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Applications: The Costs of Taxation & International Trade
Chapters 8-9
Figure 1 The Effects of a Tax
Copyright © 2004 South-Western
Size of tax
Quantity0
Price
Price buyerspay
Price sellersreceive
Demand
Supply
Pricewithout tax
Quantitywithout tax
Quantitywith tax
Tax Revenue
If tax is $T per unit, tax revenue equals …
TQ
Figure 2 Tax Revenue
Copyright © 2004 South-Western
Taxrevenue (T × Q)
Size of tax (T)
Quantitysold (Q)
Quantity0
Price
Demand
Supply
Quantitywithout tax
Quantitywith tax
Price buyerspay
Price sellersreceive
Recall …
Consumer Surplus:
Area under demand curve and above price line.
Producer Surplus:
Area above supply curve and below price line.
Figure 3 How a Tax Effects Welfare
Copyright © 2004 South-Western
A
F
B
D
C
E
Quantity0
Price
Demand
Supply
= PB
Q2
= PS
Pricebuyers
pay
Pricesellers
receive
= P1
Q1
Pricewithout tax
Deadweight Loss
The fall in total surplus that results from a market distortion, such as a tax.
Buyers have an incentive to consume less and sellers an incentive to produce less.
Figure 4 The Deadweight Loss
Copyright © 2004 South-Western
Cost tosellersValue to
buyers
Size of tax
Quantity0
Price
Demand
SupplyLost gainsfrom trade
Reduction in quantity due to the tax
Pricewithout tax
Q1
PB
Q2
PS
Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(a) Inelastic Supply
Price
0 Quantity
Demand
Supply
Size of tax
When supply isrelatively inelastic,the deadweight lossof a tax is small.
Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(b) Elastic Supply
Price
0 Quantity
Demand
SupplySizeoftax
When supply is relativelyelastic, the deadweightloss of a tax is large.
Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
Demand
Supply
(c) Inelastic Demand
Price
0 Quantity
Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.
Figure 5 Tax Distortions and Elasticities
Copyright © 2004 South-Western
(d) Elastic Demand
Price
0 Quantity
Sizeoftax Demand
Supply
When demand is relativelyelastic, the deadweightloss of a tax is large.
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax revenue
Demand
Supply
Quantity0
Price
Q1
(a) Small Tax
Deadweightloss
PB
Q2
PS
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax revenue
Quantity0
Price
(b) Medium Tax
PB
Q2
PS
Supply
Demand
Q1
Deadweightloss
Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes
Copyright © 2004 South-Western
Tax
rev
enue
Demand
Supply
Quantity0
Price
Q1
(c) Large Tax
PB
Q2
PS
Deadweightloss
Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
Copyright © 2004 South-Western
(a) Deadweight Loss
DeadweightLoss
0 Tax Size
Ronald Reagan’s Deadweight Loss
I came into the Big Money making pictures during WWII. You could only make four pictures and then you were in the top bracket. So we all quit working after four pictures and went off to the country.
Figure 7 How Deadweight Loss and Tax Revenue Vary with the Size of a Tax
Copyright © 2004 South-Western
(b) Revenue (the Laffer curve)
TaxRevenue
0 Tax Size
Application: International Trade
Export Industries
If a country has a comparative advantage in a good or service, the world price will be above the domestic (no-trade) price.
The country will export those goods and services for which it has a comparative advantage.
Figure 1The Equilibrium without International Trade
Copyright © 2004 South-Western
Consumersurplus
Producersurplus
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Equilibriumprice
Equilibriumquantity
Figure 2 International Trade in an Exporting Country
Copyright © 2004 South-Western
Priceof Steel
0Quantityof Steel
Domesticsupply
Priceaftertrade World
price
DomesticdemandExports
Pricebeforetrade
Domesticquantity
demanded
Domesticquantitysupplied
Figure 3 How Free Trade Affects Welfare in an Exporting Country
Copyright © 2004 South-Western
D
C
B
A
Priceof Steel
0 Quantityof Steel
DomesticsupplyPrice
aftertrade World
price
Domesticdemand
Exports
Pricebefore
trade
Welfare effects of an export industry
Consumers are worse off—they consume less at higher prices.
Producers are better off—they produce more at higher prices.
Producers’ gains > consumers’ losses.
Net gain from trade.
Imports
If a country does not have a comparative advantage, the world price will be below the domestic (no trade) price.
Figure 4 International Trade in an Importing Country
Copyright © 2004 South-Western
Priceof Steel
0 Quantity
Priceafter
trade
Worldprice
of Steel
Domesticsupply
Domesticdemand
Imports
Domesticquantitysupplied
Domesticquantity
demanded
Pricebeforetrade
Figure 5 How Free Trade Affects Welfare in an Importing Country
Copyright © 2004 South-Western
C
B D
A
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Priceafter trade
Worldprice
Imports
Pricebefore trade
Figure 5 How Free Trade Affects Welfare in an Importing Country
Copyright © 2004 South-Western
C
B D
A
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Priceafter trade
Worldprice
Imports
Pricebefore trade
Producer surplusafter trade
Consumer surplusafter trade
Tariffs
Taxes on imports, used to discourage importing and protect domestic industry.
Figure 6 The Effects of a Tariff
Copyright © 2004 South-Western
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Equilibriumwithout trade
Pricewithout tariff
WorldpriceImports
with tariff
QSQS QD QD
Figure 6 The Effects of a Tariff
Copyright © 2004 South-Western
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Importswithout tariff
Equilibriumwithout trade
Pricewithout tariff
Worldprice
QS QD
Producer surplusbefore tariff
Consumer surplusbefore tariff
Figure 6 The Effects of a Tariff
Copyright © 2004 South-Western
A
B
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Equilibriumwithout trade
Pricewithout tariff
WorldpriceImports
with tariff
QSQS QD QD
Consumer surpluswith tariff
Figure 6 The Effects of a Tariff
Copyright © 2004 South-Western
C
G
A
ED F
B
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticdemand
Pricewith tariff Tariff
Importswithout tariff
Pricewithout tariff
WorldpriceImports
with tariff
QSQS QD QD
Deadweight Loss
Import Quotas
Government restricts quantity of imports.
Licenses are assigned to exporters.
Figure 7 The Effects of an Import Quota
Copyright © 2004 South-Western
A
E'C
B
G
D E" F
Priceof Steel
0 Quantityof Steel
Domesticsupply
Domesticsupply
+Import supply
Domesticdemand
Isolandianprice with
quota
Importswithout quota
Equilibriumwith quota
Equilibriumwithout trade
Quota
Importswith quota
QD
Worldprice
Worldprice
Pricewithout
quota=
QS QDQS
Arguments for Restricting Trade
1. Jobs
2. National Security
3. Infant Industry
4. Unfair competition
5. Protection as a bargaining chip
The first era, from the late 1800's to World War I, was driven by falling transportation costs, thanks to the steamship and the railroad. That was Globalization 1.0, and it shrank the world from a size large to a size medium. The second big era, Globalization 2.0, lasted from the 1980's to 2000, was based on falling telecom costs and the PC, and shrank the world from a size medium to a size small. Now we've entered Globalization 3.0, and it is shrinking the world from size small to a size tiny. That's what this outsourcing of white-collar jobs is telling us — and it is going to require some wrenching adjustments for workers and political systems.
--Thomas Friedman, NYT 3/4/04
Shaking up trade theory' has some interesting points but reflects confusions in the public debate rather than dissensions in trade theory. The [Paul A.] Samuelson paper is not about offshoring of services through the Internet or other mediums, which created a panic wave, but really about a different and indeed conventional question that has recurred for half a century: Can changes such as productivity increases outside the U.S. hurt the U.S.?
Thus, imagine that you are exporting aircraft, and new producers of aircraft emerge abroad. That will lower the price of your aircraft, and your gains from trade will diminish. You have to be naive to believe that this can never happen. But you have to be even more naive to think that the policy response to the reduced gains from trade is to give up the remaining gains as well.
The critical policy question we must address is: When external developments, such as the growth of skills in China and India, for instance, do diminish the gains from trade to the U.S., is the harm to the U.S. going to be reduced or increased if the U.S. turns into Fortress America? The answer is: The U.S. will only increase its anguish if it closes its markets. Every trade economist understands this.
Jagdish BhagwatiArvind PanagariyaColumbia University, New York
End of Chapter Problems
8:11
Several years ago the British government imposed a “poll tax” that required each person to pay a flat amount to the government independent of his or her income. What is the effect of such a tax on economic efficiency? What is the effect on economic equity? Do you think this was a popular tax?
9:10
When the government of Tradeland decides to impose an import quota on foreign cars, three proposals are suggested: (1) Sell the licenses in an auction. (2) Distribute the licenses in a lottery. (3) Let people wait in line and distribute the licenses on a first-come, first-served basis. Compare the deadweight losses of the three policies.
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