Remember that quantity demanded must equal quantity supplied or the market will not be stable. This mirrored decrease in quantity ensures this is still the case. Again, this is due to elasticity, or the relative responsiveness to the price chance, which will be explored in more detail shortly. While a tax drives a wedge that increases the price consumers have to pay and decreases the price producers receive, a subsidy does the opposite. A subsidy is a benefit given by the government to groups or individuals, usually in the form of a cash payment or a tax reduction.
A subsidy is often given to remove some type of burden, and it is often considered to be in the overall interest of the public. In economic terms, a subsidy drives a wedge, decreasing the price consumers pay and increasing the price producers receive, with the government incurring an expense.
In response, the government has enacted many policies to allow low-income families to still become homeowners. Note the following policy is unrealistic but allows for easy comprehension of the effect of subsidies. With all government policies we have examined so far, we have wanted to determine whether the result of the policy increases or decreases market surplus. With a subsidy, we want to do the same analysis. Unfortunately, because increases in surplus overlap on our diagram, it becomes more complicated.
To simplify the analysis, the following diagram separates the changes to producers, consumers, and government onto different graphs. This increases producer surplus by areas A and B. This increases consumer surplus by areas C and D. To summarize:.
Areas A, B, C and D are transferred from the government to consumers and producers. There are two things to notice about this example. First, the policy was successful at increasing quantity from 40, homes to 60, homes.
Second, it resulted in a deadweight loss because equilibrium quantity was too high. Remember, anytime quantity is changed from the equilibrium quantity, in the absence of externalities, there is a deadweight loss.
This is true for when quantity is decreased and when it is increased. Taxes and subsidies are more complicated than a price or quantity control as they involve a third economic player: the government.
As we saw, who the tax or subsidy is levied on is irrelevant when looking at how the market ends up. Note that the last three sections have painted a fairly grim picture about policy instruments. This is because our model currently does not include the external costs economic players impose to the macro-environment pollution, disease, etc.
These concepts will be explored in more detail in later topics. In our examples above, we see that the legal incidence of the tax does not matter, but what does? To determine which party bears more of the burden, we must apply the concept of relative elasticity to our analysis. Which areas represent the loss to consumer AND producer surplus as a result of this tax? Which areas represent the gain in government revenue as a result of this tax?
Thus, small taxes have an almost zero deadweight loss per dollar of revenue raised, and the overhead of taxation, as a percentage of the taxes raised, grows when the tax level is increased. Consequently, the cost of taxation tends to rise in the tax level. Previous Section. Table of Contents. Next Section. Figure 5. Key Takeaways Imposing a tax on the supplier or the buyer has the same effect on prices and quantity.
The effect of the tax on the supply-demand equilibrium is to shift the quantity toward a point where the before-tax demand minus the before-tax supply is the amount of the tax. A tax increases the price a buyer pays by less than the tax. Similarly, the price the seller obtains falls, but by less than the tax. The relative effect on buyers and sellers is known as the incidence of the tax. There are two main economic effects of a tax: a fall in the quantity traded and a diversion of revenue to the government.
A tax causes consumer surplus and producer surplus profit to fall.. Some of those losses are captured in the tax, but there is a loss captured by no party—the value of the units that would have been exchanged were there no tax.
These lost gains from trade are known as a deadweight loss. Small taxes have an almost zero deadweight loss per dollar of revenue raised, and the overhead of taxation, as a percentage of the taxes raised, grows when the tax level is increased. If sellers pay a cent tax, what is the after-tax supply? If buyers pay a cent tax, what is the after-tax demand? Do the same computations as the previous exercise, and show that the outcomes are the same.
What is the equilibrium quantity traded as a function of t? What is the revenue raised by the government, and for what level of taxation is it highest? As a result, the entirety of the tax will be borne by the consumer. Generally consumers and producers are neither perfectly elastic or inelastic, so the tax burden is shared between the two parties in varying proportions. If one party is comparatively more inelastic than the other, they will pay the majority of the tax. A tax increase does not affect the demand curve, nor does it make supply or demand more or less elastic.
This potential increase in tax could be called marginal, because it is a tax in addition to existing levies. Answer the question s below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times. Use this quiz to check your understanding and decide whether to 1 study the previous section further or 2 move on to the next section.
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