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Lecture #2
Government intervention in the market
What will be covered…?
• taxes– quantity tax– value tax– tax on profit– lump-sum tax
• subsidies• price controls (minimum / maximum price)• quantity restrictions• tariffs• examples: the Polish `gambling scandal’, EU CAP
Quantity tax (e.g. excise tax) imposed on an industry (pure competition)
P
q
D
P1
S1
Q1
Pd
Q2
S2 = S1 + t
t
Ps
Quantity taxes and subsidies
P
QQ*
P*
S
D
Podatekjednostkowy
Pd
Ps
Q'
t(podatek)
Pd > P* > Ps; Pd = Ps + tQ' < Q*; Qd = Qs = Q'
P
QQ*
P*
S
D
Subsydiumjednostkowe
Ps
Pd
Ps > P* > Pd; Ps = Pd + sQ' > Q*; Qd = Qs = Q'
s(subsydium)
Q'
tax subsidy
Taxes and Social Welfare
P
QQ*
P*
S
D
Pd
Ps
Q'
B
D E
A
C
F
A – consumer surplus with taximposed
B – consumer surplus lost to the government becauseof tax
C – deadweight loss of consumer surplus
F – producer surplus with taximposed
D – producer surplus lost to the government becauseof tax
E – deadweight loss of producer surplus
B+D – tax revenues of the government
C+E – deadweight loss in social welfare resultingfrom the tax
So… are quantity taxes harmful?
• any tax disturbs the initial market equilibriumaffecting welfare
• taxes may be the only way to provide for certain public goods
• (so we may ask which tax will be least costly…)• additionally, taxes may actually correct
economic incentives and lead to efficiencygains (e.g. in the case of externalities)
Subsidies and Social Welfare
A+B – consumer surplusbefore the introductionof the subsidy
D+E – gain in consumersurplus with subsidy
F+D – producer surplusbefore the introductionof the subsidy
B+C – gain in producersurplus with subsidy
B+C+D+E+G – government spending on subsidies
P
QQ*
P*
S
D
Ps
Pd
A
F
Q'
B C
D EG
Elasticity and splitting the tax burden
Q Q
P P
S
D S
D
Q0
P0 P0
Q0Q1
PD
PS
t
Q1
PD
PS
t
Quantity tax with a monopoly
Q
P
MCD = AR
MR
Q0
P0 MC + t
t
P∆
Q1
P1
Price effect of taxes
• in a monopoly price increase resulting from the taxdepends on elasticity of demand
• this price increase may be higher or lower than the tax itself
• (while in a purely competitive market introductionof a tax cannot result in a price increase higherthan the tax rate)
• monopoly profits decrease as a result of introducing a tax
Value (ad valorem) tax, VAT
Pd =Ps(1+τ)
Example: `gambling scandal’ (PL)
• ‟the new surcharge shall be financially neutral for firms from the gambling industry, the role of which should be limited to collecting the 10% surcharge and transmitting it to the State Treasury”
• (quite unlikely…)• the media suggest that resignation from
surcharges would cost the budget 500 milion zloty
• (the product of simple multiplication)
Indeed a loss?
• gambling is already a source of budgetrevenue – tax on gambling, CIT and PIT imposed on winners
• experience shows that demand is relativelyelastic (i.a. potential substitution by illegalgambling)
• so… the actual revenue may decrease!
Tax on profits and lump-sum taxes
• following the introduction of the tax the firm is left with some share of profits (in %) orprofits decreased by a constant
• so the firm anyway aims to maximize before-tax profits
• no inefficiency!• (This is a static approach. In a dynamic
setting incentives to establish firms and invest will diminish.)
Minimum and maximum price
P
QQ*
P*
S
D
nadwyżka
Pmin
Qd Qs
P
QQ*
P*
S
Dniedobór
Pmax
Qs Qd
if Pmin > P* then Qs > Qd
The market is in disequilibrium
If Pmax < P* then Qs < Qd
The market is in disequilibrium
surplus
deficit
BD
A
∆CS=-A-B∆PS=A+B+D∆G=-B-D-E∆ES=-E-B
Minimum pricewith government buying out the surplus
Q
PS
D
P0
Q0
Ps
Q2Q1
E
Quantity restriction (quota)
P
Q
P'
P*
Q' Q*
D
S
S'
BA
•∆ CS = - A - B•∆ PS = A - C•∆ ES = - B - C
C
Voluntary quantity restriction
Q
P
D
P
Q0
S
S’
P ‘
Q1
D
BA
C
Quantity restrictionwith the government supporting the producers
Q
P
D
P
Q0
S
S’
Q1
∆CS = -A - B∆PS = A-C +C+B+D∆G= -C-B-D∆ES = - B – C
P ’
QS QD
PW
A B C
Tariffs, quantity restrictions in import
Q
P
Q0
D
P0
S
In a purely competitive market the domesticprice is set at the world price level PW.
Import
Import prohibited∆ CS=- A-B-C∆ PS= A∆ ES=- B -C
Tariffs
• QS increases, QD decreases• ∆ PS (domestic) = A • ∆ CS = - A - B - C – D• ∆ G = D• ∆ES = -B - C D
CB
QS QDQ’S Q’D
AP*
Pw
Q
P
D
S
Putting it all together: Common Agricultural Policy
• absorbs ca. 40% of the EU budget(ca. 50 billion euro)
• most important components:– import tariffs– import quotas (i.a. for former colonies)– guaranteed prices/intervention buying– direct payments– quotas (milk, wine, etc.)
(adverse) effects
• subsidies and maintaining relatively high pricelevels lead to overproduction, which the EU must buy out
• in 2007 the EU stored 13 476 812 tons of grain, rice, sugar and milk products, as well as 3 529 002 hectoliters of wine and otheralcohol
• high food prices cost a typical family ca. 1000 euro per year
(adverse) effects – contd.
• misallocation of resources: production of linenin Spain and Portugal
• fraud, e.g. olive-tree models in Italy