04 Market Outcomes and Tax Incidence

pg108-141

Misconception - Tax on firms do not affect consumers.

What Are Consumer Surplus and Producer Surplus?

Welfare economics is the branch of economics that studies how the allocation of resources affects economic well-being.

Consumer Surplus

The willingness to pay is the maximum price a consumer will pay for a good or service.
Consumer Surplus is the difference between the willingness to pay for a good (or service) and the price that is paid to get it.

Willingness to Pay for a New Economics Textbook

Producer Surplus

The willingness to sell is the minimum price a seller will accept to sell a good or service.
Producer Surplus is the difference between the willingness to sell a good (or service) and the price that the seller receives.

Willingness to Sell Tutoring services

When is a Market Efficient?

Adding consumer and producer surplus gives us total surplus, also know as a social welfare, because it measures the well-being of all participants in a market, absent any government intervention. Total surplus is the best way economists have to measure the benefits that markets create.
When an allocation of resources maximizes total surplus, the result is said to be efficient.

The Efficiency-Equity Debate

Equity refers to fairness of the distribution of benefits among the members of a society.

Economics in Media
Efficiency
Old school

Total Surplus: How Would Lower Consumer Income Affect Urban Outfitters?

Why Do Taxes Create Dead-weight Loos in Otherwise Efficient Markets?

Tax Incidence

• Excise tax - are taxes levied on a particular good or service.
• Incidence - refers to the burden of taxation on the party who pays the tax, regardless of whom the tax is actually levied on.

Example 1: Tax on Buyers

Each time a consumer buy a gallon of milk, the cash register adds $1.00 in tax. This means that to purchase the milk, the consumer must be will to pay the price of the milk plus the $1.00 tax.

Figure 4.6
A Tax on Buyers
After the tax, the new equilibrium price (E2) is $3.50, but the buyer must also pay $1.00 in tax. Therefore, despite the drop in equilibrium prices, the buyer still pays more for a gallon of milk: $4.50 instead of the original equilibrium price if $4.00. A similar logic applies to the producer. Because the new equilibrium prices after tax is $0.5 lower, the producer shares the tax incidence equally with the buyer in this example. The consumer pays $0.5 more,and the seller nets $0.5 less.

Example 2: Tax on Sellers

Now let's look at what happens when the $1.00 tax on milk is place on sellers.

Figure 4.7
A Tax on Sellers
After the tax, the new equilibrium price (E2) is $4.50, but $1.00 must be paid in tax to the government. Therefore, despite the rise in price, the seller nets only $3.50. Similar logic applies to the consumer. Because the new equilibrium price after tax is $0.5 higher, the consumer shares the $1.00 per gallon tax incidence equally with the seller. The consumer pays $0.5 more, and the seller nets $0.5 less.

So who bears the incidence of the tax?

The incidence of a tax is independent of whether it is levied on the buyer or the seller. However, depending on the price elasticity of supply and demand, the tax incidence need not to be shared equally. All of this means that the government doesn't get to determine whether consumers or producers hear the tax incidence -the market does.

Deadwight Loss

Deadwight Loss is the decrease in economic activity caused by market distortions.

Figure 4.8
The Deadweight Loss from a Tax
The yellow triangle represents the deadweight loss caused by the tax. When the price rises, all consumers who would have paid between $4.01 and $4.50 no longer purchase milk. Likewise, the reduction in revenue the seller receives means that the seller receives means that producer who were willing to sell a gallon for between $3.50 and $3.99 will no longer do so.

Economics In the Media
Tax Inelastic Goods
"Taxman," by the Beatles

Tax Revenue and Deadweight Loss When Demand is Inelastic

• Necessary goods and services - for example, water, electricity, and phone service - have highly inelastic demand.
• When demand is perfectly inelastic, the incidence, or the burden of taxation, is borne entirely by the consumer. A tax on good with almost perfectly inelastic demand represents a transfer of welfare from consumers of the good to the government, reflected by the reduced size of the blue rectangle in panel (b).

Figure 4.9
A Tax on Products with Almost Perfectly Inelastic Demand
(a) Before the tax, the consumer enjoys the consumer surplus (C.S.) shaded in blue, and the producer enjoys the producer surplus (P.S.) shaded in red. (b) After the tax, the incidence or the burden of taxation, is borne entirely by the consumer. A tax on a good with almost perfectly inelastic demand, such as phone service, represents a transfer of welfare from consumers to government, as reflected by the reduced size of the blue rectangle in (b) and the creation of the green tax revenue rectangle between P1 and P2.

Tax Revenue and Deadweight Loss When Demand is More Elastic

Figure 4.10
A Tax on Products with More Elastic Demand
(a) Before the tax, the consumer enjoys the consumer surplus (C.S.) shaded in blue, and the producer enjoys the producer surplus (P.S.) shaded in red. (b) A tax on a good for which demand and supply are both somewhat elastic will cause a transfer of welfare form consumers and producers to the government, the revenue shown as the green rectangle. It will also create deadweight loss (D.W.L), shaded in yellow, because the quantity bought and sold in the market declines (from Q1 to Q2).

Tax Revenue and Deadweight Loss When Demand is Highly Elastic

For example, a customer who wants to buy fresh lettuce at a producer will find many local growers charging the same price and many varieties to choose from. If one of the vendors decides to charge $1 per pound above the market price, consumers will stop buying from the vendor. They will be unwilling o pay more when they can get the same product from another grower at a lower price. In other words, their demand is highly elastic.

Figure 4.11
A Tax on Products with Highly Elastic Demand
(a) Before the tax, the producer enjoys the producer surplus (P.S.) shaded in red. (b) When consumer demand is highly elastic, consumers pay the same price after the tax as before. But they are worse off because less is produced and sold; the quantity produced moved from Q1 to Q2. The result is deadweight loss (D.W.L.), as shown by the yello triangle. The totoal surplus, or efficiency of the market, is much smaller than before. The size of tax revenue (shaded in green) is also noticeably smaller in the market with highly elastic demand.

Interaction Of Demand Elasticity and Supply Elasticity

Figure 4.12
A Realistic Example

Economics In the Real World.
The Short-Lived Luxury Tax

Balancing Deadweight Loss and Tax Revenue

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