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UT Knoxville ECON 201 - Tax, Tax Burden, and Welfare Economics

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ECON201 1st Edition Lecture 13Outline of Last Lecture I. What’s in a Price? a. Definition of priceII. Price Controlsa. Definition of price ceilingb. Definition of price floorIII. How Price Ceilings Affect Market OutcomesIV. Shortages and RationingV. How Price Floors Affect Market OutcomesVI. Taxesa. Definition of taxesOutline of Current Lecture I. Taxes on Buyersa. Definition of tax incidenceII. Taxes on SellersIII. Who Will Bear the Burden of a Tax?a. Definition of elasticVII. Welfare Economicsa. Definition of welfare economicsb. Definition of consumer surplusc. Definition of producer surplusVIII. How Price Changes Affect Consumer and Producer SurplusCurrent LectureI. Taxes on BuyersThe following example shows what a tax on buyers may look like in a pizza market. These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.In this market, the buyer is willing to pay a maximum of $10, with or without tax. If the tax increases, the price of the good must also decrease if the sellers want to continue making the same market. A tax on buyers essentially shifts the demand curve down by the same amount of the tax. The equilibrium too changes with an increase or decrease in taxes; above, the new equilibrium is 430 pizzas and sellers now have to change their production costs from $9.50 to $11. The difference between these numbers represents the tax, $1.50. This tax is a wedge. Tax incidence is defined as how the burden of the tax is shared between sellers and buyers.II. Taxes on SellersThe following example shows what a tax on sellers may look like in the same pizza market. In this market, the sellers can make pizzas for approximately $9.50 per pizza; however, with the $1.50 tax imposed, they now have to produce at $11 per pizza. The tax effectively raises sellers’ costs by $1.50 per pizza. This tax does not “shift” either of the curves though. The outcome is the same in both of these examples: the tax drives a wedge between the price buyers pay and the price sellers receive. It does not matter if you place the tax on the buyer or the seller; the burden and outcome are the same. III. Who Will Bear the Burden of a Tax?This answer is entirely dependent on how “responsive” buyers and sellers are to a price change.The more responsive the curve, the more elastic it is – that is, the greater flexibility it has with regard to changes in the market. The lower the value of the slope (and the flatter a curve), the greater the elasticity; likewise, the higher the value of the slope (and the steeper a curve), the lower the elasticity. Elasticity can also depend on the type of market. For example, beach front property is inelastic; the amount of beachfront doesn’t change from year to year. However, the watermelon market is elastic; various seasons can produce various loads of watermelons. Supply is heavily driven by time frame in these scenarios. So, the question really is: who can avoid the tax more? If the supply curve is more elastic than the demand curve, then the burdenof the initial tax will fall on the buyers. If the demand curve is more elastic than the supply curve, then the burden of the initial tax will fall on the sellers. As a side note, governmental policies can affect the allocation of a society’s resources and can alter the elasticity of a market as well. IV. Welfare EconomicsWelfare economics is the study of how the allocation of resources affects economic well-being. We can understand this better by looking at surpluses in the framework of market efficiency. As a recap, willingness to pay is the maximum amount the buyer will pay for a given quantity. Willingness to pay, then, measures the buyer’s “value” (also known as their satisfaction or utility). Consumer surplus is the amount a buyer is willing to pay minus what the buyer actually pays. This is shown in the equation below.CS=WTP −PIf the willingness to pay is $90, and the actual price is $80, then the consumer surplus is$90 - $80 = $10.The consumer surplus is the area below the demand curve and above the price. This area calculation can be found by calculating the area of the triangle: (1/2)*(base)*(height).Producer surplus is the amount a seller is paid for the good minus the seller’s cost. This is shown in the equation below. PS= P−costCost is the value of everything a seller must give up to produce a good (also known as opportunity cost). A seller will only produce and sell the good if the price is greater than or equal to the cost. The cost, then, is a measure of willingness to sell. V. How Price Changes Affect Consumer and Producer SurplusThe following diagrams show how price changes affect consumer and producer surplus,


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UT Knoxville ECON 201 - Tax, Tax Burden, and Welfare Economics

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