EFFECTS OF TAX AND

SUBSIDIES
MICROECONOMICS
In 1776, Adam Smith’s An Inquiry into the Nature and Causes of
the Wealth of Nations mentioned an “Invisible Hand” that
guided competitive markets to maximize efficiency.

Although no “Invisible Hand” actually exists, perfectly competitive

markets do maximize producer and consumer surplus:

2
For any given good:

Consumer Surplus is difference between the consumer’s

willingness to pay and the price

Producer Surplus is the difference between the price and the

producer’s willingness to provide

Total Surplus is the difference between the consumer’s willingness

to pay and the producer’s willingness to provide

3
For example:

Jacob is willing to pay $20 for essay editing, and Beth is willing to
edit essays for $10. The PC market price for editing is $14.

Consumer Surplus = $20-$14 = $6

Producer Surplus = $14-$10 = $4
Total Surplus = $20-$10 = $10

4
Consumer and Producer Surplus
P

Consumer Surplus Supply

A

C
P* B

D
Producer Surplus Demand

Q1 Q* Q
5
Definition: An excise tax is an amount paid by either the
consumer or the producer per unit of the good at the point of
sale.

It is also known as a quantity tax

(The difference between the amount paid by the demanders

and the amount received by the suppliers is the tax T.)

6
Example: Excise Tax
Q* = Original Q
P S+T P* = Original P
S Pd = Price Paid by buyers
Ps = Price received by
T sellers
T(ax) = Pd-Ps
Pd
P*
Ps

Demand
Q1 Q* Q

7
Consumer and Producer Surplus
P
Old S+T
A Consumer Surplus
S

C
P* B

D
Old Producer Surplus D

Q
Q1 Q*
8
Consumer and Producer Surplus
P
New S+T
A Consumer Surplus
Government Income
S
Pd
C
P* B
Deadweight
Ps Loss
D
New Producer Surplus D

Q
Q1 Q*
9
Originally, efficiency was maximized.

After the tax was imposed, portions of consumer and producer

surplus was transferred to the government
-this transfer is still efficient
-WHO gets the surplus is irrelevant

After the tax, a small triangle of producer and consumer surplus is

lost – this triangle is the deadweight loss

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Deadweight loss – reduction in net economic benefit due to
inefficient allocation of resources

Taxes create inefficiencies!!

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a) Calculate original equilibrium in the market for oranges
expressed as:

Qs=2P Qd=21-P

Q s = Qd Q* = 2P*
2P = 21-P Q* = 2(7)
3P = 21 Q* = 14
P* = 7

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b) Calculate Consumer and Producer Surplus. Show Graphically.

P CS = (1/2)bh
CS = (1/2)(14)(21-7)
21
Supply CS = 98

Consumer PS = (1/2)bh
Surplus PS = (1/2)(14)(7)
7 Producer PS = 49
Surplus
Demand

Q
14 13
c) If a $3 excise tax is imposed, calculate new equilibrium.

Old: Qs=2P Qs=Qd Q*=21-P*

P=Qs/2 2P-6=21-P Q*=21-9
P=Qs/2+3 3P=27 Q*=12
New: Qs=2P-6 Pd=9

Ps = Pd-T
Ps = 9-3
Ps = 6

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 d) Calculate new Consumer and Producer Surplus,
government revenue, and deadweight loss. Show graphically

CS = (1/2)bh
P CS = (1/2)(12)(21-9)
CS = 72
21
PS = (1/2)bh
S+T
PS = (1/2)(12)(6)
CS PS = 36
9
S
G DWL
D
6
PS
Q
12 14 15
 d) Calculate new Consumer and Producer Surplus,
government revenue, and deadweight loss. Show
graphically
P G = TQ
G = 3(12)
21 G = 36
S+T
CS DWL = (1/2)bh
9
DWL =
S (1/2)(14-12)(9-6)
G DWL DWL = 3
D
6
PS
Q
13 14 16
Notice that:

DWL = Old Surplus - New Surplus

DWL = CSPC+PSPC – [CSTax+PSTax+GTax]
DWL = 98 + 49 – [ 72 + 36 + 36 ]
DWL = 3

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 Effect is shown based
on supply curve S + tax

1100 S
$100 tax
1050
Price

Tax After Tax

revenue Market Price
1000

950
DA

3 4 5 6
Quantity (Big Screen TV’s per week) 18
 1100 S
D-tax
1050
Price

1000 Original Market Price

950
DA
3 4 5 6
Quantity (Big screen TV’s per week) 19
▪ Taxes discourage/decrease market activity
▪ Tax incidence measures the effect of a tax on buyers’ and sellers’
prices

•Tax burden falls most heavily on the

side of the market that is least elastic
in its response to a price change:

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 S + tax

110 S
Price of Internet

108 $10 tax

105 Consumer
Price Rises
from $100 to
100 $108
98
95
DA
3 4 5 6
Quantity (internet customers in 1000’s) 21
 S + tax Consumer
Price Rises
110 S from $100 to
$10 tax $103
Price of hiking shoes

DA
105
103
100 Original Market Price

95
93

3 4 5 6
Quantity (daily shoe sales) 22
Tax incidence (or incidence of tax) is an economic term for
understanding the division of a tax burden between stakeholders,
such as buyers and sellers or producers and consumers. Tax
incidence can also be related to the price elasticity of supply and
demand.

The relationship between tax incidence and elasticity is as follows:

Pd/Ps = /

where:  is the own-price elasticity of supply

 is the own-price elasticity of demand

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Example: Let  = -.5 and  = 2. What is the relative incidence
of a specific tax on consumers and producers?

Pd/Ps = 2/-.5 = -4 OR Pd = -4Ps

interpretation: “consumers/demanders pay four times as much

as producers/suppliers. Hence, an excise tax of $1 results in an
increase in consumer price of $.80 and a decrease in price
received by producers of $.20"
Next: Subsidies are negative taxes…

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•Subsidies work as a negative tax, increasing the seller’s price by
T (or reducing the buyer’s price by T; outcomes are the same)

•Subsidies will:
•Encourage overproduction
•Increase Consumer Surplus
•Increase Producer Surplus
•Be a government cost
•Government Cost is always greater than the gain in consumer
and producer surplus

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Subsidies
P
OLD S
A Consumer Surplus
Ps S-T
P*
B C
Pd

D
OLD Producer Surplus D

Q
Q* Q1
26
Subsidies
P
New S
A Consumer Surplus
Ps S-T
P*
B C
Pd

D
D

Q
Q1 Q*
27
Subsidies
P S
A
Ps S-T
P*
B C
Pd

D
New Producer Surplus D

Q
Q1 Q*
28
Subsidies
P S
A
Ps S-T
P*
B C
Pd Government Cost

D
D

Q
Q1 Q*
29
Subsidies
P S
A
Ps S-T
P*
B C
Pd Deadweight Loss
(yellow triangle)
D
D

Q
Q1 Q*
30
Definition: A price ceiling is a legal maximum on the price
per unit that a producer can receive. If the price ceiling is
below the pre-control competitive equilibrium price, then
the ceiling is called binding.

31
A price ceiling always has the following effects:
• Excess demand will exist
• The market will underproduce
• Producer surplus will decrease
• Some producer surplus is transferred to the consumer
• Consumer surplus may increase or decrease
• There will be a deadweight loss

32
 Price Ceiling
P
Old
Supply
A Consumer Surplus

C
P* B
Price Ceiling

D
Old Demand
Producer Surplus
Q* Q
33
The impact of a price ceiling depends on which consumer
receive the available good. We will examine the 2 extreme
cases:

•Consumers with greatest willingness to pay receive good

(maximize consumer surplus)

•Consumers with least willingness to pay receive good

(minimize consumer surplus)

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Price Ceiling: Maximize Consumer Surplus
P
New
Supply
A Consumer Surplus
Deadweight Loss
C
P* B
Price Ceiling

D New
Excess
Qs Demand Producer Surplus
Demand
Qs Q
Qd
35
Price Ceiling: Minimize Consumer Surplus
P
Supply
A

New
C Consumer Surplus
P* B
Price Ceiling
Qs
D New
Excess Producer Surplus
Demand Demand
Qs Q
Qd
36
Price Ceiling: Minimize Consumer Surplus
P
Supply

A Deadweight Loss=A-B
P*
B Price Ceiling
Qs

Excess
Demand Demand
Qs Q
Qd
37
•It is generally assumed that the consumers with the greatest
willingness to pay receive the good, but this does not always
occur

•Price ceilings are only effective if resale (black market) is

prevented

•Price ceilings can also cause a reliance on imports to meet

excess demand

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Definition: A price floor is a legal minimum on the price
per unit that a producer can receive. (ie: minimum wage)
If the price floor is above the pre-control competitive
equilibrium price, then the floor is called binding.

39
A price floor always has the following effects:
• Excess supply will exist
• The market will underconsume
• Consumer surplus will decrease
• Some consumer surplus is transferred to the producer
• Producer surplus may increase or decrease
• There will be a deadweight loss

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 Price Floor
P (W)
Old
Supply
A Consumer Surplus
Price Floor
C (min. wage)
P* B

D
Old Demand
Producer Surplus
Q* Q (L)
41
The impact of a price floor depends on which producer will
sell the good (which worker works). We will examine the 2
extreme cases:

•Producers with greatest efficiency supply good (maximize

producer surplus)

•Producers with least efficiency supply good (minimize

producer surplus)

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 Price Floor: Maximize Producer Surplus
P (W)
New
Supply
A Consumer Surplus
Price Floor
Ie: Min. Wage
C
P* B
Deadweight Loss

D New
Excess
Qd Supply Producer Surplus
Demand
Q (L)
Qs
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 Price Floor: Minimize Producer Surplus
P
New
Supply
A Consumer Surplus
Price Floor
Ie: Min. Wage
C
P* B

Qs=Qd
D New
Excess
Supply
Producer Surplus
Demand
Qd Q
44
 Price Floor: Minimize Producer Surplus
P
Supply

Price Floor
Ie: Min. Wage
X
P*
Y Deadweight Loss=Y-X
Qs=Qd

Excess
Supply Demand
Qd Q
45
• The attempt of a union to increase wages has two effects:

1) Some workers receive a higher wage

2) Some workers lose their jobs
• Note that there is a difference between negotiating a higher
wage (a union’s publicized goal) and ensuring wages keep up
with inflation (often a union’s achieved goal)

46
• In place of a price floor, the government can instead impose a
PRODUCTION QUOTA

• Production Quotas restrict the quantity supplied of any good

• Ie: Taxi Cabs
• Ie: Bear hunting permits

47
Production Quotas have IDENTICAL effects to price floors:

• There will be excess supply (some will want to supply but be

prevented)
• Quantity purchased will decrease
• Consumer surplus will decrease
• Some consumer surplus will transfer to producers
• Producer surplus may increase or decrease
• There will be a deadweight loss

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 Production Quota
Production Quota
P
Old
Consumer Surplus Supply
A

P1
C
P* B

D
Old Demand
Producer Surplus
Q* Q
49
Production Quotas effect on producer surplus depends on
which producers are allowed to produce (IDENTICAL TO
price floors):

• Producers with lowest willingness to produce (lowest costs

– most efficient) – producer surplus is maximized
• Producers with highest (valid) willingness to produce
(highest costs – most inefficient) – producer surplus is
minimized

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 Production Quota: Maximize Producer Surplus
P (W) Production Quota
New
Consumer Surplus Supply
A

P1
C
P* B
Deadweight Loss

D New
Qd Producer Surplus
Demand
Qs Q (L)
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 Production Quota: Minimize Producer
P Quota Surplus
New
A Consumer Surplus Supply

P1
C
P* B

Qs=Qd
D New
Producer Surplus
Demand
Qd Q
52
 Production Quota: Minimize Producer
P Surplus
Quota Supply

P1
X
P*
Y Deadweight Loss=Y-X
Qs=Qd

Demand
Qd Q
53