ECON 1116 1 October Elasticity Application Taxes Prices are allowed to adjust Market finds equilibrium Taxes change incentives and so distort market allocations away from the efficient ones Taxation an excise tax Elasticity determines who policy affects more Excise tax is tax charged on each unit of good or service sold o Pack of cigarettes gallon of gasoline etc o Focus of this course Applying a t excise tax o Market prices can adjust so that Qd Qs o Effectively we have two prices Price producer receives Pc det Quantity supplied Price consumer pays Pc det Quantity demanded Difference is the tax t Pc Pp o Taxes drive a wedge between price consumer pays and price producers receive o Government collects tQ in revenue where Q is quantity of good exchanged after tax imposed o Observation 1 2 Imposing the tax leads to reduced output Imposing the tax causes a deadweight loss a Output is below the efficient level 3 Price that consumers pay rises a Pc P0 consumers are worse off 4 Price that producers receive falls a Pp P0 producers are worse off Basically welfare loss Who gains and who loses Incidence of the tax o Some of the tax is borne by the consumer o Some of the tax is borne by the producer o Who pays more Determined by elasticity Tax incidence o The bulk of tax falls on Consumers if demand is inelastic relative to supply Producers if supply is inelastic relative to demand o Consumer prices generally rise and producer prices generally fall o Quantity demanded and quantity supplied must fall by the same amount so that Q d Q s is new equilibrium o Price must therefore adjust relatively more for the group whose quantity choices are relatively unresponsive to prices o When do consumer prices not rise or producer prices not fall with taxation ECON 1116 1 October Consumer prices do not rise if Demand perfectly elastic Supply perfectly inelastic Producer prices do not fall if Supply perfectly elastic Demand perfectly inelastic The more inelastic the curve the more that agent bears the cost Upon whom should the tax be levied o Does it matter whether the tax is imposed upon Producers excise production tax Consumers excise sales tax o No Production taxes are partially passed on to consumers in the form of higher prices Sales taxes are partially borne by producers who have to accept lower prices in order to sell their goods Which goods are better to tax o Generate least inefficiency and deadweight loss to economists o Equity or distributional issues Who should bear burden of paying most of tax If demand is relatively inelastic we know taxing the good will be costly for consumers o Efficiency How can the required government revenue be raised at lowest efficiency cost DWL Recall DWL is associated with the extent to which output is diverted from the efficient level o Efficiency cost of taxation The deadweight loss from taxation is proportional to the change in equilibrium quantity DWL 1 2 t Q For given t DWL will be smaller if there is smaller change in Q The equilibrium change in Q is smaller when either supply or demand curves are less than elastic i e when quantity supplied or quantity demanded Which goods should we tax o Efficiency goal Goods for which demand and or supply is very inelastic Ex staple foods prescription drugs medical care Consumers bear the brunt Tax often ends up being extremely regressive i e smaller share of income for high income taxpayers than low income taxpayers ECON 1116 1 October Trade off between efficiency of taxation and equity concerns is Subsidies common Prices paid by consumers and producers are different again Producer price is greater than consumer price Applying an s per unit subsidy o Market prices can adjust so that Qd Qs o Effectively we have two prices Price producer receives Pp Price consumer pays Pc S Pp Pc o Drive a wedge between price consumers pay and price producers o Government pays sQ where Q is quantity of good exchanged after receive subsidy imposed Observations o Imposing the subsidy leads to increased output o Imposing the subsidy also causes a deadweight loss Output is above the efficient level o Price that consumers pay falls Pc P0 consumers are better off Increase in consumer surplus o Price that producers receive rises Pp P0 producers are better off Increase in producer surplus o Deadweight loss to government Who gains and who loses o Some of the benefits the consumer Gain in consumer surplus o Some benefits the producer Gain in producer surplus o Benefits go to Consumers if Demand is inelastic relative to supply Producers if Supply is inelastic relative to demand
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