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