Principles of Microeconomics

7. Taxes, Subsidies, and Introduction to Welfare

Analysis*

Akos LadaJuly 29th, 2014

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Lecture 8 - Contents

1. Review of previous lecture

2. More on taxes

3. Willingness to pay and consumer surplus

4. Costs and producer surplus

1. Review

Price controls

• Binding vs. non-binding constraints.

• Binding price ceilings (e.g. rent control)• Leads to shortage• Effect is more severe in the

long run• Rationing, informal market,

decrease in quality

• Binding price floors (e.g. minimum wage)• Leads to surplus (under the

assumptions of the model

Quiz: Refer to the labor market graph below. The imposition of an $8 minimum wage

would cause

1. tax revenues to increase by $2 per worker.

2. unemployment of 35 labor hours.

3. a labor shortage of 35 labor hours.

4. no change in the equilibrium wage and employment because the minimum wage is not binding.

Labor hours65

SL

DL

Wage

80 100

W= $8

We = $6

Do you support minimum wage laws? How do you think economists would answer this

question?

1 2 3 4 5

0%

8%

69%

0%

23%

1. support strongly

2. support mildly

3. have mixed feelings

4. oppose mildly

5. oppose strongly

Do you support minimum wage laws? How do you think economists would

answer this question?

1. support strongly2. support mildly

3. have mixed feelings4. oppose mildly

5. oppose strongly

ANSWERS:1. support strongly – 28.4%2. support mildly – 18.9%

3. have mixed feelings – 14.4%4. oppose mildly – 17.8%

5. oppose strongly – 20.5%

SOURCE: Daniel B. Klein and Charlotta Stern. “Economists’ Policy Views and Voting.”

Public Choice (2006) 126: 331-342.

Taxes

1. What shifts?• If imposed on buyers, it is equivalent to a decrease

in income, shifts the demand curve left• If imposed on sellers, it is equivalent to an increase

in input costs, shifts the supply curve left2. What is the size of the shift?

• The amount of the tax3. Tax incidence (who pays for the tax burden)

• Whether the tax is charged to the producers or to the sellers is irrelevant – the tax incidence is the same in both cases

• What matters is the elasticity of Supply and Demand

• If Supply is more inelastic, the larger share of the burden falls on the sellers.

• If Demand is more inelastic, the larger share of the burden falls on the buyers

2. More on taxes

1. What shifts?

If imposed on buyers, it is equivalent to a decrease in income, shifts the demand curve to the left

If imposed on sellers, it is equivalent to an increase in input costs, shifts the supply curve left

Q

P

Q

P

D0

S0

D0

S0

$10

500

$10

500

D1

S0

2.What is the size of the shift?

For a $ 1.50 tax imposed on buyers…

~ The amount of the tax! ~

D1

For a $ 1.50 tax imposed on sellers…

$8.50

$7.50

$6.00D0

S0

$10

500 Q

P

900

$1.5 (tax

)

S1

$11.50

D0

S0

$10

500 Q

P

300 300

$12

$13.50

$1.5 (tax

)

900

PS=P*=

PB=PB=

P*=

3.Who pays the tax burden?

For a $ 1.50 tax imposed on buyers…

D0

S0

D0

S0

$10

500

D1

S1

For a $ 1.50 tax imposed on sellers…

$9.50

$11.00

Q

P

Q

P

450

Whether the tax is charged to the producers or to the sellers is irrelevant the tax incidence is the same in both cases

500

450

PS

=

Total Tax

$1.50

Buyers pay

$1.00

Sellers pay

$0.50

$10$9.50

$11.00

Total Tax

$1.50

Buyers pay

$1.00

Sellers pay

$0.50

S1

A tax creates a wedge

D0

S0

D1

P*

Q

P

… between what goes out of the pocket of the buyers, and what goes into the pocket of the sellers. The wedge is the tax that goes to the government.

Amount Buyers pay = PB

Q*0Q*`

Amount Sellers receive = PS

Total Tax

(wedge) $1.50

Quiz: In the graph below, the after-tax price paid by buyers and price received by sellers are,

respectively,

Price received by sellersPrice paid by buyers

Q

P

D

S + tax

S

$6.00

$5.00

$4.00

$7.50

$2.50

3 5 7

1. $4.00 $6.002. $5.00 $6.003. $6.00 $5.004. $6.00 $4.00

P*PS

PB

Buyers payless of the

tax

3.Who pays the tax burden?

If Supply is more inelastic, the larger share of the burden falls on the sellers.

D0

S0

D0

S0

If Demand is more inelastic, the larger share of the burden falls on the buyers

P*

Q

P

Q

P

Q*0

What matters is the elasticity of Supply and Demand

Same total Tax

Sellers paymore of the

tax

Same total Tax

Buyers paymore of the

tax

Sellers pay less of the

tax

~ those that are more flexible (adaptive) pay less, those that are less flexible pay more ~

Q*1 Q*

0Q*1

PS

PB

Quiz: Suppose the government enacts a tax as shown in the diagram below. The policy

will cause

1. the equilibrium price to rise by $2.

2. buyers to bear a higher burden of the tax than sellers.

3. buyers and sellers to each bear a $1 burden of the tax.

4. quantity to fall by 4 units.

Q

P

D

S + tax

S

$6.00

$5.00

$4.00

$7.50

$2.50

3 5 7

3. Willingness to Pay and Consumer

Surplus

Welfare Economics

• Recall, the allocation of resources refers to:• how much of each good is produced• which producers produce it• which consumers consume it

• Welfare economics studies how the allocation of resources affects economic well-being.

• First, we look at the well-being of consumers.

Willingness to Pay (WTP)

A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good.

WTP measures how much the buyer values the good.

name WTP

Anthony $250

Chad 175

Flea 300

John 125

Example: 4 buyers’ WTP

for an iPod

WTP and the Demand Curve

Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded?

A: Anthony & Flea will buy an iPod, Chad & John will not.

Hence, Qd = 2 when P = $200.

name WTP

Anthony $250

Chad 175

Flea 300

John 125

WTP and the Demand Curve

Derive the demand schedule:

4John, Chad, Anthony, Flea

0 – 125

3Chad, Anthony, Flea

126 – 175

2Anthony, Flea176 –

250

1Flea251 –

300

0nobody$301 &

up

Qdwho buysP (price of iPod)

name WTP

Anthony $250

Chad 175

Flea 300

John 125

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

WTP and the Demand Curve

P Qd

$301 & up 0

251 – 300 1

176 – 250 2

126 – 175 3

0 – 125 4

P

Q

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

About the Staircase Shape…

This D curve looks like a staircase with 4 steps – one per buyer.

P

Q

If there were a huge # of buyers, as in a competitive market,there would be a huge

# of very tiny steps,and it would look

more like a smooth curve.

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

WTP and the Demand Curve

At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher.

P

Q

Flea’s WTP

Anthony’s WTPChad’s WTP

John’s WTP

Consumer Surplus (CS)

Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays:

CS = WTP – P

name WTP

Anthony $250

Chad 175

Flea 300

John 125

Suppose P = $260.

Flea’s CS = $300 – 260 = $40.

The others get no CS because they do not buy an iPod at this price.

Total CS = $40.

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand Curve

P

Q

Flea’s WTP

P = $260

Flea’s CS = $300 – 260 = $40

Total CS = $40

$0

$50

$100

$150

$200

$250

$300

$350

0 1 2 3 4

CS and the Demand CurveP

Q

Flea’s WTP

Anthony’s WTP

Instead, suppose

P = $220

Flea’s CS = $300 – 220 = $80

Anthony’s CS =$250 – 220 = $30

Total CS = $110

4. Costs and Producer Surplus

Cost and the Supply Curve

name cost

Jack $10

Janet 20

Chrissy 35

A seller will produce and sell the good/service only if the price exceeds his or her cost.

Hence, cost is a measure of willingness to sell.

• Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).

• Includes cost of all resources used to produce good, including value of the seller’s time.

• Example: Costs of 3 sellers in the lawn-cutting business.

Cost and the Supply Curve

335 &

up

220 – 34

110 – 19

0$0 – 9

QsPDerive the supply schedule from the cost data:

name cost

Jack $10

Janet 20

Chrissy 35

Cost and the Supply Curve

$0

$10

$20

$30

$40

0 1 2 3

P

Q

P Qs

$0 – 9 0

10 – 19 1

20 – 34 2

35 & up 3

$0

$10

$20

$30

$40

0 1 2 3

Cost and the Supply CurveP

Q

At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower.

Chrissy’s

cost

Janet’s cost

Jack’s cost

$0

$10

$20

$30

$40

0 1 2 3

Producer SurplusP

Q

Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost

PS = P – cost

$0

$10

$20

$30

$40

0 1 2 3

Producer Surplus and the S CurveP

Q

PS = P – cost

Suppose P = $25.

Jack’s PS = $15

Janet’s PS = $5

Chrissy’s PS = $0

Total PS = $20

Janet’s cost

Jack’s cost

Total PS equals the area above the

supply curve under the price, from 0 to

Q.

Total PS equals the area above the

supply curve under the price, from 0 to

Q.

Chrissy’s

cost

0

10

20

30

40

50

60

0 5 10 15 20 25 30

P

Q

PS with Lots of Sellers & a Smooth S Curve

The supply of shoes

S

1000s of pairs of shoes

Price per pair

Suppose P = $40.

At Q = 15(thousand), the marginal seller’s cost is $30,

and her producer surplus is $10.