Lecture 5 Government Policies-HA

LECTURE 5 – CHAPTER 6 & 8 – PRINCIPLES OF ECONOMICS
GOVERNMENT INTERVENTION
AND THE WELFARE ECONOMICS
Government Intervention and the Welfare Economics
OBJECTIVES
 Price controls and their effects on market outcomes

 Taxes and effects on market outcomes
 Taxes and Deadweight Loss
 Determinants of Deadweight Loss
Price control
 Who set the price controls?
The government/policy makers
 When?
Policymakers believe that the market price is
unfair to sellers or buyers
 2 types of price control:
price ceiling and price floor
Price control (cont.)
• a legal maximum • a legal minimum
Price floor
Price ceiling
on the price at which on the price at which

a good can be sold a good can be sold
• Eg: rent control • Eg: minimum wage

 Other examples of price ceiling and price floor in Vietnam

 Other examples of price ceiling and price floor in Vietnam
• a legal maximum • a legal minimum
Price floor
Price ceiling
on the price at which on the price at which

a good can be sold a good can be sold
• Eg: Rent control • Eg: Minimum wage

 Price ceiling effect on market outcome:
Price Price
(a) A Price Ceiling That Is Not Binding (b) A Price Ceiling That Is Binding
Supply Supply
€4 Price
ceiling PE
3 €3
PE
2 Price
Shortage ceiling
Demand Demand
QE QS QD
Quantity 0 75 125 Quantity

 Rent control: Does the situation get better?
In the Short Run Rental In the Long Run
Rental Price
price
Supply
Supply
Controlled rent Controlled rent
Shortage Demand
Shortage
Demand
0 Quantity of apartment

 Price floor effect on market outcome:
(a) A Price Floor That Is Not Binding (b) A Price Floor That Is Binding
Price Price
Supply Supply
Surplus
PE €4
Price
floor
€3 3
Price
floor
2 PE
Demand Demand
QE QD QS
0 100 Quantity 0 80 120 Quantity

 Minimum wage: Does the situation get better?
Wage Wage
labour labour
labour surplus
Supply Supply
(unemployment)
Minimum
Equilibrium wage
wage
labour labour
demand demand
0 Equilibrium Quantity of 0 Quantity Quantity Quantity of
employment labour demanded supplied labour

 Evaluation of price control:
• Governments use Price Controls because they think that the
market outcome is unfair
• Aimed at helping the poor
• Often hurt those they are trying to help
• Other ways of helping those in need
• Rent subsidies
• Wage subsidies

 Summary about price ceiling and price floor
• A legal maximum on • A legal minimum on
Price floor
Price ceiling
the price at which a the price at which a

good can be sold good can be sold
• Eg: Rent control • Eg: Minimum wage
• A binding price ceiling • A binding price floor
results in a shortage results in a surplus
OBJECTIVES
 Price controls and their effects on market outcomes

 Taxes and effects on market outcomes
Taxes and effects on market outcomes

 Who actually bears the burden
of the tax? Buyers or Sellers or
Both of them?
 If buyers and sellers share the
tax burden, what determines
how the burden is divided?
 Tax incidence: the manner in
which the burden of a tax is shared
among participants in a market
Taxes and effects on market outcomes (cont.)

 3 steps process: effect of tax on market outcome (Recall
Chapter 4)
 Whether
the law affects  In which New
the supply direction equilibrium
curve or the curve price and
demand shifts? quantity
curve?

Price of
 Tax burden Price  A tax on
Buyers S2 sellers shifts the
on sellers pay (PB)
Equilibrium
with tax
supply curve
S1  upward by
$3.30
 Eg: The town Price
Tax ($ 0.50) the amount of the
without 3.00 tax ($0.50).
decides to place a tax (PE) 2.80 Equilibrium without tax
$0.50 tax on ice- Price
cream cones sellers
receive
sellers (PS)
PB > PE ; PS < PE Demand, D1
Tax burden on sellers = PE - PS

Tax burden on buyers: = PB - PE 0 90 100 Quantity

Price
 Tax burden Price Supply, S1
on buyers Buyers
pay (PB) $3.30
Equilibrium without tax
 Eg: The town 3.00
Tax ($0.50)
Price  A tax on buyers
decides to place a without
2.80
shifts the
$0.50 tax on ice- tax (PE) demand curve
 downward by
cream cones Price sellers  the amount of the
tax ($0.50).
buyers receive (PS) Equilibrium
with tax
PB > PE ; PS < PE D1
D2
Tax burden on sellers = PE - PS
Tax burden on buyers: = PB - PE 0 90 100
Copyright©2003 Southwestern/Thomson Learning
Quantity

 Compare effects of tax on market outcome:
Tax burden on sellers Tax burden on buyers
Shift in Demand
Shift in Supply (upward)
(downward)
PB > PE ; PS < PE PB > PE ; PS < PE
Q with tax < Q without tax Q with tax < Q without tax
Taxes levied on sellers and taxes How exactly is the tax

levied on buyers are equivalent. burden divided?

 How the Burden of a Price
1. When supply is more elastic
Tax Is Divided? than demand . . .
Price
Supply
 Case (a): Elastic Supply, buyers
pay
Inelastic Demand Tax
Price 2. . . . the
 The incidence of the tax without incidence of the
tax tax falls more
falls more heavily on heavily on
Price consumers . . .
consumers sellers
receive 3. . . . than
on producers. Demand
0 Quantity

 How the Burden of a Price
1. When demand is more elastic
Tax Is Divided? (cont.) Price than supply . . .

buyers pay Supply
 Case (b): Inelastic Supply, Price 3. . . . than on
without tax
Elastic Demand Tax
consumers.
 The tax incidence falls more

Price
heavily on producers sellers
2. . . . the
Demand
incidence of
receive the tax falls
more heavily
on producers . . .
0 Quantity

 Who actually bears the
burden of the tax? Both
buyers and sellers.
 What determines how the
burden is divided? A tax
burden falls more heavily on
the side of the market that is
less elastic.
 Application: Payroll tax
OBJECTIVES

 Taxes and effects on market outcomes
Tax and deadweight loss

 Tax Revenue Price
• T = the size of the tax Supply

Price buyers
• Q = the quantity of
Size of tax (T)
pay
Tax
the good sold revenue
(T × Q)
• T x Q = Tax Revenue Price sellers
receive
Demand
Quantity
sold (Q)
Quantity Quantity
Quantity
0 with tax without tax
Tax and deadweight loss (cont.)

Price
 Deadweight
loss: The fall in
total surplus Price
buyers = PB
A Supply
pay
that results from B
C
Price
a market without tax = P1
D
E
distortion, such Price

sellers = PS
receive F
as a tax.
Demand
Q1
Q2 Quantity
0

 Deadweight loss: The fall in
total surplus that results from a Price
market distortion, such as a tax. A Supply

PB
B
C
P1
E
D
PS
F
Demand
0 Q2 Q1 Quantity

Price
 Deadweight Losses Lost gains
and the Gains from trade Supply
from Trade: Taxes PB

cause deadweight losses Size of tax
because they prevent Price without
tax
buyers and sellers
from realizing some of PS
the gains from trade. Demand

Cost to sellers
Value to buyers Reduction in quantity

due to the tax
0 Q2 Q Quantity

 Watch this video
OBJECTIVES

 Taxes and Deadweight Loss
Determinants of Deadweight Loss

 Tax Distortions and Elasticities
(a) Inelastic Supply (b) Elastic Supply
Price Price
Supply When supply is relatively

elastic, the deadweight
loss of a tax is large.
When supply is
relatively inelastic, Size Supply
the deadweight loss of
of a tax is small. tax
Size of tax
Demand Demand
0 Quantity 0 Quantity
Determinants of Deadweight Loss (cont.)

 Tax Distortions and Elasticities (cont.)
(c) Inelastic Demand (d) Elastic Demand
Price Price
Supply Supply
Size of tax
When demand is
relatively inelastic, Size
the deadweight loss of
of a tax is small. tax Demand
When demand is relatively

elastic, the deadweight
Demand loss of a tax is large.
0 Quantity 0 Quantity
 Tax Distortions and Elasticities (cont.)

The greater the elasticities of demand and supply:
 the larger will be the decline in equilibrium quantity and,
 the greater the deadweight loss of a tax.

 DWL,Tax Size and Tax Revenue
Tax   DWL 

 DWL,Tax Size and Tax Revenue
Tax   Tax Revenue  then 


 DWL,Tax Size and Tax Revenue (cont.)
Tax   DWL  Tax   Tax Revenue  then 

SUMMARY

 Taxes and Deadweight Loss
 Determinants of Deadweight Loss

Lecture 5 Government Policies-HA

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LECTURE 5 – CHAPTER 6 & 8 – PRINCIPLES OF ECONOMICS

 Price controls and their effects on market outcomes

Price control (cont.)

• a legal maximum • a legal minimum

on the price at which on the price at which

Price control (cont.)

Price control (cont.)

Price control (cont.)

• a legal maximum • a legal minimum

on the price at which on the price at which

Price control (cont.)

Price control (cont.)

Controlled rent Controlled rent

Price control (cont.)

Price control (cont.)

Price control (cont.)

Price control (cont.)

• A legal maximum on • A legal minimum on

the price at which a the price at which a

 Price controls and their effects on market outcomes

Taxes and effects on market outcomes

Taxes and effects on market outcomes (cont.)

Taxes and effects on market outcomes (cont.)

PB > PE ; PS < PE Demand, D1

Tax burden on sellers = PE - PS

Taxes and effects on market outcomes (cont.)

Taxes and effects on market outcomes (cont.)

Taxes levied on sellers and taxes How exactly is the tax

Taxes and effects on market outcomes (cont.)

Taxes and effects on market outcomes (cont.)

Tax Is Divided? (cont.) Price than supply . . .

 The tax incidence falls more

Taxes and effects on market outcomes (cont.)

 Price controls and their effects on market outcomes

Tax and deadweight loss

• T = the size of the tax Supply

Tax and deadweight loss (cont.)

distortion, such Price

Tax and deadweight loss (cont.)

market distortion, such as a tax. A Supply

Tax and deadweight loss (cont.)

from Trade: Taxes PB

the gains from trade. Demand

Value to buyers Reduction in quantity

Tax and deadweight loss (cont.)

 Price controls and their effects on market outcomes

Determinants of Deadweight Loss

Supply When supply is relatively

Determinants of Deadweight Loss (cont.)

When demand is relatively

Determinants of Deadweight Loss (cont.)

 Tax Distortions and Elasticities (cont.)

Determinants of Deadweight Loss (cont.)

Determinants of Deadweight Loss (cont.)

Tax   Tax Revenue  then 

Determinants of Deadweight Loss (cont.)

Tax   DWL  Tax   Tax Revenue  then 

 Price controls and their effects on market outcomes

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