: Demand curve shifts downwards because buyers now factor in the tax.
Price Analysis:
Initially willing to pay $3.00 for the 400th million gallon, now their willingness to pay becomes $2.40:
New buyer price = $3.00 + $0.60 (tax) = $3.60.
Similarly, the economic burden is shared:
Sellers bear the same economic burden as before, confirming the distribution of economic burden does not depend on where the tax is levied.
Tax Wedge: The difference between the price buyers pay and the price sellers receive ($0.60 in this example).
Important Note on Economic Burden
Definition: "Economic burden/incidence" refers to the impact of tax on the redistribution of resources in terms of price, not quantity changes.
For instance, while taxes induce shifts in supply/demand, quantities generated reflect market efficiency instead.
Section 2.2: Subsidies
Subsidies Definition: Payments to buyers or sellers for each unit purchased or sold.
Purpose of Subsidies:
Lower the price of goods/services to consumers to encourage more purchases at each free market price level.
Examples of Subsidies in the US:
College Education
Health Care
Energy Savings
Impact of a Subsidy via College Education Example:
Tuition assistance of $10,000/year creates an upward shift in demand.
Pre-subsidy equilibrium:
Quantity = 4 million students, Price = $25,000 per year.
After subsidy, price consumers pay drops to:
From $25,000 to $21,000
Sellers receive $31,000 per student (a benefit of $6,000 per student post-subsidy).
Economic Benefits of Subsidies:
Each buyer benefits by $4,000 (as they now pay $4,000 less).
Each seller benefits by $6,000 (receiving $6,000 more).
Important Note on Economic Benefits
The term "Economic benefit" pertains to the impact of the subsidy on redistributing resources affecting price, not quantity.
Changes in quantity due to subsidies relate to discussions around market efficiency.