Study Notes on Tax and Subsidy Effects, Elasticity of Demand and Supply

Tax Incidence
- Definition: The division of burden between buyers and sellers when a tax is levied.
- Questions: Who pays the tax? Is it the buyer or the seller?
- Discussion on how the tax is split between the two groups.
Subsidy Effects
- Definition: A subsidy is a financial support extended by the government to an economic sector, generally with the aim of promoting activity in that sector.
- Example: A $4 subsidy on a good alters the price structure for both buyers and sellers.
- Results in buyers paying less than the market price and sellers receiving more than the market price.
- Economic implication: The true benefit of the subsidy is divided between both consumers and producers, depending on elasticity.

Elasticity Definition
- Elasticity measures the responsiveness of consumers and producers to price changes.
- Types: Price elasticity of demand (ED) and price elasticity of supply (ES).
Elasticity of Demand (ED)
- Formula for elasticity:
  $E_D = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}$
- Essential concept: A downward sloping demand curve indicates that as price decreases, quantity demanded increases.
- Example Calculation: A decrease in price from $10 to $8 causing an increase in quantity demanded from 60 to 100 units.
- Change in QD: 100 - 60 = 40
- Percent change in QD:
  $\frac{40}{60} \times 100 = 66.67\%$
- Change in price: $8 - $10 = -$2
- Percent change in price:
  $\frac{-2}{10} \times 100 = -20\%$
- Elasticity calculation:
  $E_D = \frac{66.67}{20} = 3.33$
- Interpretation: For every 1% decrease in price, quantity demanded increases by 3.33%.

Perfectly Inelastic Demand
- Definition: Demand does not change regardless of price; elasticity equals 0.
- Example: Life-saving medications are often necessary without alternative substitutes.
Perfectly Elastic Demand
- Definition: Quantity demanded changes infinitely with the slightest change in price; elasticity approaches infinity.
- Example: Commodities in perfectly competitive markets where many sellers provide identical goods, like a homogeneous product (e.g., a specific grade of wheat).

Subsidy Graphical Representation
- Initial equilibrium quantity (q0) and price without subsidy.
- Introduction of a subsidy creates a wedge between what buyers pay (PB) and what sellers receive (PS).
- If a subsidy of $4 is implemented:
  $P<em>S - P</em>B = 4$
- New equilibrium quantity (q1) achieved due to the subsidy.
Consumer Surplus and Producer Surplus
- Consumer surplus: Area representing the benefit to consumers arises from paying a lower price.
- Producer surplus: Area representing extra benefit to sellers due to receiving a higher price.
Cost of Subsidy
- Total cost of the subsidy represented graphically as a rectangle.
- Net loss of surplus can occur if the additional units produced have a lower benefit than their cost.

External Benefits
- Definition: Benefits extending beyond the immediate consumer to society at large.
- Example: Education creates external benefits as educated individuals contribute to tax revenues and knowledge generation that benefits society.
Market Equilibrium and Social Benefits
- Discussion on how demand may not reflect the full social benefit.
- Example: Vaccination leading to social benefits by reducing disease spread in the community.
- Implication of subsidies arises when we consider these externalities, leading to more socially optimal quantities of goods produced.

The discussion regarding taxes and subsidies is deeply connected to elasticity, which helps determine the real economic incidence and distribution of benefits or burdens.
Understanding these concepts allows for better economic policy-making.