ECON 1116 1 OctoberElasticity Application: Taxes- Prices are allowed to adjust- Market finds equilibrium- Taxes change incentives, and so distort market allocations away from the efficient ones- Elasticity determines who policy affects moreTaxation: an excise tax- Excise tax is tax charged on each unit of good or service soldo Pack of cigarettes, gallon of gasoline, etc.o Focus of this course- Applying a $t excise taxo Market prices can adjust so that Qd = Qso 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 – Ppo Taxes drive a wedge between price consumer pays and price producers receiveo Government collects tQ’ in revenue, where Q’ is quantity of good exchanged after tax imposedo Observation:1. Imposing the tax leads to reduced output2. Imposing the tax causes a deadweight lossa. Output is below the efficient level3. Price that consumers pay risesa. Pc > P0; consumers are worse off4. Price that producers receive fallsa. Pp < P0; producers are worse off- Basically, welfare loss- Who gains and who loses? Incidence of the taxo Some of the tax is borne by the consumero Some of the tax is borne by the producero Who pays more? Determined by elasticity- Tax incidenceo The bulk of tax falls on: Consumers, if demand is inelastic relative to supply Producers, if supply is inelastic relative to demando Consumer prices generally rise and producer prices generally fallo Quantity demanded and quantity supplied must fall by the same amount so that Q’d = Q’s is new equilibriumo Price must therefore adjust relatively more for the group whose quantity choices are relatively unresponsive to priceso 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 consumerso 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 levelo 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 thanlow-income taxpayers)ECON 1116 1 October Trade-off between efficiency of taxation and equity concerns is commonSubsidies- Prices paid by consumers and producers are different again- Producer price is greater than consumer price- Applying an $s per-unit subsidyo Market prices can adjust so that Qd = Qso Effectively, we have two prices Price producer receives, Pp Price consumer pays, Pc S = Pp – Pco Drive a wedge between price consumers pay and price producers receiveo Government pays sQ’, where Q’ is quantity of good exchanged after subsidy imposed- Observations:o Imposing the subsidy leads to increased outputo Imposing the subsidy also causes a deadweight loss Output is above the efficient levelo Price that consumers pay falls Pc < P0; consumers are better off Increase in consumer surpluso Price that producers receive rises Pp > P0; producers are better off Increase in producer surpluso Deadweight loss to government- Who gains and who loses?o Some of the benefits the consumer Gain in consumer surpluso Some benefits the producer Gain in producer surpluso Benefits go to: Consumers if:- Demand is inelastic relative to supply Producers if:- Supply is inelastic relative to
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