Taxes

Consumer Surplus

The excess of the price that buyers are willing and able to pay for the good over the actual price paid

• Defined as the extra satisfaction gained by consumers from paying a price that is lower than that which they are prepared to pay
• Represented by the area under the demand curve and above the equilibrium price

Producer Surplus

The excess of what a producers is willing and able to put up for sale for a good over the actual price he receives

• Defined as the excess  of actual earnings that a producer makes from a given quantity output, over and above the amount the producer would be prepared to accept for that output
• Represented by the area under the equilibrium price and above the supply curve.

Government Intervention

Indirect taxes

• Specific/Per-unit tax: fixed amount of tax per unit of a good
• Ad valorem tax: Percentage of the SALE price of a commodity

Supplier’s view towards tax: Adds to Cost of Production

• Supply curve SHIFT left
• Represented by vertical distance between 2 SS curves
• Does not affect Demand, affects Qd

Effect of tax: Raise equilibrium price and reduce Qty exchanged

Tax incidence: Division of tax between Consumers and Producers

• Consumers pay taxes to the extent of Px increase
• Producers pay taxes to the extent of Px increase not enough to cover the tax
• Amount of tax burden that producers can shift to consumers depends on relative Px elasticity of Demand and Supply
• More Px elastic demand, greater incidence on producers
• More Px inelastic demand, greater incidence on consumers
• More Px elastic supply, greater incidence on consumers
• More Px inelastic supply, greater incidence on producers

Subsidy

Per unit subsidy is a fixed amount of money given to the producers for each unit they sell

Effects

• Lowers Cost of Production
• Supply curve SHIFT right
• Raises producers income
• Lowers equilibrium Px and increase Qty exchanged
• Transfer of income from taxpayers to producers, when tax revenue pays for subsidy
• Extra resources allocated to subsidised industries/sectors

Price Controls

Objectives

• Keep Px of good at affordable level
• Support incomes at higher level than market equilibrium
• Stabilise Px
• Prevent exploitation by suppliers in times of shortage

Price Floor

• Effective Px Floor: Legally established minimum Px above the market equilibrium
• Creates surplus
• Government may absorb surplus
• Inefficient allocation of resource (Agricultural produce Px floor)
• Unemployment (Minimum wage law)

Price Ceiling

• Effective Px Ceiling: Legally established maximum Px below the market equilibrium
• Creates shortage
• Rationing may be needed
• Goods sold on 1^st come 1^st serve basis
• Inefficient allocation of resource (too little produced)
• May result in Black Market

Black Market

• Sellers ignore government’s price restrictions and sell illegally at whatever Px equates illegal DD and SS
• If all goods are sold in black market, Px = point on DD where Qs intersects, higher than normal equilibrium Px
• Normally, only some Qty of Px controlled good is sold in black market
• When Price Ceiling and Black Market co-exist, government will only achieve goal of restricting production, but cannot keep prices down or satisfy notion of equity in the consumption of temporarily scarce commodity

Appendix

• The Utility Theory
• The Diamonds-Water Paradox