Chapter 4 Markets in Action: Government Participation Price Floors/Ceilings Tariffs/Quotas Sales Taxes
Dec 30, 2015
Chapter 4Markets in Action:
Government Participation Price Floors/Ceilings
Tariffs/Quotas
Sales Taxes
Welfare Analysis
• To determine the impact on trade policies, we must determine how the participants in the economy are affected– Participants include:
• Consumers (Households)
• Producers (Firms)
• Government
Consumer Surplus• Consumer Surplus (CS) is a method to
determine the net benefit of consumption
• Definition: “extra amount consumers are willing to pay for an item compared to what they have to pay”
– Graphically, this is the area under the demand curve
Consumer Surplus II
• Area under demand curve is the total value of consumption
• At $10, value to consumer is (a+b+c), but consumer must pay (b+c)
• So CS = a
QD
15
0
10
5
10 15
a
b d
c e
a
b
c
P
Consumer Surplus III• If the price falls
to $5, then the total value of consumption is (a+b+c+d+e)
• Consumer must pay (c+e)
• So, CS= (a+b+d)
15
10
5
a
b d
c e
a
b
c
P
d
e
1510
DQ0
Producer Surplus (PS)
• “Extra benefit” to producers
• “What producers can charge” – “What producers willing to charge”
• Graphically: Area between market price and supply curve
Producer Surplus II• Suppose the
market price is $5
• Firm is willing to sell unit 8 at $5, but for units 1-7, the firm is willing to sell each at a price less than $8
• PS = x
0
1
S
Q
P
5
10
8 15
x
yz
Producer Surplus III• If the market
price rises to $10, the firm is willing to sell at most 15 units.
• For units 1-14, the firm is willing to sell at a price lower than $10
• PS = (x+y+z)0
1
S
Q
P
5
8 15
x
yz
10
Market Equilibrium• A nation’s welfare can then be determined by the sum
of consumer surplus (CS) and producer surplus (PS) (plus any government revenue)
Welfare = CS + PS + GR
• Note that an increase in market price decreases CS yet increases PS
• So an increase in market price does not necessarily have a negative impact on the economy.
Government Intervention
• What we have looked at before were cases where the "invisible hand" and market mechanism worked without interference from outside sources.
• Lets look now at what happens when there is government intervention in the market
Government Intervention
• Cases where governments (Federal, State, Local) intervene:– Price Ceilings– Price Floors– Sales Taxes– Tariffs– Quotas
Price Ceilings• Price Ceiling:A government regulation that limits
how high a price can be charged for a good/service • 2 possible situations :
1) ceiling set above the equilibrium price
2) ceiling set below the equilibrium price
Where do we see price ceilings in place?
Price FloorsPrice Floors: A government regulation that limits how low aprice may be charged for a good/service
2 possible situations :
1) ceiling set above the equilibrium price
2) ceiling set below the equilibrium price
In what situations do we see price floors in place?
Quotas
• Limit the quantity of imported goods that can enter a market
• 2 possible scenarios
1) Binding quota (*)
2) Non-binding quota
Why would the government ever use a quota rather than a tariff?
Quotas• Suppose the US autarky (no trade) price is
$10.00. Suppose also that the price that the rest of the world pays is $5.00.
• If the US begins to trade, its own firms will supply 5 units at $5.00, while demanding 20 units
• This means the US must import 15 units
Quota
• Suppose a quota is put in place that limits imports to 7 units. What will happen to:
1) US production
2) US consumption
3) Price US consumers pay
Sales Taxes
While there are many different types of sales taxes, we will focus on a specific tax.
A specific tax is a tax where for each unit of a good sold, a certain amount of money is paid to the government.
One type of this tax is called an EXCISE TAX.
Taxes
• NOTE: • Sellers (Producers) only receive the price
that excludes the tax. • Buyers are faced with the price that
includes the tax. • Taxes have thus driven a wedge between
the prices.
TAX INCIDENCE
• This is the idea concerning "who bears the burden of the tax." Is it always the consumer who pays the full price of the tax??
Scenarios:
1) Perfectly inelastic demand
2) Perfectly elastic demand
3) Perfectly elastic supply
Modeling Taxes
• Suppose that a $10 per unit tax is placed on a good. The pre-tax price of the good is $25.
Firms make supply decisions based on the price that they receive, not the price that we pay.
Depending upon demand elasticity, consumers react by reducingthe amount consumed.
Depending upon supply elasticity, suppliers react by reducingthe amount produced.
D
S
P
Q0
25
S + Tax
30
20
2520
Tax raises price consumerspay, but also reduces the amountsuppliers receive – tax burdenshared
Govnt. Rev.
Taxes
• In this case, the burden is shared.
What happens to the burden of the tax if demand and supplyelasticities are different?
Taxes
• What can we conclude from this???
1) The more inelastic the demand and supply of a commodity, the smaller the decline in output from a given tax.
2) Relative burden of taxation among buyers and sellers follows the "path of least resistance" ( i.e. tax is shifted in proportion to where inelasticity is greatest)
3) Where is government revenue the highest? To which goods does this relate?