Chapter 15

Market Interventions

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics

The effect of a tax or subsidyPolicies designed to raise pricesImport tariffs and quotas

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Taxes

A specific tax is a fixed dollar amount that must be paid on each unit bought or paid

An ad valorem tax is a tax that is stated as a percentage of the good’s price

The incidence of a tax indicates how much of the tax burden is borne by various market participants

In studying the effects of taxes it’s important to distinguish between the amount a consumer pays for a good and the amount a firm receives Use Pb for the amount a consumer pays, Ps for the amount a

firm receives If the tax is T per unit, then Ps = Pb - T

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The Burden of a Tax

Consider the effect of a specific tax of T dollars per gallon paid by gas stations on their sales of gasoline

Graphically, there are three ways to determine the tax’s effect:Shift the supply curve up by TShift the demand curve down by TUse a wedge between the amounts consumers pay

and firms receiveAll three methods yield the same resultsMakes no difference whether the tax is levied

on consumers or producers 15-4

Effects of a Specific Tax

Shifting the supply curve is one way to determine a specific tax’s effects

Demand curve remains unchanged For any price paid by consumers, firms now receive

less than when there is no tax Won’t be willing to supply as much as before Supply curve with the tax is a distance T above the original

supply curve New equilibrium price paid by consumers is price at

which the demand curve and new supply curve cross Amount bought and sold falls Price paid by consumers rises; price received by firms falls

In a competitive market the burden of a tax is shared by consumers and firms

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Figure 15.1: Effects of a Specific Tax – Shifting the Supply Curve

Gallons of Gas per Month

Pri

ce P

aid

by

Co

nsu

mer

s ($

/ga

llo

n)

QT Qo

Ps = Pb - T

Po

Pb

Increase in Consumer Cost per Gallon

Decrease in Firms’ Receipts per Gallon

A

BT

D

S

ST

Po + T

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Tax Incidence

Incidence of a tax depends on the shapes of the demand and supply curves

In general, the more elastic is demand and less elastic is supply, the more of the tax is borne by firms

Consumers bear the larger share of the tax when demand is less elastic than supply

ds

s

EE

E

tax of share Consumers'

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Figure 15.2: Incidence of a Specific Tax – Two Special Cases

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Figure 15.3: Effects of a Specific Tax – Shifting the Demand Curve

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Welfare Effects of a Tax

Use the no-tax demand and supply curve to measure aggregate surplus in the absence of a tax

The tax reduces the amount bought and sold to the quantity at which the distance between the supply and demand curves is T

Since quantity bought and sold is higher without the tax, so is aggregate surplus

To see the welfare effect of the tax, compute the difference in aggregate surplus at the quantities with and without the tax

The deadweight loss of taxation is the lost aggregate surplus due to a tax

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Welfare Effects of a Tax

Welfare effects can be used to assess winners and losers from a tax or other policy

Graphical analysis of a tax shows: Consumers and producers both lose, government gains tax

revenue Society overall loses (deadweight loss)

Taxation can be used to move resources from the private sector to the government But the government receives less than private parties give up Effect of a tax on welfare depends on what is done with the

revenue Use algebra to compute the value of deadweight loss

from a tax 15-11

Figure 15.6: Welfare Effects of a Specific Tax

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Which Goods Should be Taxed?

Size of the deadweight loss from taxation of a good depends on the shapes of the demand and supply curves If supply or demand is perfectly inelastic, for example, there is

no deadweight loss The tax doesn’t change the quantity bought and sold

If either supply or demand is very inelastic, deadweight loss caused by a tax will be low Implies the government should aim to tax good for which the

deadweight loss from taxation will be low If two goods have equal and constant marginal cost,

the good with less elastic demand should face a larger tax

Distributional considerations can also affect the choice of goods to tax

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Figure 15.8: Taxation with No Deadweight Loss

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Sample Problem 1 (15.1):

The market demand function for corn is Qd – 15 – 2P and the market supply function is Qs = 5P -2.5, both measured in billions of bushels per year. Suppose the government imposes a $2.10 tax per bushel. What will be the effects on aggregate surplus, consumer surplus and producer surplus? What will be the deadweight loss created by the tax?

Subsidies and Their Effects

A subsidy is a payment that reduces the amount that buyers pay for a good or increases the amount that sellers receive

Subsidies can be either specific or ad valorem (like taxes)

Often result from lobbying effortsUsually increase sales of the affected goodsCause deadweight loss

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Subsidies and Their Effects

Consider the effect of a government subsidy of T dollars for each gallon of ethanol produced

Can find the equilibrium with the subsidy by:Shifting supply curve down by TShifting demand curve up by TLooking for the quantity at which the demand curve

lies a distance of T below the no-subsidy supply curve

Consumers pay T dollars less than firms receive

Subsidy increases the amount bought and sold

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Welfare Effects of Subsidies

Welfare analysis of a subsidy shows consumers and producers both gain

The sum of the reduction in price to consumers and the increase in price to firms exactly equals the size of the subsidyThe side of the market whose demand or supply is

less elastic has a larger price changeAggregate surplus falls

This is because the government incurs an expense, the per-unit subsidy times the number of units sold

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Figure 15.9: Deadweight Lossof a Subsidy

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Policies Designed to Raise Prices

Governments often attempt to manipulate markets to benefit a particular group

When they want to help sellers in a market, they turn to policies meant to raise prices

A price floor establishes a minimum price that sellers can charge

A price support program raises the market price by making purchases of the good, increasing demand

Production quotas impose limits on the quantity that individual firms can produce

Voluntary production reduction programs offer firms inducements to decrease their output voluntarily

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Figure 15.12 (a): Price Floor

A price floor establishes a minimum price that sellers can charge

With minimum price of P, quantity bought and sold is Q1

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Figure 15.12 (b): Price Support

A price support program raises the market price by making purchases of the good, increasing demand

Here, total sales are Q2: Government purchases

Q2-Q1

Private buyers purchase Q1

Price is P

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Figure 15.12 (c): Production Quota

Production quotas impose limits on the quantity that individual firms can produce

Total sales of Q1 are achieved through a production quota

Could also be achieved through a voluntary reduction program

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Welfare Effects of Policies for Raising Prices

Compare all four policies, each raising the price of milk from P0 to P1

All create deadweight lossPrice support program is least efficient

Causes unused milk to be producedOther three policies create equal deadweight

lossPrice floor and production quota have same

effects

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Figure 15.13: Welfare Effects of Policies for Raising Prices

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Figure 15.13: Welfare Effects of Policies for Raising Prices

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Policies that Lower Prices

Sometimes governments adopt policies that are designed to lower prices To improve the well-being of buyers Example: rent control laws

Reduces amount of the good available for purchase Creates deadweight loss

Because buyers can’t purchase all they want at the ceiling price, they may behave inefficiently Increases deadweight loss Example: extreme searching for rent-controlled apartments

Sellers have an incentive to inefficiently degrade the quality of their products

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Figure 15.16: Price Ceiling

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Sample Problem 2 (15.12):

Suppose that the demand function for pizzas is Qd = 65,800 – 1,200P and the supply function is Qs = 4,000P – 20,000. Suppose the College Student Party is elected and places a price ceiling on pizza of $10 per pizza. How many pizzas will be bought and sold? Assuming that the highest willingness to pay consumers are the ones to consume the supplied pizzas, what will the effect be on the aggregate, consumer, and producer surplus?

Import Tariffs and Quotas

Many countries use tariffs or quotas to discourage importsExample: the U.S. imposes a tariff on frozen orange

juiceA tariff is a tax on imports

A tariff is a tax on sellers in a marketBut only on foreign sellers

A quota directly limits the total quantity of a good that can be imported

In some cases governments use a mix of tariffs and quotas

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Tariffs

Analyzing the effects of a tariff, T, assume that the country consumes a small share of the world’s production of the goodDoesn’t affect world price, Pw

Import supply curve is horizontal at Pw

Tariff shifts the import supply curve upward by the distance TForeign firms must now sell their goods for Pw + TPrice to domestic consumers rises, domestic

consumption fallsAmount sold by domestic producers increasesImports decline

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Figure 15.17: Effects of a Tariff

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Welfare Effects of Tariff

The domestic government is concerned with domestic aggregate surplus: the sum of consumer surplus, domestic producer surplus, and government revenue

Under the tariff: Consumers are worse off Domestic consumers are better off Government receives revenue equal to the quantity of imports

times the amount of the tariff Domestic deadweight loss arises from reduction in total

consumption The tariff allocates production inefficiently away from

foreign producers to domestic producers

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Figure 15.18: Welfare Effectsof a Tariff

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Sample Problem 3 (15.14):

The market demand function for corn is

Qd – 15 – 2P and the market supply function is Qs = 5P -2.5, both measured in billions of bushels per year. Suppose the import supply curve is infinitely elastic at a price of $1.50 per bushel. What would be the welfare effects of a $0.50 per bushel tariff?

Quotas A quota limits the supply of imports to some maximum

quantity The government can use either a quota or a tariff to

achieve a desired outcome of imports and domestic price Consumers and domestic firms are both as well off with the

quota as with the tariff Difference is that government revenue is zero under the quota Instead, revenue is earned by foreign firms lucky enough to

import their goods Quota has lower domestic aggregate surplus than tariff

If government allocates import rights to domestic firms, domestic firm’s producer surplus would increase Domestic aggregate surplus would be the same for quota and

tariff

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Figure 15.19: Effects of a Quota

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